First, the good news: assets under management in hedge funds have not only surpassed their previous peak of around $2trn (€1.6trn) reached in 2007, but they are also likely to attract another trillion dollars by 2016, according to ‘Institutional Investment in Hedge Funds’, a survey by Citi Prime Finance.
Now the bad news: the correlation between the traditional 60:40 equity/bond portfolio and the authoritative HFRI composite hedge fund index has been rising since 2002 and is now at an all-time high. The index also shows that the dispersion between the top and bottom 10% performers has narrowed markedly since 2008, largely because the best are no longer delivering stellar returns.
Louis Bacon’s recent decision to return $2bn to investors in Moore Capital Management’s flagship fund was viewed as an isolated event. But eyebrows were raised when its star manager Greg Coffey decided to quit, aged 41, and when another pedigree firm, Brevan Howard, also decided to return capital. Do hedge fund managers want to be smaller because the markets in which they operate have shrunk?
The question has gained currency with the recent publication of ‘The Hedge Fund Mirage’, by Simon Lack, a former hedge fund investor. He concludes that: “If all the money that’s ever been invested in hedge funds had been put in the Treasury bills instead, the returns would have been twice as good.” Popular media headlines promptly pronounced the death of hedge funds. Yet their AUM continues to defy gravity. Two factors explain this riddle.
One is the relentless investor thirst for uncorrelated absolute returns – positive investment outcomes irrespective of market conditions. From a standing start at the time of the 2000-02 bear market, for example, pension plans worldwide now have a 5% allocation, totalling over $1.4trn today. In the beginning, mouth-watering returns drove the growth. Now, it is the search for low-volatility risk-adjusted returns that does. Hedge funds are perceived to be well placed in this context.
Another reason behind headlong growth is the rapid convergence between mainstream and hedge fund strategies that first started in 2004. Hedge fund managers seeking stable revenue streams have been emulating their long-only cousins. Likewise, long-only managers facing outflows from equity products and mounting threats from indexed funds have been adopting hedge fund tools to deliver uncorrelated returns. “As correlations within and across asset classes have spiked,” notes Benjamin Poor, manager of market intelligence, Citi Securities and Fund Services, “it has become critical for managers to employ high-conviction, contrarian techniques to stand out from the pack”.
According to Towers Watson, of the top 20 managers of alternative investments used by pension plans, around 15 are household names with a long-only pedigree. Most are emerging as significant players in one or more key alternatives: commodities, hedge funds, infrastructure and private equity.
Since 2008, most defined benefit plans worldwide have experienced mounting deficits. Worse still, extreme equity market volatility has also injected unusual fluctuations directly in the balance sheets of the plan sponsors and indirectly in their share prices. Moderate-return, low-volatility investment options have gained ascendancy.
The old-style diversification, based predominately on the equity-bond mix and relative return benchmarks, is being replaced by a new form that seeks to manage risks more than returns, volatility more than correlations. Its core aim is capital conservation, with an absolute-return benchmark.
The version now gaining traction is akin to the old-style balanced mandates but with five key differences: it deploys a broader palate of assets; it engages in tactical tilts to capitalise on periodic price dislocations; it targets an absolute return benchmark; it adopts an absolute-risk focus; and it separates out alpha and beta. This eclectic approach has turned the spotlight on alternatives in general and on hedge funds in particular.
Hence the current wave of investment in hedge funds is different from the last in one important respect. The first was primarily high-net-worth individuals seeking large returns from stand-alone strategies within broad risk parameters, while the current wave is largely pension plans seeking modest returns from a blended solution within narrow risk parameters.
The resulting institutionalisation is professionalising what was once a cottage industry.
Today, the biggest increase in allocations year on year is among pension plans which have invested between $1bn and $5bn in hedge funds. The comparable figures in 2002 were $1m and $5m, according to the CREATE-Research programme.
However, as an unintended consequence, with bigger allocations have come the demands for greater transparency in a host of areas. These include: performance attribution analysis; liquidity breakdown of portfolios; exposure of the top 5 to 10 positions by name, sector/industry/geographical breakdown of assets, core risk analytics, country risks, stress tests; and real time access to portfolio information. “Even hedge funds not stung by outflows realise that times have changed and are coming to the table with an open mind in regard to fees, transparency, and new portfolio solutions,” notes Poor. He cites the increased use of separately managed accounts and the so-called ‘fund-of-one’ (a bespoke limited partnership created for a single investor) as examples of hedge funds willing to provide custom solutions for institutional investors.
Pension funds demand discipline, but discipline can stifle pension funds’ creativity and lead to missed opportunities. Ironically, it is more acceptable for a pension fund to lose money in other asset classes than in hedge funds – the latter carry a bigger ‘headline’ risk. Institutionalisation brings its own challenges.
The hedge fund universe is boundless. As markets in financial, physical and intangible assets evolve, the scope for price anomalies will always be there. The key to success is having talented individuals who can devise new strategies and commercialise them at an ever-faster rate.
Like rock stars, they prefer to work in small bands: they see size as the enemy of alpha. They also see theirs as a lifestyle business where profits matter more than growth, scope more than scale, performance more than size, autonomy more than brand.
Hence we encountered two future scenarios for hedge funds in our research.
The first envisages institutionalisation changing the hedge fund industry beyond recognition. It rests on the view that, with the information explosion, price anomalies will be ever fewer and alpha will become an ever bigger zero-sum game, net of fees. Hence, the search for low-volatility low-risk options will intensify this decade, as will the pressure on fee models. The 2-and-20 structure will become history.
The second scenario envisages a bifurcation between product alpha and solutions alpha. The former will centre on talent pools deployed in small craft shops run as lifestyle businesses that aim to deliver stellar returns. It rests on the view that economic growth and market evolution around the world will always create price anomalies for those who have the autonomy, space and agility to generate high-conviction ideas and execute them. In contrast, the solutions alpha will be in the eye of the beholder: whatever enables a pension plan to meet its liabilities.
Institutionalisation has become a lifesaver for the hedge fund industry at this phase of its evolution. It reflects investors’ shift from one market environment to another. The world of investing is cyclical, adaptive and self-correcting. Strategies go in and out of fashion. It is rash to project the here-and-now into the future. It is even rasher to write eulogies.