Nov 24/15 – Hedge fund underperformance – an ominous sign?

2015-11-24 1pm EDT  |  #hedge funds #HYG #JNK #SUNE

Every time I turn around another hedge fund is blowing up or closing. I know the industry has experienced massive growth and some weeding out is to be expected, but the recent downturn has been unusually brutal.

Have a look at this great chart from Goldman Sachs that shows the performance of hedge funds versus the S&P 500 over the past fifteen years.

Apart from the 2008 financial crisis, this has been the most difficult period for hedge funds since the turn of the century.

There are a lot of different theories about the reasons for this underperformance, but I think the main over riding factor is the poor performance of credit. Since the 2008 credit crisis, hedge funds have relied on cheap money fuelled by an ever accommodative Federal Reserve. Whether it was David Tepper who figured out how to ride the QE wave directly, or Carl Icahn who “encouraged” targets to lever up their balance sheet by issuing debt and buying back equity, hedge funds have milked the abundant liquidity to its fullest.

Now that liquidity is not so plentiful, hedge funds are having a difficult time adapting. The credit markets are continuing to recoil, and this is weighing heavily on hedge funds’ typical themes.

Take for example SunEdison. The company has problems, but the credit market’s shutting off the tap has made the situation infinitely worse.

This particular SUNE bond in the chart above is priced at 27 is now yielding 21.6%. The credit market has completely closed for SUNE making any bounce in their equity price extremely difficult. SUNE has almost $3 billion of debt, with an equity value of only $1 billion, so the bond market is now setting the tone for the stock price.

Although this is an extreme case, at the margin this is happening everywhere. Credit markets are not bouncing, and just keep grinding lower.

Have a look at the two big high yield bond ETFs:

With the Federal Reserve readying participants for higher rates, the markets are being slowly starved of oxygen. This is showing up in the credit markets first. We are seeing other strange effects (like negative swap spreads), but the Federal Reserve’s actions are affecting all financial markets (and not in a good way). Hedge funds are simply more finely tuned towards these financial conditions than most other investors. Maybe I am being too generous. Maybe I should say hedge funds are more leveraged to this liquidity than other investors.

Let’s not forget prior to the 2008 credit crisis, the two famous Bear Stearns real estate hedge funds that collapsed way before the problem was even on the radar of most regular investors. This could well be a repeat of the same affair.

The recent hedge fund disastrous performance might be an ominous sign of more financial market turmoil to come. Often when these sorts of unwinds start, the mistake is assuming that is over too quickly…

Thanks for reading,

Kevin Muir

the MacroTourist