Hedge funds used to be all about performance. Stellar investment returns could win managers bragging rights, the enduring loyalty of investors and a fortune. But after a year when the average hedge fund is lagging broad market indices, their performance is nothing to write home, or to investors, about.
Over the year to date, hedge funds are down 4.4 per cent according to HFR, the Chicago-based data provider. The S&P 500 is up 0.3 per cent over the same period. Across most hedge fund investment strategies, managers are in negative territory for the year, blown off course by a storm of volatility, illiquidity and geopolitical uncertainty, particularly in the eurozone.
Luke Ellis, chief investment officer and head of the multi-manager business at Man Group, one of the world’s largest alternative investment houses, admits that in absolute terms, industry performance has not been good. “It has been a staggeringly difficult period during which to run money,” he says.
John Bailey, founder and chief executive officer at Spruce Investors, a US-based group that invests on behalf of endowments, family offices and wealthy individuals, says poor performance is putting pressure on managers.
“Against the backdrop of tough market conditions, patience is not something investors typically have. They are unlikely to keep the faith for long with managers who are not performing. Managers can quickly find themselves under real survival pressure if they fail to match investor expectations. Even one year of poor performance can be the difference between success and failure for some hedge funds,” he says.
Emma Sugarman, global head of capital introductions, BNP Paribas, based in New York, says while allocations to the hedge fund industry have slowed down, there is also a fundamental shift in where assets are going as investors re-evaluate the risk and return potential of hedge fund investing.
She notes that institutions are increasingly going direct to hedge funds and this is putting pressure on small to mid-sized funds of hedge funds. “The very largest, blue-chip, funds of hedge funds are still gaining assets. Money going directly to hedge funds is generally a positive development for the industry,” says Ms Sugarman.
Paul Hamill, global head of prime services at HSBC, based in London, says before the financial crisis, performance was the single most important factor for investors in hedge funds. Long-term performance remains important, he says, but other factors such as risk and control infrastructure, non-correlated returns, quality of investment team and investment philosophy, liquidity terms, stability and asset manager brand are becoming more important in the selection process.
Mr Ellis says recent performance woes can be attributed not only to the choppy market conditions, but also to the way in which the hedge fund industry itself has developed in recent years.
“If you really look at what hedge fund managers are about, it is bringing risk management to asset management,” he says.
“Risk management essentially tries to cut out the left hand side of the performance curve. In this sense risk management is almost like buying a put option. And what drives the pricing of that put option is volatility, correlation and liquidity.”
Over recent months markets have displayed incredibly high correlation, high volatility and severe illiquidity.
At points when the market is relatively stable, decent trading volumes have been seen, says Mr Ellis. The problem for many hedge funds is that big moves seem to be happening on low volume days.
“For hedge funds, that means they have been sailing into strong headwinds. The risk rules that we have been taught to employ have been kicking in because the market moves far enough for them to do so but then reverses on a very frequent basis. So the cost of risk management, in that volatile environment, is very high,” he says.
Against the backdrop of continuing volatility, a high degree of fear and trepidation appears to have crept into hedge fund investing. In this regard, hedge funds are not unlike more traditional fund managers, many of whom are also taking a cautious approach. Retail investors are typically sitting on large cash balances and institutions, in many cases, are leaving their portfolios untouched in an effort to ride out the storm.
As a result, the number of non-hedge fund professionals actively trading at any given time is relatively low. Mr Ellis says this combination of factors could leave hedge funds trading against each other, squeezing returns.
As hedge fund managers take a relatively low risk approach, the task of identifying truly outstanding managers becomes more onerous, according to Mr Bailey.
“Investors are looking for true alpha generators and managers who have demonstrable skill at shorting. Finding those managers is no easy undertaking. It requires a great deal of networking and you really have to put in the time and effort to meet as many managers as possible. You will come across a lot of bad managers but it is worth it to find the good ones,” he says.
Mr Ellis confirms that returns are available in the market, but continuing uncertainty makes those returns difficult, if not impossible, to harvest. “The fact is there is a tremendous amount of alpha lying around in stocks and credit but people are not able to extract it until we get some sort of clarity about how things are going to look even in two weeks’ time.”
Ms Sugarman says the flight to quality that started in the immediate wake of the crisis is continuing, with almost all new and reallocated money going to the best known and established funds. “We are also seeing a greater desire among hedge funds to be able to shift their balances quickly based on geopolitical developments. For that reason lots of funds are establishing relationships with multiple prime brokers.”
Predictions of the death of the hedge fund industry are not a new development. As the year-end approaches and redemptions are made, some hedge funds will be forced to close, but Mr Ellis doubts that an industry implosion is on the cards.
“This is nothing like 2008. There is none of the panic. It is clear there are redemptions across the industry and I think what we will see is more and more funds giving up rather than blowing up.”
Indeed, predictions of the death of hedge funds are not a new development. Even I thought there would be less, not more, hedge funds after the 2008 crisis. But the reality is institutions keep piling into hedge funds as they need to allocate a certain percentage of their portfolio to this 'asset class'.
Sophisticated institutions are developing alpha internally and approaching their hedge fund allocations in a more intelligent manner, focusing on transparency, liquidity (flip side of transparency), truly uncorrelated alpha and knowledge leverage. And real smart money is now seeding emerging hedge fund managers, realizing the benefits of getting in early with tomorrow's potentially top fund managers.
These are not easy times for any fund manager. Hedge funds' fading star is part of a larger industry-wide problem of alpha falling by the wayside. Extreme volatility is confounding even the best fund managers as they try to cope with all the uncertainty surrounding the eurozone.
In my opinion, pension funds and wealth funds are best suited to capitalize on what is going on in these markets. Why? Because they can buy shares of companies that have been decimated due to surging hedge fund redemptions, sit on them and wait it out. Importantly, their time frame is much longer than hedge funds and mutual funds, but few pensions are using this to their advantage because they do not have the internal expertise to capitalize on opportunities as they arise.
As for hedge funds, the landscape is changing, just as it is for private equity funds. They won't die, and things are not as bad as 2008, but the demands of institutional investors growing increasingly tired of doling out huge fees for underperformance are growing. Only the best will survive the structural shakeout in the "alpha" industry. Below, some Sunday inspiration for hedgies and fund managers struggling in this environment (love this clip; watch it every time I need inspiration).