The unlamented decline of hedge funds

published 10 January 2016

160109-hedge-funds — Hedge funds won't be mourned

For much of the last 15 years, it was hard to look at any rich list without seeing some young hedge-fund manager who had made themselves a few hundred million by trading in some exotic instrument that few of us had ever heard of. For most young financiers, hedge fundswas the sector to work in the founders made tens of millions, while the staff were invariably paid far more than they would be elsewhere.

Now, however, the tide appears to be turning. Seneca Capital is just the latest of a number of high-profile hedge funds to close their doors to outside investors. Earlier in the month LionEye shut down, and in October Lucidus Capital Partners and BlueCrest Capital Management also closed to outsiders. Even George Soros, in many ways the founder of the modern hedge-fund industry, has shut his fund to outsiders. In total, more than 600 funds closed in the first nine months of last year, according to figures from Hedge Fund Research. Even those that remain are not doing very well. Europe's largest fund, Brevan Howard, which used to boast it had never lost money for investors, has now made losses for two years in a row on its flagship fund.

True, it is still too early to call time on the sector. There are still many new hedge funds being launched. According to Hedge Fund Research, more than 700 were started last year, which was down on 800 a year earlier. That is slightly more than there were closures. But the new ones are far smaller than those that are closing. Overall, the money flowing into hedge funds was down 40% in 2015, according to the data firm eVestment. It seems clear that the expansion is now over. A few will carry on, some will still do well, and there will be the occasional successful launch. But they are unlikely to dominate the market much longer.

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There was never very much evidence that they made much money for their investors. Very few funds managed consistently to beat the market, certainly when compared with other forms of pooled investment. Nor did many of them seem able to go against the trend, which was supposed to be the whole point of them during a bull market they made money and in a bear market they lost it, much like everyone else.

The more interesting question is whether they added anything of value to the way markets work. Most forms of financial innovation are unfairly criticised. The corporate raiders of the 1980s were often brash, and certainly cut a few corners, but they also sharpened up the performance of many traditional industries and broke up unwieldy conglomerates. They generally left firms in better shape than they found them. The private-equity industry made capital work more efficiently, replacing equity with debt, and many funds have been surprisingly effective owners of the firms in their portfolio, especially in mature industries where nobody else would be paying much attention to them.

Swaps, futures and derivatives, despite being famously described by Warren Buffett as "weapons of financial mass destruction", still play a useful role in protecting companies against price fluctuations, even if the size of the sector has become wildly exaggerated. Even the much criticised high-frequency traders add liquidity to the market, although probably quite a bit more than we really need. Many of those industries became too big, but, at root, they were addressing a genuine need.

But the hedge funds? It is hard to work out any way in which they benefited anyone other than their founders, and the few investors who managed to back the occasional successful one early on. If they had genuinely found a way of improving investment performance at a lower cost, that would have been great. But they didn't (as it happens, the exchange-traded funds have done that, and done it very well). Or if they had found ways of delivering capital to businesses that wouldn't otherwise get it, that too would have been very useful. But they didn't (as it happens, peer-to-peer lending, along with crowd-funding, is doing that instead). In fact, their only real innovation was a fee structure that was massively generous to the people running the fund and punitively unfair to the people investing in it. It is hard to see much wider benefit from that.

Worse, they created three big problems. Plenty of people think the City exists mainly to make a few traders very rich without doing anything worthwhile and the hedge funds had a tendency to confirm that damaging impression. They sucked up a lot of talent that might otherwise have gone to work on something more useful and more valuable in the long term. And the massive incentives to make quick profits probably contributed to the short-termism of which the financial industry is already guilty.

Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years.

He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.