How Hedge Funds Lost Their Way and Why They’ll Come Back

Nir Kaissar

April 13, 2021

Stock pickers appear ready to come out of the wilderness.

There’s no shortage of shiny objects for investors to chase these days, from Bitcoin to SPACs to NFTs to pot stocks to GameStop and green energy. Notably missing from the list are equity hedge funds, and they have been for many years. But that may be about to change.

Equity hedge funds once ruled the investing world. During their heyday in the 1990s and 2000s, hedgies seemed to have a freakish gift for picking stocks, racking up big returns for their clients and themselves. Investors begged to get in, and only the richest and most connected among them got a nod, which made hedge funds all the more alluring.

Then, suddenly and mysteriously, they seemed to lose their touch. The HFRI Equity Hedge Total Index returned 14% a year from inception in 1990 through the financial crisis in 2008, doubling the total return of the S&P 500 Index. Since 2009, however, the tables have turned. The HFRI index has returned 8% a year through February, roughly half the return of the S&P 500.

To understand what happened, and why fortune may return for equity hedge funds, it helps to know a bit about how stock pickers make money for investors. They basically have three levers. The first, and by far the most consequential, is merely owning a broad basket of stocks, which all but guarantees that their portfolio will move in close step with the stock market. Not surprisingly, the HFRI index has been strongly correlated with both the U.S. stock market (0.76 with S&P 500) and the global stock market (0.78 with MSCI All Country World Index) since 1990. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.) In other words, when the stock market goes up, so do most stock portfolios.

Second, and far less consequential, is the stock pickers’ preferred style of investing. A picker with a penchant for growth stocks, for example, is likely to outpace the market when growth stocks are in favor. The same is true for any other style of investing, be it value, momentum, quality or something else.

Third, and almost entirely inconsequential, are the specific stocks selected. Sure, it’s possible that after accounting for the performance of the broad market and the manager’s preferred style, that manager will have added some value by picking one growth stock rather than another, to extend the previous example. But it’s exceedingly unlikely.

In sum, the return from stock picking = market + style + stock selection.

That simple equation has profound implications. It means that, with rare exception, what distinguishes one stock picker from another is style because most pickers are exposed to the market, and the specific stocks they choose are largely irrelevant. As a result, stock picking comes down to being in the right style at the right time. Growth managers will fare best when growth investing is hot, and value managers will shine when value investing has the edge, and so on.

That’s a problem for most stock pickers because they’re often confined to one style. Someone who manages a U.S. large-cap growth mutual fund, for instance, can’t decide to start buying small value companies in emerging markets. But this is where hedgies have a distinct advantage because they’re generally free to invest anywhere.