Everyone is asking the wrong question about hedge fund performance

What's a hedge fund anyway? The August market swings made it clear that question is getting harder to answer.

Broadly, hedge fund managers are meant to be experts at controlling risk, and generating profits, no matter what the market is doing. For this, they're paid handsomely.

But the last week of August - which saw the most volatile stock market since the financial crisis - showed that in the short-run, it doesn't always work that way.

Activist investors, in particular, hold highly concentrated positions in a small number of companies. That is what they are paid to do. It also means they can't escape a broad sell-off in stocks. They were among the most publicized losers.

"I would say that August was an unusual month for the hedge fund industry because you had very large dispersions of returns across various hedge strategies. Those hedge funds that have a long-net exposure to the equity market, in particular the activist strategies, did bad," said Don Steinbrugge, managing partner of Richmond, Virginia-based Agecroft Partners, a marketing and consulting firm for the hedge-fund industry.

Those big names getting bruised in August don't necessarily extend to the entire hedge fund industry, though.

In fact, there were a number of big winners in the month, like volatility hedge funds run by New York-based Capstone Investment Advisors and London-based 36 South. The average hedge fund was down only 2.2% in August, according to data from Hedge Fund Research, compared with the S&P 500 which fell 6.2%.

So far this year, the average hedge fund is down 1% for the year, while the S&P 500 is down about 6.2% year-to-date.

Activists feeling the pain

The activists like Dan Loeb, David Einhorn, and Bill Ackman, saw their portfolios suffer, especially on Monday, August 24, when the Volatility Index (VIX) hit its highest level in four years as markets got crushed. Here's a scorecard for August:

1. Loeb's Third Point Off Shore fund, which employs an event-driven and value investing strategy, fell 5.2% and is now up just 0.1% for the year.
2. Einhorn's Greenlight Capital flagship fund fell 5.3% in August, bringing the fund down 14% for the year.
3. Ackman's Pershing Square Holdings fell 9.2% and was last down 0.1% for the year.

Activists take stakes in companies and agitate for change that'll boost returns. Their bets are usually long-term, with campaigns that can take months and end with a management change, sale, or change in structure. For the most part, activists are not going to have much hedging. And even when they do, it can move against them.

Take Ackman for example. He has a massive short position on Herbalife, a multi-level marketing company he believes is a "pyramid scheme." Shares of Herbalife rose 14% in August.

Meanwhile, Ackman's big equity positions, including drugmaker Valeant, Canadian Pacific Railway, and Mondelez, all fell in August. Einhorn lost money on his big positions too, including Apple, which fell more than 12%, and SunEdison, which tanked more than 55% last month.

Activists aren't the only ones feeling some pain from August. The sudden downdraft could've also caught some so-called long/short equity hedge funds off-guard. Those funds typically bet on a decline in individual share prices - by selling short - nearly as often as they bet on gains - by going long.

Long-biased turned out wrong

That's because when the market was ripping over the last five or so years, many long/short equity funds were becoming more long-biased.

"Generally speaking, when you take a look at the market from 2008 until now, it's been a positive market. Most guys in that time got killed on shorts, so they don't short a lot," explained a person from a multibillion-dollar hedge fund, who could only speak anonymously. "Most of the money in that time has been made on the long side."

In a market meltdown, a portfolio like that will suffer. What's particularly painful for a manager is if the shorts that should help offset losses don't also fall.

"They don't move at all and that really hurts," said the hedge funder.

Reuters/ Brendan McDermid

David Einhorn of Greenlight Capital

Not traders

Another issue some big fund managers faced was the speed at which the market was moving. In the last three weeks, you had an up day up 2% then a down day down 3%. It was flipping and flopping.

"Most managers are not traders. They buy and they hold," explained the hedge funder. "It's really hard, with volatility, for these guys to be changing their exposures."

So what will hedge fund investors make of all this? A lot depends on how the fund was pitched in the first place.

One hedge funder familiar with how these discussions with investors take place explained that hedge fund managers, for the most part, aren't telling investors these days that they'll be up in a down market. That's just not the case anymore.

"It used to be in the early 2000s, hedge fund managers would say, 'I'd make money in all environments.' They used to say that in the past to defend fees," this person said. "They don't say that very much. Today, most managers say if you look at my returns net of fees against the market or mutual funds, I'm going to do better over a period of time with less volatility in that period."

And the high profile fund managers whose losses draw publicity, have track records that can withstand a few weeks of turmoil. Ackman, for example, was the best-performing big fund manager in 2014, netting 40.4% for the year.

The fee debate

Still, the less-than-stellar performance brings up the whole debate about hedge fund fees, and it could prompt some withdrawals by the end of the year.

The recent numbers "definitely makes it harder to justify fees," said a fund investor, explaining that they've pared back some of their hedge fund exposure.

Typically, fund managers are paid through a compensation structure commonly known as the "2 and 20," which means they'd charge investors 2% of total assets under management and 20% of any profits. The fees can vary from fund to fund, with some charging less and others charging more such as "3 and 30."

A shorter leash

The hedge fund investor we spoke to said whether or not people stay for the long-term or decide to redeem comes down to the fund manager meeting expectations.

"If expectations are that they would perform this way, people are likely to stay. If expectations are that they would outperform in every market, then I can see where people would likely redeem. I think the leash is a lot shorter than it used to be for most hedge fund people."

For some managers, the volatile market is going to be a boon - if they can show that they're able to profit from the stock price swings.

"I think that you're going to see an increase in demand for strategies that are not correlated to the equity markets," said Steinbrugge, the marketing consultant. "Big picture-I don't see money leaving. I actually think you could see money going into the hedge fund industry. Hedge funds tend to do better than long-only indexes during market selloffs."