“No matter how you “slice-and-dice the data,” hedge funds are struggling to meet their promise to clients to consistently produce high returns with low correlation to markets. It’s kind of: ‘I promise you a Rolls Royce and I give you a Honda.'” – Matt Granade, Chief Market Intelligence Officer, Point72 Asset Management

There are more hedge funds in the world than Dunkin’ Donuts. What does that statement have to do with negative alpha? Everything.

Too many funds + similar strategies + limited opportunity set + high fees = underwhelming returns. Simply put: there’s not enough alpha to go around.

Back in the day, long/short equity funds (the largest hedge fund strategy by assets) actually used to hedge. They used to take risk. They used to look quite different than the overall stock market. And they used to deliver alpha.

How do they look today?

In aggregate, like a lower beta version of an index fund. With a correlation of 0.87 to the S&P 500 over the past few years, they pretty much move in lockstep with the market.

Note: the HFRI Equity Hedge Index is comprised of investment managers who maintain positions, both long and short, in primarily equity and equity derivative securities.

With such a high correlation, those using long/short funds to “protect” against the next bear market are likely to be highly disappointed when it comes.

How do we know this? We have a number of data points in recent years.

In 2008, when the S&P 500 lost 37%, long/short funds were down 26.7%. In 2011, when the S&P 500 dropped 16.3% from May through September (monthly closing basis), long/short equity funds lost 13.2%.

Since March 2009, the S&P 500 has had 29 down months with an average return during those months of -2.9%. Long/Short funds were down in 28 out of 29 of those months with an average return of -1.8%.

As long as their net exposure to the broad market remains high (not a lot of hedging), investors should expect the next downturn in equities to lead to a similar result.

This might be acceptable if long/short funds were “delivering alpha” as promised, but as you can see in the chart below, the only alpha delivered in recent years has been negative.

Investors who merely wanted a lower correlation equity option would have been better served with a simple combination of 50% Utilities/50% Consumer Staples (2 lowest beta sectors) than an exposure to long/short funds.

The returns since 2003 are not even close, and such a combination (Utilities/Staples) even outperformed in 2008. Beyond performance, there is no comparison in terms of increased transparency/liquidity and lower fees from Utilities/Staples ETFs versus a hedge fund.

Note: Many Hedge Fund Investors believe that the HFRI Equity Hedge Index overstates returns due to survivorship bias. As such, I have also included the investable HFRX Equity Hedge for comparison purposes. Actual performance is likely somewhere in between the two.

That’s not to say there aren’t unique long/short hedge funds out there that actually do something different and add value to a diversified portfolio over time. There certainly are, but not nearly as many as people believe and picking them before they exhibit strong performance is not nearly as easy as advertised.

Overall, long/short equity as an asset class has not been additive to portfolios in years. What could change that? Less funds chasing the same opportunities, with more alpha to go around.

On that front, the market finally seems to be moving in the right direction, on pace for a 3rd straight year of net hedge fund closures:

“Thus far this year (through the second quarter, the most recent date for which HFR has data available), 481 hedge funds have shut down, compared with the 369 that have been launched. 2017 is on track to be the third straight year that the number of liquidations have outpaced the number of funds coming to market.” – Source: HFR, MarketWatch

Is that enough for these funds to start delivering alpha again? Only time will tell, but as long as there’s more hedge funds than Dunkin’ Donuts, count me a skeptic.