Why Are Hedge Funds Struggling in 2014?


Stock markets meandered throughout last week, with the DJIA down 0.3% and the S&P 500 losing 0.1%.  After broadly rising in the first part of the week, stocks fell quickly on Friday as fears of geopolitical risk resurfaced once again.   

Domestic economic data was on the lighter side, with housing, manufacturing and consumer sentiment the only real data to digest.   

Housing figures suggested that weather continued to influence market conditions, particularly in the case of new home sales.  

 During March, new home sales fell 14.5% to 384,000 on a seasonally adjusted annual basis.  Conditions were weak in most regions, but areas such as the West (down 16.7%) and South (down 14.4%), were the hardest hit.  Resulting from the slowdown in sales, the inventory of unsold homes jumped 3.2%, returning to late 2010 levels.   

Existing home sales fared modestly better, but still retrenched 0.2% in March.  Existing home sales have fallen in seven of the previous eight months.  Along with falling sales, prices of existing home sales has fallen, nearing prices from the middle of last year.  The good news is that falling prices acted as an offset to rising mortgage rates, keeping home affordability in check.  

Elsewhere, manufacturing data offered a more optimistic picture of the economy.  Durable goods orders rose 2.6% in March after a 2.1% gain in February.  Strength was broad based, but usually volatile sectors like transportation experienced strong gains.  Additionally, solid numbers were seen in computers & electronics, electrical equipment and nondefense capital goods.   

On a regional perspective, the Kansas City and Richmond Manufacturing surveys were both in positive territory for the most recent month.  In both regions, new orders were positive, indicating that momentum in the manufacturing sector could be here to stay.    

The only piece of news on consumers came from the Consumer Sentiment survey.  Relative to its initial April reading of 82.6, the final April figure of 84.1 suggests growing confidence among consumers.  In fact, according to Econoday, April’s reading was the “third best of the recovery.”  Consumers’ expectations for the economy looking forward remain in a tight range, albeit at the higher end of that range, but consumers are feeling significantly better about current conditions.  The current conditions index jumped to 98.7 in April, which is the highest level since the recovery began.   


Source: Econoday 


2014 has been a year marked by shaky equity markets and relatively higher volatility than observed in 2013.  With falling equity market correlations and increased stock dispersion, it was presumably a more favorable environment for hedge funds.  Unfortunately, that has not been the case as most alternative investment approaches are posting less than stellar results so far this year. 

While on the surface a 1.3% first quarter return from the HFRI Equity hedge index was not terrible compared to the S&P 500’s 1.8% gain, it masks a disappointing March for many managers that erased the positive alpha they built up in the first two months of the year.  In fact, March ultimately ended up being the first negative month for the HFRI index coinciding with a positive S&P 500 since 2011.  Most reports indicated that trend has continued into April, with the broad long/short universe now just slightly positive for the year, despite a positive 2% return in the broad markets.  


The clearest explanation for these performance struggles was the much-ballyhooed rollover in high momentum growth stocks – particularly in technology and biotech.  What had been a source of consternation for many short books in 2013 slowly grew to become a more prominent long exposure within many portfolios, according to data compiled by Credit Suisse.  Based on Barra analysis performed by that group, momentum factor exposure quadrupled between the start of 2013 and March 2014. 

Source: Credit Suisse Prime Services 

The unwind in high momentum stocks caused dramatic losses for many hedge funds.  Hedge fund Coatue Management, for example, is widely reported to be returning more than $2 billion to investors after the recent uptick in volatility.  The technology-focused former Tiger Cub reportedly lost 9% in the month of March.  Another Tiger Cub, Rob Citrone of Discovery Capital, also reportedly lost 9% in March and ended the first quarter down more than 7%. 

Outside of this phenomenon, a number of widely owned value oriented names performed poorly as well, preventing other investor types from escaping the first quarter unscathed.  Fannie Mae and Freddie Mac, of which the common and preferred equity is widely owned by hedge funds, plunged in March amid a Senate-proposal to shut down the entities.  General Motors, another popular turnaround story owned by a number of managers, was down 20% through March amid recall issues and allegations of cover-ups of known safety problems. 

On the macro side, reversals in several key markets have proven to be a source of frustration for many.  After a 60% run in 2013, the Nikkei sold off sharply amid heightened skepticism over the Bank of Japan’s ability to execute its plan to increase inflation and weaken its currency.  Rebounds in the yen and US interest rates were also unexpected and caught many portfolios mis-positioned.  This has left global macro and CTA funds on track for their fourth consecutive annual decline. 

Despite the recent issues, hedge fund assets continue to climb.  Based on data compiled by Hedge Fund Research (HFR), total hedge fund assets hit a new record high of $2.7 trillion at the end of the quarter.  The latest data from Preqin shows that 92% of institutional investors plan to increase or maintain their allocations to hedge funds in the next 12 months.

Sophisticated investors continue to cling to the belief that these strategies will help insulate their portfolios from the buffeting forces of global financial markets.  While conditions have largely been benign since Mario Draghi created his own version of the Bernanke-put nearly two years ago, recent stress in Ukraine/Russia serves to remind investors how quickly risk sentiment can change – particularly in the context of dissipating Fed support.  One must hope that hedge fund managers have not assimilated too much to the recent environment so that they can still deliver on their expected value proposition. 


In contrast to last week, there will be plenty of economic news to digest in the week ahead.  Markets will be attuned to consumer confidence, 1st quarter GDP growth and nonfarm payrolls.   

On the policy front, central bank meetings in Israel, Egypt, Hungary, US and Japan will be the most closely followed. 


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