For awhile there, I started to doubt one of the basic tenets of capitalism and investing: Money flows to where it is treated best.

While the hedge fund industry as a whole (though not all individual hedge funds) has been a disastrous asset management category for nearly 8 years now, its collective AUM continued to rise, to about $3 trillion at last count. The flows continued to pour in despite the lackluster, market-trailing performance that’s become something of an annual rite for the industry.

There’s some nuance, of course – it’s really the bigger funds that have been getting even bigger, as “wealth managers” at the wirehouse brokerages steadily allocate between 10 and 20% of their clients’ assets to the “alternative” sleeve. Family offices also tend to invest via platforms, and platforms can’t really function without multi-billion dollar funds to give money to. Think of it like a retailer stocking predominantly big, well-known (and thus, safe) brands on their shelves.

The irony of this relentless shoveling of cash to the top 30 funds is that the funds themselves are frequently living off historical outperformance that was generated in the 90’s and the early 2000’s. This was a time before Reg FD made it impossible to get the “first call” when a CFO was calling a favorite analyst to have him raise or lower earnings guidance. This was a time when there were probably less than a 1000 funds competing (vs 12,000 today) and alpha was plentiful everywhere one looked. This was a time of guaranteed profits from tech IPO giveaways that kept top funds loyal to the bankers’ firms’ trading desk. This was a time when a hundred-million dollar fund was considered large, and could still be nimble enough to pick off smaller opportunities. This was a time before robots and software squeezed arbitrage opportunities into decimals of decimals.

If you have a fund that thrived in those times, you can still eat off that track record, despite a lack of alpha in recent years. Many do. There are plenty of smaller institutions, family offices and eager-to-play ultra-high net worth’s that don’t ask themselves whether any of those edges exist anymore. And the “private bankers” who cover these accounts don’t think to put those questions in play either. Their business cards may no longer read “financial advisor” or “stockbroker”, but they all have quotas and production grids just the same.

But maybe this year marks a turning point of sorts – or at least a moment where harder questions are being asked. Some of the industry’s best-loved brand-name managers are struggling mightily in what is essentially a flat market. It wasn’t supposed to be that way. When people think “alternative”, they’re not hoping to see an alternative to gains.

For every David Tepper, who seems to smash it out of the park with uncanny consistency, there are three Tiger Cubs that have wrecked investor confidence. For every John Burbank, who nailed the macro this year, there are ten funds that were blown up in oil, Brazil, the short dollar trade or all three at once. Losing 20% of your investors’ capital in a year like 2008 is somewhat understandable (or explainable in trustees’ meetings where the intermediaries go to sing for their supper). Losing 20% of your investors’ capital in a flat year and you better have had some incredible up-years in the recent past to offset it with.

The real challenge and hurdle for investing in hedge funds, in my experience, is that:

a) You can’t get into the great ones, they don’t want your money

b) Even if you get in, after a few good years, they can’t wait to give you your capital back

c) You can’t predict which emerging funds will grow to be great in the future (no one has demonstrated this ability, at any level)

d) Access fees and other administrative costs, when added to the actual costs of the funds, make outperformance even tougher

e) In today’s environment, there are a million ways to be non-correlated to the S&P 500 without them. And it’s much cheaper.

Obviously, I’m not the only person to have reached these conclusions in recent years. The Wall Street Journal notes that hedge fund asset-raising in the 3rd quarter of this year was at the worst pace since the 3rd quarter of 2009. Given the high profile blowups that have become daily fodder for the press, the fourth quarter could wind up being flat or even negative. This is the first time we’ve seen the industry not grow in forever.

Apparently, there is a limit. Maybe the basic tenets of capitalism and investing still apply after all, even if on a lag.

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For more on this topic, I highly recommend the below twofer from Ben Carlson at A Wealth Of Common Sense. He gets into the mindset of why people allocate to hedge funds and some of the nuance that’s important to understand before categorically dismissing the industry.

My Thoughts on Hedge Funds (A Wealth of Common Sense)

and

Why People Invest in Hedge Funds (A Wealth of Common Sense)