After nearly a decade of central planning by global monetary authorities, the hedge fund industry has found itself unable to generate any alpha since 2011. As Barclays recently calculated, the average monthly alpha has declined to -0.07% (annualized ~0.8%) from 2011 to May 2016 compared to an average of +0.48% (-5.9% annualized) for the entire period analysed (1993 to May 2016).

This has resulted in not only formerly respected hedge fund managers like Bill Ackman (as well as countless more) being forced to revise the traditional 2 and 20 fee structure to retain fleeing clients, but also the biggest outflow from active managed funds on record, as inflows into passive, ETF-based asset managers continue unabated.

This unprecedented shift in capital away from active managers and toward passive strategies has resulted in not only a chilling effect on the hedge fund industry, culminating with the fewest hedge fund launches since 2000, and massive redemptions, creating a feedback loop which assures even lower returns in the future and even more pain for the "2 and 20" crowd...

... but also concerns about a market in which "passive", robotic, algo-driven decision makers are the marginal buyers and sellers of securities.

And while it is the case that so far, the market has been spared an observation of how a largely passive investing crowd would respond during a downturn (and more importantly what happens to market liquidity), the time is drawing nearer with every passing day, and certainly as central bankers collectively try to prop up global yield curves.

So what are the implications from this shift toward passive investing?

Conveniently, that is the topic of the latest Flows and Liquidity piece from JPM's Nikolaos Panagirtzoglou, in which he makes some interesting and troubling observations, of which three are key: 

• Markets become more brittle, risky: "The shift towards passive funds has the potential to concentrate investments to a few large products. This concentration potentially increases systemic risk making markets more susceptible to the flows of a few large passive products."
• Crashes, when they happen, will be bigger and badder: "the shift towards passive funds tends to intensify following periods of strong market performance as active managers underperform in such periods of strong market performance. In turn, this shift exacerbates the market uptrend creating more protracted periods of low volatility and momentum. When markets eventually reverse, the correction becomes deeper and volatility rises as money flows away from passive funds back towards active managers who tend to outperform in periods of weak market performance."
• Markets become less efficient: "if passive investing becomes too big, potentially crowding out skilled active managers also, market efficiency would start declining. In turn, this would present opportunities for active managers to extract arbitrage profits."

Here are his thoughts:

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And then, just in case hedge funders' lives were not bad enough, JPM decided to remind them that "HFs are failing to produce alpha for another year."

Hedge funds have produced lackluster performance this year. The performance of HFs was not only poor in absolute terms but also relative to a traditional bond/equity portfolio benchmark. In particular, relative to a bond/equity portfolio benchmark, with weights chosen to reflect the relative distance of bond and equity volatility from that of HFs, HFs underperformed by 2.2% in 2016. According to Figure 5 this negative “alpha” in 2016 was worse than the -1.6% seen in 2015, but better than the -5.0% seen in 2014. But it is still disappointing given the failure of the HF industry to achieve positive alpha for three consecutive years. And before 2013, one needs to go back to 2010 for another positive alpha. Similarly in terms of flows, Figure 6 shows that the HF outflows over the past year are the worst since the Lehman crisis.

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While this is bad news for hedge funds everywhere, who are likely to suffer even greater AUM declines, and even lower fees, it may all change overnight should central banks - the entities whose only true mandate has been to be the market's Chief Risk Officers since 2009 and not allow even the smallest downturn - lose control and "make hedging great again." Then again, it may be too late: if there is another market crash, it is possible that what little faith and confidence in the market remained, is gone for ever. That said, with some of the smartest people around forced to engage in socially productive activities for a change instead of just creating ever more debt, there could be worse outcomes.