Very articulate and well stated. I've been researching hedge fund performance since listening to an audio book for The Quants; it's been interesting to see the performance of the "all-stars" mentioned in the book since its publication. Like Boaz Weinstein, whose Sabra, managed to lose money in 2013, 2014 AND 2015 despite the S&P growing over 40% over that time. If you look at 2012 - 2016, the Barclays Hedge Fund index shows hedge have underperformed the S&P significantly except for 2015 (where they outpaced the S&P by about 1%). I read that there is an issue with the index that fund performance disclosure is voluntary and so the number reported may even be higher than it actually is. One thing hedge funds nail is the "sales" angle; they manage to get positive coverage for their name even if only one of their funds is outperforming, they make sure the financial press covers it.
Hedgefunds comped against S&P is a red herring. Any institution investing in hedgefunds is already stock-β saturated. Of course they can get all the stock-β they want to for xx bips. They know that. They're looking at alternatives (hence the name) because they don't want more stock-β. The real comp is against the yield their excess cash would otherwise earn -- zero in the US, and negative in Europe.
This is an argument that hedgefunds themselves pose to justify their existence. Personally, I believe it's a good one for their existence. However, it doesn't justify their fees. In the mid 2000's the hedgefund industry claimed their fees were justified because they provided absolute return at pretty low levels of risk (they were underperforming the SPX). In 2008, the hedgefund industry touted that while they lost money, they outperformed the SPX and that justified the fees. Since then, the new argument is that they are underperforming because the markets "are artificial" implying that the fees are still justified and it's the market's fault they aren't earning enough returns.
Boaz Weinstein has a history of succeeding despite failing 1) he got a Goldman internship on the strength of his chess game not trading prowess as per David Tepper of Apaloosa Capital Management 2) he lost $1.8B for Deutsche Bank and still raised funds for Saba Capital http://www.wsj.com/articles/SB123387976335254731... He is not raising funds on the strength of his performance....
Funds don't need to "justify" their fees, any more than the corner pizzeria needs to "justify" charging $2 extra for anchovies. If the buyer finds value, he purchases the product. If not, he doesn't. Again, the yardstick many institutions face is: zero or negative return on their sovereign-debt portfolio.
I find this an incomplete argument often used by institutional managers such as with pension funds to justify hedge fund investment. There are other asset classes with low or negative co-variance to the stock market but have either higher rate of returns or lower measures of risk such as standard deviation or max drawdown -- and sometimes they have both. From the period mentioned, hedge funds have averaged 3.35% return; if you look at the Vanguard intermediate term bond fund over roughly the same period, earned about 4.94%. If you look at the max drawdown of hedge funds, there is significant volatility; ie: Citadel -55% in one year, Greenlight down 20% and others. Bonds don't do this. So given bonds have a similar or higher return, and lower STD Dev and drawdown than hedge funds, it's a little harder to justify hedge fund investment. Especially when you can manage beta through basic asset allocation and diversification. Bonds are one example of low covariance with S&P; there are other such as utilities stocks, sovereign debt, and on and on.
I think what you're saying is that if the marketing is good enough, there will be enough suckers in the market. And you're right. For a while. Unfortunately last two quarters have seen net outflows from hedge funds, over $20B. Over that same time Vanguard has seen over $100B net inflows to indexing. The turning point may be hedge funds have clearly now consistently underperformed other asset classes that reduce stock market beta, while exposing owners to higher std dev. As a result, we see things like net inflow to investment-grade bonds YTD is ~$20B. REIT ETFs similarly are up on inflows (at least Vanguard's VNQ that I checked). It doesn't hurt that people like Warren Buffet are calling out hedge funds; it becomes harder for the industry to keep its marketing engine one step ahead of its performance.
Institutional investors generally don't want more bond-β, either. Yes, bonds and bond-like instruments (e.g. utility stocks) have had great returns as interest rates have gone to zero -- but you can't buy yesterday's performance, only tomorrow's. Institutional investors aren't "suckers" -- typically they're highly educated, highly experienced, highly astute. As to outflows, you make my point for me. If hedgefunds serve a purpose in institutional portfolios, they'll find buyers; if not, they won't. The market can and does decide what fees are "justified."