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Andrew Beer This article was authored by Andrew Beer, founder of Beachhead Capital Management LLC in New York.

As of mid-month October, 2014, the S&P 500 was down over 5% and the MSCI World was down 6%. In this context, drawdowns among hedge funds have been unexpectedly large. Before fees, the HFRX Global Investable index was down over 4%, while the Equity Long/Short and Event-Driven sectors were down 5% and over 7%, respectively (note that the reported losses are lessened by the reversal of accrued performance fees). The average alternative multi-manager mutual fund (generally with 0.2 to 0.3 equity beta targets) was down 3% net of fees.

What explains the underperformance? A significant portion likely is due to position crowding, which occurs when many hedge funds hold similar positions. In good times, additional buying can support stock prices and contribute to excess returns. For instance, the GS VIP index, which tracks positions in which hedge fund managers have a significant stake, outperformed the S&P 500 index by around 400 bps (per annum) from 2009 to September 2014. Performance like this is used to support the thesis that hedge fund managers add value over time through stock selection.

In periods of market stress, however, those same positions can underperform significantly as hedge funds cut positions simultaneously. The table below shows the GS VIP performance during the market drawd......................

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