Why Do Hedge Funds Fall Out Of Favor?

Hedge Funds Fall Out Of Favor

Institutional investors like pensions and university endowments are pulling back sharply, shifting capital toward index funds and private equity as redemptions surge to levels not seen since the 2008 financial crisis. Harvard University, for example, has announced plans to cut its endowment team in half and shutter its internal hedge fund operations due to disappointing results. In this analysis, Gregory Blotnick explains why this reallocation is taking place.

While some of the criticism is justified, there are widespread misunderstandings — particularly regarding long/short equity strategies — that deserve clarification. The irony is that these redemptions are happening at a moment when hedge funds may be poised to outperform. Long/short strategies utilize tools like leverage, derivatives, and short-selling to generate returns in both rising and falling markets.

Although hedge funds date back to Alfred Winslow Jones in 1952, the industry really gained momentum in the 1980s and saw rapid growth after the dot-com bubble burst in the early 2000s. The financial media from that era — including Forbes and The Wall Street Journal — often reflected the debate between structural market shifts and temporary cycles.

In the late 1990s, the mood toward hedge funds soured after the dramatic implosion of Long-Term Capital Management in 1998, and discontent deepened as many funds lagged behind during the tech-driven market surge of 1999. The industry seemed to bottom out when hedge fund pioneer Julian Robertson shut down Tiger Management in 2000 — a fund that had recently been the second-largest in the world — shortly before the broader market nosedived.

Changes In The 2000's

Long/short equity funds went on to shine in the early 2000s. In 2000, while the S&P 500 dropped 9%, these funds returned 16%. The next year, they gained 5% as the S&P slid 12%, and in 2002, they lost only 2% compared to the index’s 22% drop.

By mid-2002, The Wall Street Journal noted a change in tone: “With the Dow and Nasdaq hitting new lows, investors are searching for places to preserve capital. Hedge funds look like a logical choice after outperforming the market over the last two years.” That year, hedge fund assets under management rose by 38%.

Just a few months later, the Journal added: “Hedge funds are seen as a way to profit even in declining markets, making them especially appealing now.” A similar pattern emerged after 2008, when long/short equity strategies lost only 12% versus the S&P 500’s staggering 37% decline.

Blotnick, who is the founder of Valiant Research LLC, says that this illustrates how even sophisticated allocators are prone to recency bias — the tendency to focus on the most recent events — and only seek downside protection after a crash. Today, we’re seeing the reverse: investors are exiting just when these strategies may be most beneficial.

After nearly eight years of a sustained bull market, it’s no surprise that hedge funds have lagged. Yet many investors still judge performance primarily by upside participation against the S&P 500 — which misses the point of long/short strategies. These funds are generally designed to reduce portfolio correlation to the broader market, dampen volatility, and ultimately deliver stronger risk-adjusted returns over time.

Unfortunately, many investors are withdrawing capital from long/short hedge funds at the exact moment when those investments could provide critical diversification and protection. To learn more, visit Blotnick's personal homepage.