At the crossroads of performance and relevance
Since the end of the financial crisis many hedge funds continue to be frustrated by sharp and unpredictable, macro market moves driven by central banking intervention.
An investor in the S&P500 since 2009 would have made a return of 76.3% (excluding dividends); a return of 45% in 2010, 29.33% in 2011 and 28.64% in 2012, according to the data service S&P Capital IQ. Since 2010, the average equity hedge fund has produced returns (after fees) of 14.5%, according Hedge Fund Research Inc. Such underperformance along with the major regulatory changes has profoundly affected the way returns are made and clients are serviced.
“The hedge fund industry is going through both cyclical and secular changes. But as an industry, assets under management are peaking in absolute terms so funds are being raised,” says Ray Nolte, Co-Managing Partner and Chief Investment Officer of SkyBridge Capital.
The concentration of assets into the hands of a smaller number of managers appears to be a predictable client response to difficult market conditions. “In the current environment it is extremely difficult for startup GPs to raise capital. It is also hard for smaller established managers to gain traction.
“More money is being channeled to big managers. The large managers keep getting larger because clients are comfortable with big managers during uncertain times. And as clients’ AUM grow they channel more assets to the bigger funds, which supports this trend.”
One of the weaknesses of large fund management organisations is that their conservative nature can discourage innovation. “Large asset managers may not be as creative or be able to innovate new, less correlated investment approaches in the near term, but perhaps over the long run new strategies are unsustainable as their innovation is competed away.”
Nolte explains why capital has shifted out. “HNW investors have been influenced over the last five years by the more than 100% rise in the S&P 500. They are inclined to benchmark stock indices versus hedge funds. However, in the last 12 months, I have seen renewed interest out of HNW individuals and UHNW family offices who are coming off the sidelines and returning to the alternative assets market. One driver is that fixed income investing has run out of steam. Bonds as an asset class are under downward pressure. This has compelled them to look at alternative assets to substitute as part of the bond book.”
He defends the efficacy of hedge funds. “Investors need to recognise that if you are running a truly long term portfolio you also need to include private equity and hedge funds for their correlative properties. Hedge funds are efficient when constructed as a component of a portfolio. But don’t discriminate against them as an equity alternative rather than a portfolio component.”
Institutional clients have become more demanding at all levels from strategy to reporting. Nolte reflects on this as a positive outcome. “Today, institutions want to hear the ‘alpha proposition’ relative to their portfolios. Our fund of funds approach is alpha-centric so our strategies and themes are heavily research driven.”
He adds: “Managers cannot just provide hedge fund beta as there isn’t much value in it when compared with 10 years ago. And ‘access’ is not as valuable as it once was. You must show investors you have an edge. Days of running a couple of hundred million dollars and grow as a fund of funds manager are dead. Now you need more than two or three people. You need a real business to attract clients, gain business and achieve AUM scale.”
Unfortunately, these requirements have raised the cost of starting and running funds, prohibiting many managers from establishing or growing a GP. “Fund management infrastructure and IT costs have steadily risen due to more compliance requirements.
“Clients want more much more transparency throughout the entire investment and reporting processes. And as a consequence, we are demanding complete transparency from the managers we are using. This was definitely not the case pre-crisis. But these new systems have proven to be helpful for portfolios as they allow extensive stress testing.” Selecting and working with managers can be challenging in today’s macro driven conditions. “Style drift is certainly one problem we keep an eye out for with the managers we work with,” Nolte says. “We select managers who can run a specific rather than general strategy within our mandate.”
Due diligence and understanding the nature of performance has changed considerably since the financial crisis. “Today, everyone is more careful about manager selection; there is less buying of ‘return numbers’ than during pre-crisis days. Now we ask a manager, ‘How do you do it?’ and we seek to understand the way they invest.” Nolte laments the performance of long/short hedge funds. “As a general matter, we wouldn’t buy into a leveraged equity, long short hedge fund because they have mostly underperformed.
“Long/short equity strategies have represented half of the industry’s funds and post financial crisis it has hugely underperformed. Risk on, risk off has made it difficult for a typical manager to perform well. Managers end up not differentiating good stocks from bad and even if you are managing risk there has been little return in recent years.”
Nolte adds: “Institutions used to split their equity book into two segments: beta and alpha (long and short equity). Now they are forced to rethink that due to the underperformance of long/short strategies over the last several years. Now there is a migration back to long only, active equity managers and an increased use of ETFs to adjust portfolio balance.”
Perhaps one of the biggest changes that will affect the future of hedge fund management is the decline of holistic thinkers in the form macro managers and stars in favour of specialists. “The hedge fund and investment management industry are not creating any new macro style managers in the likes of Buffett, Soros. Now with the closure of banks’ proprietary trading desks, there is almost no opportunity to allow this kind of training to develop.
“Most asset managers are specialised and strategy focused on themes like M&A and derivatives. New multi-strategy funds have assumed dominance over macro funds. The 1980s and 90s training ground for macro style thinking and trading is no longer present.”