Hedge funds were once the hottest investment around, but they've long ceded the spotlight to top performers, including private equity, real estate, tech startups and even cryptocurrencies.

The last memory of this is of Bobby Jain the new multi-strategy fund, Jain Global, with $5.3 billion in commitments and will begin trading this week. In the heyday of hedge funds, a launch of that size — one of the biggest ever — by one of the industry's brightest lights would have been major financial news. There has been lukewarm interest.

The reason is that hedge funds don't make money like they used to. After a fiery start in the 1990s, their performance has been on a steady decline. Hedgies have blamed many factors along the way, from persistently high stock valuations and aggressive short sellers to low interest rates and, more recently, lack of talent.

But the real culprit can be summed up in a single word: capacity. Simply put, there are only so many opportunities in the markets for huge profits, perhaps enough to successfully distribute several tens of billions of dollars. When hundreds of billions of dollars started pouring into hedge funds in the mid-1990s, and certainly by the time they became a multitrillion-dollar business a decade later, they were doomed to disappointment.

Hedge funds have no incentive to accept this reality, because it would require them to dilute themselves, and they make a fortune in fees – on average more than 1% a year in management fees plus nearly 20% in profits. So instead of addressing the core issue, they tried to change their scope.

At first, hedge funds claimed to be the go-to place for star stock pickers and stealth investment strategies, such as merger arbitrage, managed futures and risk parity. But the star pickers eventually got pulled or got lucky, as almost everyone does, and once new hedge fund strategies became commonplace and available through lower-cost exchange-traded funds.

Then the field became superior risk-adjusted returns. Hedge funds may not be able to beat the stock market regularly, they acknowledged, but they are less volatile than stocks. Wouldn't you rather have a 7% annual return with a 7% annual standard deviation—a common measure of volatility where lower is better—from hedge funds than a 10% return with 15% volatility from the stock market? shares? The answer for many investors was no.

So the hedge funds rolled again, this time trumpeting a multi-strategy approach where they spread their bets across different assets and portfolio managers, as Jain Global is likely to do. Translation: If a high-priced hedge fund strategy is likely to disappoint, then investors should try to own more of them. It's almost as comical as when Wall Street banks told investors in the 2000s that buying subprime mortgage debt would magically become safer and more profitable if investors put more into their portfolios. It didn't work with mortgages and it's not likely to work with hedge fund strategies.

In fact, multi-strategy funds have been around for a while, and their track record is not flattering. Like the industry as a whole, they got off to a strong start in the 1990s and early 2000s – Credit Suisse's Multi-Strategy Hedge Fund Index peaked at 10.7% per year over the decade ending in 2004. But it's been in decline since then , with the index returning just 5.2% annually over the 10 years to May.

Granted, hedge funds don't like to be compared to the S&P 500 Index because it's a different strategy. But if the goal is to make as much money as possible, then it's fair to ask how hedge funds compare to one of the cheapest, easiest-to-own and best-performing investments around. And the answer is not favorable. The S&P 500 has outperformed the multistrategy index by 3.5 percentage points a year since 1994, including dividends, and has beaten it about two-thirds of the time over 10-year periods.

Multi-strategy funds say they would do better if they weren't so short. “One of the most important binding constraints in the industry is the availability of talent,” Pablo Salame, Citadel's co-CIO, said in a recent interview. It's so hard to find help these days, apparently, that Citadel had to return $25 billion to clients since 2017 because it didn't have enough money managers.

It's hard to believe. Of course, Citadel could have allocated more money to the existing stable of managers. More plausibly, Citadel lost $25 billion in fees because it couldn't generate big returns on that much money, no matter how many star managers it had.

If hedge funds won't accept the limitations of their capacity, investors will eventually do it for them. North American hedge funds managed $3.7 trillion at the end of 2023, up from $2.2 trillion in 2014, according to data provider Preqin, but the rise in assets was largely attributed to rising asset prices. Net flows into North American hedge funds have slowed to a trickle in recent years, amounting to just $4.6 billion from 2015 to last year. Even if investors don't pull their money out of hedge funds, the industry will lose market share as new capital is deployed elsewhere.

A fund was well aware of its capacity limitation. Renaissance Technologies Medallion Fund is the best performing hedge fund of all time. It estimates its capacity at about $10 billion and returns money to investors regularly to keep it at that size. The fund is so limited, in fact, that there is no room for outside investors. The funds that Renaissance offers to foreigners are no more important than those of its competitors.

Some hedge funds can go on to make a lot of money for a lucky few. The industry can't do better than that at its current size, no matter how much talent it employs. The only question is how long it will take investors to come to terms with it.