Are Hedge Funds Beginning to Right Size Themselves?

There are some signs that the hedge fund industry is moving towards a more appropriate capital base. Leo Kolivakis, who covers hedge funds and other classes of investment for Canadian pension funds, noted that outflows from hedge funds have picked up recently. Mediocre returns delivered at great expense for several years may be starting to focus attention on the $2TN size of the industry and perhaps cause investors to question their previously held return expectations. The Alternative Investment Managers Association (AIMA) in London, the lobbying group for the industry, must be surprised. They keep issuing reports and analyses telling everybody how good hedge funds have been, although this view seems at odds with the actions of departing investors.

Of course some hedge fund managers are taking the initiative and returning capital to clients, such as Louis Bacon. The industry could use more managers who recognize the prevailing limits on their own strategies. But overall, the article finds that assets are s23% lower than their peak just prior to the financial crisis four years ago.

The problem with the structure of AIMA’s analysis is that it doesn’t contemplate that the industry could ever be overcapitalized, whereas that is what empirical evidence strongly suggests. Fortunately, it’s beginning to look as if hedge fund investors are questioning AIMA’s orthodoxy. 2012 will likely be the 10th straight year in which a simple 60/40 stocks/bonds portfolio has beaten the broad hedge fund industry averages. In a win for the little guy, it’s turning out that investors with quite modest means that render them unqualified to be a “sophisticated” investor (and therefore eligible to be a hedge fund client) are quite easily and cheaply able to outperform investors who have signed up with the Masters of the Universe.

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