I’ve been noticing quite a few 2009-vintage long/short equity hedge funds (the 137% gross, 42% net exposure variety) with steadily expanding capital bases, via both portfolio compounding and capital inflows. The latter is understandable given the spectacular return trackrecords of these funds. Yet, ever the skeptic anytime I observe capital chasing performance, I’d like to share an anecdote with my Readers. A few weeks ago, I met someone who relayed the following Stanley Druckenmiller story (for more on Stanley Druckenmiller, be sure to check out these articles):

In 2007, a list of hedge funds was shown to Stanley Druckenmiller and his opinion of those managers requested. Glancing at the list, Druckenmiller pointed to a few and said, “These guys will blow up. They don’t understand that when things get bad, they need to take down gross, not just net.” Lo and behold, the predictions of Druckenmiller once again proved true – those funds blew up in 2008.

Regardless of whether the story is actually true or false, I think it still conveys a valuable point. In extreme environments, the leverage associated with high gross exposure is dangerous, even if you carry a low level of net exposure, because the underlying assets will behave erratically as historical correlations breakdown.

How many of these newly minted 2009-vintage long/short, high gross low net, equity funds, with swollen egos after years of outperformance, will know/remember this when the storms approach? Only time will tell.