(MoneyWatch) There's an adage among investment professionals that you don't want to be a member of a crowd. It means that it's time to exit when an investment strategy gets "crowded" due to investors chasing returns. William Bernstein, author of the new mini-book "Skating Where the Puck Was" demonstrates the wisdom of this adage when he examined the return of hedge funds and found that their performance deteriorated as more investors got into the game.
For the period 1998-2012, Bernstein analyzed Hedge Fund Research's Global Returns series using a three-factor analysis -- meaning analyzing the exposure to the risks of the stock market, small stocks and value stocks. He found that while hedge funds showed significant outperformance early on, that outperformance shrank and then turned negative as investors chased those returns. From 1998 through 2002, hedge funds produced an incredible alpha (or outperformance) of 9 percent. However, from 2003 through 2007, their alphas went to -0.7 percent. And from 2008 through 2012 the alpha sank even further to -4.5 percent.
Why did that happen? David Hsieh, professor of finance at Duke's Fuqua School of Business, provided a simple explanation -- alpha is a finite resource. In 2006, Hsieh estimated that there was about $30 billion in alpha available to the entire hedge fund industry. The implication is that as more money enters the industry, there's less and less alpha to go around per hedge fund. This wasn't good news for hedge fund investors, because dollars had been flowing in at a rapid pace.
Assuming his estimate is correct, we can now determine what that means for hedge fund investors using simple math. Hsieh estimated that at the time the industry had about $1 trillion under management. Thus, $30 billion of alpha spread over $1 trillion of assets is 3 percent alpha for the industry.
It is also worthwhile to consider the following. Again, assume that Hsieh is correct that there is a finite amount of alpha, and it is $30 billion. Let's go back in time to when the hedge fund industry had just $300 billion under management. Then the industry-average alpha would have been 10 percent, close to the 9 percent alpha Bernstein calculated during the 1998-2002 period. Investors would have received above-benchmark returns, and then poured more money into hedge funds. As a result, the available alpha has become more diluted. Despite their poor performance since 2002, total hedge fund assets under management continue to grow, with the industry now managing over $2 trillion.
But the news gets worse for hedge fund investors. It's important to understand that the very act of exploiting market mispricings makes them disappear. So, in fact, the alpha available to the industry isn't constant.
Long-Term Capital Management, the notorious hedge fund that collapsed in 1998, is perhaps the perfect example. LTCM discovered that the market seemingly mispriced new 30-year Treasuries, so it used large amounts of leverage to generate huge returns. However, other funds saw what LTCM was doing and rushed to get their share. This act caused the mispricing to disappear, nearly causing a financial disaster in the process due to the large amounts of leverage employed by LTCM. (You can read more about this near disaster in my book, "The Only Guide to Alternative Investments You'll Ever Need.")
So what's the bottom line? The evidence suggests that if there were ever any "easy pickings" for hedge funds, with the increased competition, those easy pickings are long gone. And today's hedge fund investors are likely to be paying obscenely high fees while taking all the risks of hedge funds and missing out on the benefits of publicly available securities (such as low costs, broad diversification, total transparency and daily liquidity).
The lesson for investors is that whenever an investment strategy that's supposedly exploiting some market mispricing has become popular, it's already too late to join the party. Even worse, as Bernstein pointed out, is that when a strategy becomes popular not only will it have low expected returns due to the crowding, but the investors are now "weak hands" who tend to panic at the first sign of trouble. That leads to the worst returns occurring at the worst times, when the correlations of all risky assets move toward one.