Why Hedge Funds Did Poorly in 2011

Drew W. Demakis

Much has been said about the poor performance of hedge funds in 2011. Here’s why we don’t believe this undermines the case for hedge funds.

The HFRI Fund of Funds Composite Index, the most commonly used broad measure for funds of funds and a good gauge of the overall industry, ended 2011 with a 5.6% loss, underperforming the S&P 500 Index’s 2.1% gain. The last time the composite underperformed the stock market was 1998—the year that the largest existing hedge fund, Long-Term Capital Management, failed. Hedge funds also lagged the market in 1994 , as the display shows. 2011: A Rare Down Year for Hedge Funds vs. Equities

We don’t believe that lagging equities in three of the last 22 years undermines the case for hedge funds, because we think the factors that made 2011 so challenging are largely temporary. In many cases, the valuations of hedge-fund assets became dislocated from fundamentals that are stable to improving. As we see it, the recent declines created some compelling opportunities.

The victory for the S&P 500 in 2011 was driven by an unusually narrow group of stocks—those with high dividend yields and low beta, which few hedge funds found attractive.

Hedge funds, meanwhile, were whipsawed by the market’s rapid swings in response to changing news flow about how policymakers around the world were going to address deficits and liquidity pressures. These mood swings hurt many hedge funds that use downside-limiting measures such as stop-loss arrangements. While stop-losses have been an effective source of downside protection over time, they can hurt returns in a period of rapid market rebounds.

The end of the year was also particularly difficult for those hedge funds that hold less liquid, more complex securities, including event-driven and distressed credit managers. Trading in these securities slowed, bid-ask spreads widened and prices declined substantially.

The proposed Volcker Rule appears to have had a pernicious impact on the market for these securities by restricting dealers’ ability to take temporary positions in credit securities in order to facilitate trades.

But market conditions have improved in the first couple of months of 2012, which is not to say there won’t be further upheavals ahead. More important, the underlying cash flows and fundamentals of US distressed asset-backed securities have not deteriorated. As investors refocus on these fundamentals, fear will abate, helping many hedge funds to regain lost ground.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio- management teams.

Drew W. Demakis is Chief Operating Officer and Chief Risk Officer for Alternative Investments at AllianceBernstein.

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