So, it looks like happy days are here again for hedge funds. Assets surged by $149 billion in the fourth quarter of 2010 when the typical fund was up 5.5 percent. This puts total industry assets at $1.917 trillion, a tad below the all-time high of $1.93 trillion set in the second quarter of 2008, according to Hedge Fund Research (HFR).
Altogether, investors poured in $13.1 billion in net new capital to hedge funds in the fourth quarter, pushing total 2010 net inflows to $55.5 billion, the highest one-year sum since 2007, HFR points out.
Last years huge inflow obviously reflects renewed investor confidence in hedge funds, even though dozens of them gated investors two years ago or placed illiquid assets in side pockets. Dozens lost more than 40 percent in 2010, in line or worse than the low fee index mutual funds.
Meanwhile, investors have begun to warm up to smaller funds, another indication that investors are willing to take more risk with hedge funds. Earlier in the year most new money flowed into fund firms with more than $5 billion in assets. For the full year more than 80 percent of net new assets were allocated to firms with more than $5 billion. However, in the fourth quarter, only 51.6 percent of inflows went to those large firms.
And with funds managing more than $150 million in assets required to register by July, fund flows to smaller portfolios could pick up as the year progresses.In many cases this makes sense. After all, the smaller the fund the better the performance.
According to HFR, funds that have been around for less than 24 months have gone on to outperform those already in existence for more than 24 months over virtually every time period.
For example, the annualized return for new managers over the past three years is 7.77 percent versus 0.30 percent for established managers. The difference over the five-year period is 11.4 percent vs. 5.6 percent while for 10 years it is 16.6 percent vs. 10.4 percent.
However, as investors increasingly embrace hedge funds, especially small ones, there are also many downsides. Fees are unlikely to come down. A slew of billionaire wannabes will now have the confidence to try to launch new funds, many of them with flimsy credentials. It is only a matter of time before we also see the revival of the big mega-launch: a new fund that raises several billion dollars.
But, there is still the sober reality. A large number of hedge funds dont outperform the market over a long period of time. Many hedge funds do wind up dazzling investors for a couple of years. But more often than not they wind up following a couple of initial strong years with a huge down year, bringing their brief lifetime return down to money market-like returns.
The reality is there are very few hedge fund managers like Jim Simons, Paul Tudor Jones II, Bruce Kovner, Seth Klarman, Louis Bacon, David Tepper and Richard Perry who have passed the test of decades.