The real reason hedge funds have been underperforming

May 28, 2014, 9:16 PM UTC
(c) Don Farrall

FORTUNE — Hedge funds have long been accused of clustering, or crowding into too many of the same trades — whether their herding behavior is better or worse than that of other institutional investors is a matter of much debate. Another recent—and frequent—­­­­complaint has been that hedge funds underperform the broader market, with an average return one third that of the S&P 500 Index for 2013.

As the monthly numbers for May begin to come in, we will surely be hearing more about struggling hedge funds, but this misreads both how hedge funds work and recent events in the market.

First of all, when people talk about “hedge funds” in this case they are actually referring to long/short equity funds such as the one founded in 1949 by Alfred Winslow Jones, the sociologist and journalist (he wrote for Fortune) who popularized the term (and that particular strategy; there are now many different strategies that fall under the umbrella term “hedge fund” that perform differently from each other). The reason Jones—and a great many subsequent managers—embraced the long/short strategy is that it enables you to make money in good markets on your longs and in bad markets on your shorts. This is not to say that in all markets you will make money on both your longs and your shorts, rather that the combination of profits on longs in rising markets and shorts in falling markets will create an attractive, diversifying return over time.

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Very rarely, however, the longs and the shorts both underperform the markets during the same month. According to our analysis based on data from Goldman Sachs, this dual underperformance has happened only 10 times—or 6.5% of the time—since Goldman began tracking hedge fund holdings and monthly performance in 2001. Yet it happened in March, and then it happened again in April, making two consecutive months of losses on both the long and short side for the first time ever. So while the S&P 500 has posted a 2% rise so far this year, equity long/short funds have declined by about the same amount.

You might think from looking at the S&P 500 that not much has happened during this two month period, but underneath that broad index there has been a substantial shift out of growth and momentum stocks—including many of the most popular and significant longs in hedge funds such as Google (GOOG) and Apple (AAPL) —and into the more defensive value stocks, which are currently under-owned by hedge funds. The reversal was fairly severe, with the technology and healthcare sectors hit hardest, in addition to some internet stocks that recently went public, which, prior to the sell-off, had unrealistic and aggressive forward growth estimates priced into the stock prices. The crowding into, and out of, those trades isn’t a cause but a symptom of the narrowing of the market in general, where small changes in the supply/demand imbalance can have a dramatic impact on market prices (in this case, the catalyst for the sell-off was comments by the Fed’s Janet Yellen in February that were perceived as hawkish).

This situation is unusual, but it can happen in the latter stages of a bull market (the industry’s euphemism for it is “a period of consolidation”). Typically during this stage of the cycle, the weakest hands enter the market and chase what had worked for the preceding periods, in this case growth and momentum versus value. Then when the trades do not work out as planned, as has been the case in the last two months, the weak hands are first to unwind their positions, creating selling pressure on both sides of the portfolio, long and short.

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There have been similar periods where large themes and crowded positions have moved against hedge fund managers, but historically, these periods have been short-lived. In the past, those managers who stayed the course usually discovered that these conditions are transitory and don’t last.

The takeaway is not that hedge funds are laggards, or trades are too crowded, but more simply this: There are times when being long/short doesn’t always work, but they are usually short-term. In the last few years, the long-only strategies have outperformed the more diversified, long/short strategies. Over the long term, however, the theory still holds true that diversification is the only free lunch in finance. That’s the long and short of it.

Ian McDonald is chief investment officer of Arden Asset Management and Darren Wolf is director of research. This article represents the authors’ viewpoint of the subject matter contained and is not intended as investment advice or recommendation for a specific subject. 

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