Why Hedge Funds Are Failing Right Now - Business Insider

Over the last several weeks Wall Street has learned a powerful and painful lesson: Sometimes nothing is safe.

Call them what you want to ? Top Dogs, Smart Money, Heavyweights ? these are the kings, and their castles are crumbling.

Funds that looked bulletproof are getting smoked.

Ray Dalio's famous 'All Weather' fund is down 8% for the year. The top performer of 2012 is down 5.66% for the year as of last week.

Market gurus may try to make what's happening sound complicated, but it's really not. In fact, what's going on can be explained in two big market and investing themes. The first theme is the overall effect of the Federal Reserve's change in policy and what it's doing to risk across asset classes. The second theme is an age-old debate about how people should structure their investments in general.

First the Fed. After Bernanke announced that the Fed would gradually reduce purchase of Treasuries, the market has become unrecognizable. Interest rates on the 10-year Treasury note have leaped to 2.5% from 1.93% in early May.

Investors are selling bonds like crazy, and hedge funds with exposure to credit markets ? like Metacapital Management, the best performer of 2012 which made mortgage backed arbitrage its cornerstone? ? are suddenly losers. Bond mutual funds and exchange traded funds (ETFs) have seen record monthly redemptions of $61.7 billion through June 24th, according to Bloomberg.

Meanwhile, the stock market has been a whipsaw. In early April the S&P 500 hit 2007 highs (1575), climbing steadily until Bernanke's speech on the 19th, when it decided to take us all on a ride. That's when if fell and kept falling almost 5%. At the beginning of last week traders were starting to think this was the new normal, and then all of a sudden, over the past three days the S&P rallied 2.7%.

This is the return of volatility. It had been kept bottled up, and now it's on the loose to wreak havoc on investors who thought they knew what they were doing.

As U.K. hedge fund manager Hugh Hendry put it in a note (via Zero Hedge):

The invisible regime of low volatility and low correlations that had been so supportive of risk markets for at least the last year started to become unhinged... As cross-asset correlations rose, the Fund became less diversified.

What that means in plain English is that assets that once had nothing to do with one another started exhibiting the same behaviors. Hendry' fund is down 2.1%. Some of the calls that he made earlier this spring, like going long Japanese equities, turned against him.

That brings us to the second theme ? the debate about investing being played out in markets right now.

It goes something like this: Old school portfolio managers like Jack Bogle's Vanguard maintain that a 60/40 portfolio (60% stocks, 40% bonds) will serve you well. The newer breed of high-powered hedge fund managers think differently. They argue that a 60/40 strategy puts too much risk (and thus the portfolio's success) into equities.

That's why Dalio created the first "risk parity" fund (yes, the All Weather) in 1996. Ideally, it spreads risk evenly across one's portfolio by using leverage to amp up traditionally secure assets (like bonds) and deemphasizing more volatile assets like stocks.

You can imagine how that wouldn't work in this market.

From Reuters:

Bridgewater created a portfolio based on two of the four basic economic scenarios: rising growth, falling growth, rising inflation, falling inflation. Different types of assets do well in each of these scenarios and the all-weather portfolio contemplates spreading its risk evenly.

After Bernanke made his statement, those economic scenarios fell apart as stock and bond prices fell together. Now that stocks are making their way up and 10-year Treasury bonds are still yielding 2.4%, risk parity still isn't the answer.

Meanwhile, the $19.5 billion Vanguard Balanced Index Fund, which uses the 60/40 method is up 5.48% this year through June 24th, according to Investment News.

Timing is everything, and if you called this, you're smarter than a lot of brilliant people.

Or you're just lucky ... this is investing after all.

Source: http://www.businessinsider.com/why-hedge-funds-are-failing-right-now-2013-6

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