Are Hedge Funds Growing Out of Control?

The number of hedge funds and the amount of capital they control has been growing at an incredible rate recently. Yet the out-sized returns promised by hedge fund managers have failed to materialize for most investors. While most hedge funds are closely held entities that only the super-wealthy can invest in, the presence of major pensions and university endowments sheds a meaningful amount of light on the industry.

Given the limited data available, hedge funds in aggregate have not been beating the market at all. A very few funds have had well-publicized returns in excess of 300%, but the enormous expense ratios associated with these funds mean that only the managers are getting truly wealthy. An annualized return well in excess of 100% after all expenses seems to be well worth the limited investor control, but the risks that were undertaken to achieve these returns are essentially unknowns.

One Houston-based hedge fund made headlines when it lost billions of dollars in investor cash due to natural gas options. The market moved unpredictably and the smart money got burned. Or did it? Another Houston-based hedge fund made billions taking the opposite position on natural gas during this same period. In essence, one group of smart guys ended up taking all the money that used to belong to the not-so smart guys. The only question investors need to ask themselves is if they can tell the difference between the winners and the losers.

The real trouble with the growth of hedge funds, however, is that their returns are starting to correlate much more closely with the rest of the market. As hedge funds grow in size, it becomes difficult to aggressively invest without coming to resemble a very expensive mutual fund.