The World’s Smartest Investors Can’t Figure Out The Markets…And That’s A Really Bad Thing

Hedge fund managers sit at the top of the financial world’s food chain. They’re generally seen as the smartest money managers, and their companies have the most flexibility to pursue new opportunities. The result is supposed to be the best possible returns – for clients who can afford the high fees.

But lately things haven’t worked out that way. Hedge fund managers appear baffled by the behavior of stocks, bonds and pretty much everything else, as time-tested strategies fail and brand-name managers report terrible results, in a growing number of cases throwing in the towel, returning their investors’ money and riding off into the sunset.

To take one of many recent examples, Cerrano Capital LLC, according to the Wall Street Journal “a $700 million hedge fund backed by some of the industry’s biggest names,” announced its closure after less than a year in business. Its initial results were lackluster and the manager reportedly tired of the cold reception he received from potential investors.

A higher-profile mess is David Einhorn’s Greenlight Capital, which through August of this year was down 25% versus an 8.5% gain for the boring old S&P 500 – an index that can be owned via ETFs for vanishingly low fees.

Then came October’s brutal takedown of tech and finance stocks, which you’d think would provide both vindication and quick profits for the hedge funds that had previously lost big by ignoring and/or shorting those obviously-overpriced sectors.

But no. It turns out that most hedge funds had given up on the traditional long/short hedge-your-bets approach and simply piled into the hottest momentum plays, getting crushed when those stocks finally tanked. Some notable casualties:

Daniel Loeb’s Third Point down 6%, or roughly $1 billion in October.

Tiger Global Management down 9.4%

Soroban Capital Partners 9%

Glenview Capital Management 11%

Melvin Capital Management 15%

On October 24 alone, long/short equity hedge funds lost an average of 1.44%.

Why is this happening and why should anyone care?

First and least bad, the number of hedge funds has exploded in the past couple of decades. But the number of extraordinary money managers didn’t increase commensurately. So a rising supply produced declining quality, which is now showing up in unfavorable results. That’s no big deal. All markets experience periodic gluts and manage them via die-offs which bring things back into balance. This is healthy.

Second and emphatically not healthy, the world’s governments have reacted to past financial crises by creating trillions of dollars of new currency and buying up financial assets to protect the big banks that finance incumbents’ reelection campaigns and to generate a “wealth effect” to maintain economic growth.

Why is this bad? Because governments and central banks don’t discriminate. They just buy representative assets across the board, pushing prices of securities up in lock-step. This produces rising “markets” but makes old relationships between price, earnings, yield, cash flow, etc., obsolete. Put another way, if everything is going up in concert, then investment models based on some securities being more attractive than others stop working.

Combine an influx of new, less-competent managers with the failure of the strategies that used to work and you get today’s hedge fund universe, full of former winners who are now reduced to trend following to keep their clients. And who will be absolutely crushed if Apple, Google, Facebook, et al return to their intrinsic values 50-or-so percent below current prices.

By why is this bad? Because capitalism operates via prices, which tell people with capital how to allocated it (hence the term capitalism). Cripple the price signaling mechanism by indiscriminately pushing up prices within entire asset classes, and capital is allocated randomly rather than efficiently. Projects that shouldn’t be financed go ahead, and then eventually fail.

Since the capital market pricing mechanism has been perverted not just here but pretty much everywhere, it’s safe to assume that the amount of misallocated capital in the world is at a record high. Which means the failures when they come will be many, varied, and huge. Hedge funds, viewed this way, are canaries in the financial coal mine, their failures pointing towards much bigger ones to come.

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