Top 400: Hedge funds coming of age
The credit crunch is forcing a reckless teenager to become a responsible adult, according to Amin Rajan
Hedge funds had a near-death experience in 2008. Devices like ‘gates' and ‘side pockets' designed to lock in their clients failed to prevent the stampede sparked by the market crash. When prime brokers duly triggered the margin calls, the punch bowl vanished in thin air: the party was over. Leveraged beta could no longer be dressed up as alpha.
In the ensuing fire-sale, asset values plunged by 19% from a peak of $1.9trn (€1.3trn) in 2007. The fall was all the more dreadful: remember, hedge funds were in business to make money even in topsy-turvy markets. Masters of the universe were publicly humbled. Many threw in the towel. For a while, the survivors envied the dead.
However, the latest data from Hedge Fund Review shows that the industry has pushed its global AUM a shade above $2trn. The sound of daily hedge fund implosion is a distant memory. So, is this business as usual? Is the magic of mean reversion as powerful as ever? Our research suggests that hedge funds have risen from the ashes, for sure: but they are bigger, safer and duller.*
Contrary to the old caricature, they no longer run on to motorways to pick up pennies; nor drive Ferraris with a Citroen's handbrakes. They focus on lower risk/lower returns, not out-sized returns; on asset gathering, not huge profits. The Madoff scandal merely hastened the process.
The curse of Gorbachev
Mind you, in their heyday, hedge funds did do something positively disruptive. What mobile phones did to landlines, what low budget airlines did to flag carriers, hedge funds did to long only managers: forced them back to their time-honoured mission to deliver absolute returns, with a clear separation between alpha and beta.
As an unintended consequence, however, hedge funds suffered the ‘Gorbachev syndrome', named after the last leader of the Soviet Union. It cautions that people who start a revolution are often its first victims.
The success of hedge funds in the 2000-03 equity bear market sparked a worldwide interest in absolute returns not correlated with market ups and downs, especially the big ones. Worldwide, some $5trn of assets herded into alternatives, with hedge funds attracting nearly a quarter of the total. In hindsight, the scale was breathtaking: many of the new strategies had been tested neither by time nor events. What seemed like an article of faith was just disguised greed, whose intensity was only exceeded by the subsequent fear when markets tanked in 2008.
For hedge funds, it was not enough that long-only funds failed their clients at the end of a raging bull market in the 1990s. Hedge funds had to succeed in their own right by delivering absolute returns in good times and bad; especially in periods of high volatility, as experienced in 2007-08.
The stellar performance of a small minority deservedly grabbed media headlines. For the rest, uncorrelated absolute returns remained a mirage. The published performance numbers are unreliable as they leave out those who failed. But they could not conceal a rising correlation with other asset classes. Like a rising tide, easy money lifted all the boats.
Internal research from a US prime broker in 2008 showed that in the previous three years - the ‘golden age' for hedge funds - 3% of managers delivered 97% of value. Undoubtedly, there were star performers out there. The rest had a stark choice: shape up or ship out.
The prevailing view was that when you have seen one successful hedge fund manager, you've seen one. Persistency was a major challenge: few managers were delivering on the trot for more than two years.
From growth to maturity
Hedge funds exploit price inefficiencies in a range of markets. On the downside, they hit capacity ceilings very quickly, as opportunities get arbitraged away with newcomers.
On the upside, however, the hedge fund universe is boundless, like its physical counterpart. As markets in financial, physical and intangible assets evolve, price inefficiencies abound.
The key challenge is having talented individuals - mini-Einsteins - who can devise new trading strategies and commercialise them at an ever faster rate. Only a few can do it.
The other challenge concerned scalability. Growing the business in response to rising demand involved transitions that, hitherto, the majority of hedge fund managers were unwilling to accept owing to the resulting dilution of their craft. They saw theirs as lifestyle businesses where profit mattered more than growth, scope more than scale, performance more than size, autonomy more than ownership. However, with survival at stake in 2008, options narrowed.
Some had shotgun weddings - eg, GLG Partners with Man Group; Thames River Capital with F&C. Unsurprisingly, hedge funds dominated asset industry M&A activity in 2009-10.
Some quit: the most high profile one being Duquesne Capital Management founded by Stanley Druckenmiller, a prominent protégé of the legendary George Soros.
Some switched to retail clients via regulated vehicles like UCITS, now dubbed ‘Newcits' to underline their hedge fund credentials. They have already amassed nearly $200bn, according to Eurekahedge.
Above all, most of them chose the institutional route, as pension funds made sizeable allocations to low-volatility absolute return funds. In response, hedge fund managers are creating an infrastructure of governance, systems and controls that meet their clients' fiduciary standards. The downside is that their returns are diluted by extra risk controls. But that doesn't seem to bother pension clients, who are targeting around 8% return after fees and charges. They know only too well that to search for high returns usually ends in tears. It's a sign of the times that this ‘new normal' is roughly half of what most hedge funds routinely promised five years ago.
This development not only makes them credible players in the pension space. It also changes their cottage industry nature. After all, pension clients prefer to stray further afield in familiar territory rather than discover new ones. Three further points are worthy of note in this context.
First, the typical boom-era of two-and-twenty fees is history for the bulk of mandates in the pension pipeline. Some funds are also demanding a ‘most favoured nation' clause to get lower charges and preferential access to prime capacity.
Second, pension funds' pursuit of absolute returns is no longer couched in terms of product alpha: defined here as excess returns over a cash benchmark. Increasingly, solutions alpha is being sought, too. It involves securing targeted returns at lower charges. While product alpha remains scarce, the best one can do is to chase other low-volatility options that match liabilities.
Third, hedge funds are now exposed to a raft of new regulation. These include the AIFM Directive in the EU and the compulsory registration with the Securities and Exchange Commission in the US. These measures will further hasten their industrialisation, no what matter their client base.
After their baptism of fire, hedge funds have aged rapidly. While it lasted, their party made the Wild West look tame.
Best performers are still earning fame and fortune, continuing to inspire media intrigue and gossip usually reserved for soap opera celebrities. As for the rest, they are keeping up appearances and keeping down their expenses, like the rest of us.
The new institutional money has proved the saving grace. And, hey, why care about the extra bureaucracy, so long as you still have an office in London's prestigious Mayfair?
Prof. Amin Rajan is CEO of CREATE-Research
*'Convergence and Divergence: New Forces Shaping the Investment Universe'. Available free from firstname.lastname@example.org