Long considered the titans of Wall Street, hedge fund managers have long thrived under a simple premise: They are smarter than the average investor and can produce bigger profits.

That image of the slick, well-connected trader, making bold bets with hundreds of millions of dollars, has attracted trillions from wealthy investors, pension funds and endowments who were willing to pay high fees and hand over 20pc of any profits to the elite class of traders.

Now, though, many investors are reconsidering. Hedge funds produced returns of about 5pc last year, according to Hedge Fund Research, compared with the 10pc rise of the Standard and Poor’s 500-stock index, a broad collection of stocks that is trading near record highs.

“The hedge fund industry has started to collapse on itself. There are too many players going after the same thing.”

Investors have responded accordingly, pulling $111 billion out of the industry in 2016, according to eVestment, an institutional investor data firm. More than 1,000 funds closed their doors last year, the largest number since the 2008 financial crisis.

Many of the advantages the industry relied on for decades have started to disappear, industry experts say. There are more hedge funds placing the same type of bets. And finding a unique idea, an undervalued company or one with flaws that no one else has spotted, is becoming more difficult, particularly at a time when so many stocks are rising, they say.

“The hedge fund industry has started to collapse on itself,” said Charles Geisst, a Wall Street historian at Manhattan College in New York. “There are too many players going after the same thing.”

The industry’s troubles began after the financial crisis, when shocked investors saw the value of their investments plummet, industry experts say. They had expected savvy stock pickers to shield them from the widespread losses facing everyday investors.

“That made investors more aware,” said Alina Lamy, senior analyst for quantitative research at Morningstar Research. “Plus, they are much more expensive. Why are we paying you more if you are not giving much more return?”

Indeed, during the economic recovery — which pushed stock markets to record levels — those who put their money in passive investments were rewarded. Over the past 10 years, the return for passive investors was 5.7pc annually, while those with money in active funds had 5.3pc annual returns, on an asset-weighted basis, according to Morningstar. More than 90pc of large-cap active funds, those with at least $6bn in assets, underperformed their passive counterparts, according to S&P Dow Jones Indices.

Hedge funds are also losing favor among some of their most important clients. The California Public Employees’ Retirement System withdrew $4bn from hedge funds, saying they are too expensive and complex. The $51bn New York City Employees’ Retirement System gave up on the industry last year.

“It was a bad investment. The rate of return had not been what we anticipated,” said Henry Garrido, an NYCERS trustee who led the effort to dump hedge fund investments. The high fees were eating away at meager profits, he added.

Despite the second-guessing, the top 25 hedge fund managers collectively earned a whopping $11bn in 2016, according to a recent report by Institutional Investor’s Alpha magazine. On top again was Renaissance Technologies’ James Simons, a former Cold War code breaker who made $1.6bn — or $4.3 million a day.

Simons’s fund reported double-digit gains, according to Alpha magazine. But nearly half of the top 25 managers finished the year with single-digit gains.

“A large per cent of hedge funds are not very good, which drives down the returns” of the industry overall, said Don Steinbrugge, managing partner at Agecroft Partners, a hedge fund marketing firm. But the best-run funds continue to bring in record profits, he said. And the industry is still massive, with more than $3 trillion in assets.

The industry’s recent slump may be temporary, some financial analysts argued. Passive funds are designed to match the market’s performance. If the stock market becomes more volatile or declines, hedge funds may regain their appeal.

Still, the recent tumult has left some bruises.

For veteran value investor Warren Buffett, the hedge fund industry’s recent tumbles were predictable. Buffett has been critical of the high fees charged by most fund managers - a 2pc management fee and 20pc of the profits earned, known in the industry as ‘2 and 20.’ (Fees for investing in passive index funds can be much cheaper, generally a tiny fraction, as low as 0.1pc in some cases.)

“If you even have a billion-dollar fund and get 2pc of it, for terrible performance, that’s $20m,” Buffett said this month. “In any other field, it would just blow your mind.”

Nine years ago, Buffett and Ted Seides, managing partner for Hidden Brook Investments, wagered $500,000 on whether a low-cost fund that tracked the performance of the S&P 500 would perform better for investors than a hedge fund.

With just a few months remaining, Buffett is winning.

Buffett’s index fund has achieved a compounded annual return of 7pc so far, while Seides’s hedge funds delivered profits of only 2.2pc. That means an investor with $1m who sided with Buffett would have earned $854,000, while Seides’s followers would have collected $220,000.

In a recent column, Seides acknow­­ledged his deficit but argued that given more time, hedge funds would eventually win.

Still, he said, “the bet is over. I lost.”

— The Washington Post Service

Published in Dawn, The Business and Finance Weekly, June 5th, 2017