Baseball's "Steroid Era" was a blast for the fans. Huge sluggers, looking like video game enhanced cartoon characters, blasted home runs. These players made the players in the 1970s look like silly stick figures. The fans cheered and willfully ignored the signs of blatant cheating.
In the hedge fund arena, mysteriously brilliant market maestros delivered stunning returns, de-linking the relationship between risk and return. Only fools and mere mortals delivered a return in relation to risk. These geniuses delivered market beating returns in any market environment.
Hedge fund investors fell over themselves to invest in these funds. They paid ridiculously inflated fees, locked their money up for years, and didn't deem to talk to the manager, less they piss him off with silly questions and be banned from investing.
I worked as a hedge fund marketer during the steroid years. I can tell you that it was very frustrating trying to compete with the cheaters and the frauds. I'm sure the baseball players who were not jacked up on steroids felt the same way.
As in baseball, these funds distorted all the historical numbers, perhaps persuading institutional investors that hedge funds in general outperformed the market. This led to a huge influx of cash into the world of hedge funds, taking away the arbitrage opportunities for all hedge fund managers and flattening overall returns.
Since 2008, the combination of a huge market decline and a massive government crackdown on insider trading, has largely purged the industry of frauds and outright cheaters. The taking down of SAC marks the end of the steroid era in hedge funds.
Hedge fund start-ups are at new lows, and the industry is at a crossroads. Compliance costs to satisfy institutional investors are huge. Big funds are grabbing talent but in general delivering mediocre returns.
So what happens now? The industry has been burned to the ground, but green shoots will come up. The industry should return to its roots of brilliant, eclectic managers delivering volatile but potentially huge marketing beating returns, all at very significant risk. All the consultants touting hedge funds to institutional investors as an investment that delivers a slightly better return for less risk should realize they are dealing with bad numbers and give it up.
So what does a regular investor do? If you are lucky to invest with the small handful of hedge fund managers who are brilliant, original thinkers, by all means do so. But your chance of finding these people and investing with them is probably less than zero. So stick to the boring, dull but ultimately successful basics: smart asset allocation combined with relentlessly low fees. Index the vast majority of your portfolio to broad market indices, domestic and international. Rebalance no more than annually.
Be your own hedge fund manager. Take a very small amount of your money and look for opportunities that deliver asymmetric returns: a loss of 100% of a small amount of money if you are wrong, but a profit of 1,000% if you are right. These opportunities are always out there.
Stay away from the steroids. They are fun while they last but the hangover is nasty.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Baldwin Partners Group, LLC is a state registered investment advisor. Alex Bentley is the CEO, Founder and an investment advisor representative of Baldwin Partners Group, LLC.