Investors Exit Hedge Funds After Another Bad Month

Hedge funds wrapped up another lackluster month in August by substantially underperforming the stock market, and investors are showing signs that their patience is wearing thin.

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Swelling redemptions have been a noticeable trend over the past three months, which have seen a net of $15.56 billion in outflows from the $2.52 trillion industry.

The funds saw redemptions of $11.81 billion for July, the most recent month for which data is available, with fixed income the only strategy to see inflows, according to eVestment, a New York-based hedge fund research firm. Fund flows for the the full year, though, remain positive at $9.93 billion.

The recent flight is reflective of difficulties the industry has seen in a highly correlated market driven far more by the latest news out of Europe or Washington and not by individual company performance, experts say.

While the Standard & Poor's 500 posted a total return gain 2.25 percent in August, hedge funds rose just 0.66 percent. The story has been the same throughout the year, where the stock market has risen 13.5 percent and hedge funds have gained about 4.1 percent.

"This year has been very difficult for long-short equity managers. The past few years have been very difficult because the market has been driven by macro events and most managers are fundamentally driven and they do best when fundamentals are driving stock prices," says Don Steinbrugge, managing member at Agecroft Partners in Richmond, Va.

"In addition, long-short equity managers tend to have a certain part of portfolios allocated outside the U.S., and the U.S. has significantly outperforrmed the rest of the world," he adds. "So anyone who's had exposure to stocks outside the U.S. has had a difficult time keeping up with the S&P 500."

One exception to the weak performance came in large funds — with more than $1 billion in assets under management — which returned 1.9 percent to record their best month since January, according to eVestment.

But managers warn that one of the problems facing the hedge fund industry is that in stressful times investors tend to move toward the bigger funds, which historically have underperformed their smaller counterparts.

"Once a fund becomes so large (multiple billions), it becomes much more difficult for the manager to successfully generate strong investment returns," George Schultze at Schultze Asset Management in Purchase, N.Y. said in an email interview. "This is because their universe of tradable ideas gets much smaller."

Schultze believes that "smaller, more nimble managers that are able to invest long- and short- across a wide range of companies and/or securities" will benefit in the current climate.

That has long been the case for the hedge fund industry, even though some of the larger names in the business get all the press. Hedge funds cater to institutions and wealthier investors and are less regulated than their mutual and exchange-traded counterparts.

From 1996 to 2010, the cumulative total return for small funds was 576.91 percent, mid?size was 370.12 percent, and large was 317.74 percent, according to a study from data firm PerTrac.

Investors, though, often trend toward the comfort of the larger funds — run by big names like John Paulson and Jim Chanos — because they have less volatility and tighter controls.

"There is a tradeoff," says Jed Alpert, managing director of global marketing at PerTrac. "Small funds may not have all the robust operational and risk systems in place...Endowment and pensions looking to put money to work will invest in larger funds."

Indeed, the industry remains a challenge to large investors looking for places to profit.

Schultze warns, for instance, that fixed income, which has brought in a whopping $23 billion this year to lead all strategies by a wide margin, "is completely overvalued and is likely going to set up to be the short trade of our lifetimes."

With long-short strategies — and virtually all asset classes — at the mercy of headlines, the challenge will not be easy.

"I don’t see a decline in demand for hedge funds, I see an increase in demand for hedge funds," says Steinbrugge, the manager at Agecroft. "One of the primary drives for an increase in demand for hedge funds is coming from large institutional investors...They look at hedge funds as a way to both diversify their portfolio and also enhance the overall return of their fund."