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Written by: Don Steinbrugge | Agecroft Partners
The following comments are excerpted from Agecroft Partners’ Don Steinbrugge’s presentation delivered at the 69th CFA Institute Annual Conference held on May 9th, 2016 in Montreal. In Mr. Steinbrugge’s session titled “What Current Trends Tell Us about the Future of the Hedge Fund Industry” he discussed a number of the recent quotes and articles directed to the hedge fund industry that were covered broadly by the media.
Third Point Capital CEO Dan Loeb thinks hedge funds are in the first stage of a “washout” after “catastrophic” performance this year.
The HFRI Fund Weighted Composite Index posted a decline of -0.67 % in Q1 of this year, which on the surface isn’t that bad. Upon closer examination, this moderate decline is hiding the vastly different paths various managers and strategies traveled during the quarter.
In January and February, strategies with a lot of beta, exposure to the equity and fixed income markets, such as activists, long/short equity, and distressed debt, generated very poor performance, which was significantly worse than most investors’ expectations. Investors do not mind if these strategies underperform during a bull market, but they are expected to reduce downside volatility during periods when the market sells off. Fortunately, these strategies rebounded significantly during the month of March and only finished the quarter slightly down. Nonetheless, investors remain disappointed that these strategies did not provide the downside protection they expected.
Strategies that are uncorrelated to the capital markets performed very differently. For example many direct lending and reinsurance managers posted positive returns in each of the first three months. Market neutral and relative value fixed income managers generally exhibited significantly less volatility than high beta oriented strategies. CTAs, although volatile, enhanced a diversified portfolio’s Sharpe Ratio by being negatively correlated during the quarter; they were up in January and February and then gave back some of the gains in March when other strategies rallied.
What is also not apparent when looking at the quarter's performance is the huge dispersion of returns exhibited by managers within each strategy. In many cases there was over a 20% differential in returns between the best and worst performers within a single strategy. When strategies underperform investors’ expectations and when dispersion of returns between managers increases significantly, it results in a significant increase in fund redemptions, especially for those managers that underperformed.
It is our belief that most of this money will stay within the hedge fund industry. Some will be reinvested within the same strategy with managers that have significantly outperformed their peers. Other will shift away from high beta oriented strategies that exhibited significant volatility in the first quarter and re-invest in uncorrelated strategies that protected investors’ capital during the selloff in January and February.
This increase in demand for strategies uncorrelated with the capital markets is also driven by two other factors. The first is investors’ concern that the capital markets have significant tail risk. The sluggish growth of the world economy raises fears of another 2008 type selloff, which could be compounded by monetary authorities around the world lacking the dry powder necessary to stimulate the global economy.
In addition, hedge fund investment decisions stem from allocators’ forward looking view of each strategy’s expected return and associated risk (volatility). Back in 2009, it was very difficult to raise assets for a market neutral equity strategy or a relative value strategy expected to generate mid to high single digit returns because most investors were looking for strategies that could generate mid teen returns. As interest rates came down, spreads tightened and equity valuations increased, investors’ return expectation for beta oriented strategies declined. Three years ago, investors were generally looking for a 10% minimum return to warrant an allocation. Over the past three years expected returns have continued to decline. Today most investors are looking for a mid to high single digit return for their hedge fund portfolio. In this environment, uncorrelated strategies look very competitive from a risk return standpoint.
As investors pull their money out of poorly performing funds, we will see an increase of fund closures. Some of these firms’ assets will decline to the point where they are no longer profitable. Others will acknowledge that the significant drawdown they suffered in the first quarter will materially impair their ability to raise capital for the next several years.
Hedge funds lose most money since 2nd quarter of 2009.
It is true that the hedge fund industry saw the most outflows in the first quarter of 2016 since the second quarter of 2009. To put this in perspective, the hedge fund industry has grown fivefold in the past 15 years from approximately $600 billion in 2000 to $3 trillion at the end of 2015. The $15 billion of outflows the industry experienced in the first quarter of this year represents only one half of 1 percent of the industry assets. Even eight quarters in a row of $15 billion in redemptions, would barely make a dent in industry’s AUM.
Former hedge fund manager and multi-billion dollar family office CEO Steve Cohen recently spoke at the Milken Institute Global Conference and stated, “It’s hard to maximize returns and also maximize assets.”
Many hedge fund investors agree that there is an inverse correlation between assets size and performance. This can be viewed on an industry basis and at the manager level. At the industry level, the 5x increase in hedge fund industry AUM since 2000 has made it more difficult for managers to generate strong returns.
While this does not mean that hedge fund managers cannot make money, it does mean that return expectations have generally come down and more so in some strategies than others.
At the manager level, before 2008 it was very common for successful hedge fund managers to close their doors to new investors to keep assets under management at a level where they could maximize returns. Today, more and more managers are growing their assets well above their optimal asset level and effectively prioritizing asset gathering over performance.
Some institutional investors’ hedge fund strategy is to build out diversified portfolios comprising of the largest most well know managers. While some large managers continue to generate very strong returns, a portfolio diversified across only the largest managers will probably generate sub optimal returns.
Cohen also noted that talent within the industry is thin.
The number of hedge funds has significantly increased in the past few years to an estimated 15,000 funds. We believe that only 10-15% are of the quality to justify their fees. These percentages are also consistent with our views on the mutual fund industry where most managers under perform their benchmark. The high percent of lesser quality managers considerably dilutes the performance of the hedge fund industry as a whole which is reflected in the returns of the hedge fund indices. Even with the recent poor performance, I believe that money will stay invested in hedge funds, in large part because most professional hedge fund investors believe they can do significantly better than the indices. The key to successfully investing in hedge funds is to select the strategies and the top talented managers that will enhance the risk adjusted return of a portfolio. Seeing an increase in the closure rate of low quality hedge fund organizations would be a positive for the industry.
Buffett stated that hedge funds get unbelievable fees for bad results.
Not surprisingly, the hedge fund industry views these comments as prejudicial and unfair. While his comments may be true for a majority of funds, there are a number of managers that are extremely talented and well worth the fees they charge. In addition, there are a number of strategies that add significant diversification benefits to portfolios that cannot be replicated by ETFs or index funds.
Christopher Ailman, CIO of CalSTERS, stated the “2 and 20 model is dead.”
Actually, the standard fee, included in hedge funds’ operating documents, has come down very little over the past few years. We have, however, seen a significant increase in hedge funds negotiating lower fees for large, institutional mandates. Pension funds, like CalSTERS, that can allocate more than one hundred million dollars to a manager should almost never have to pay 2 and 20 unless it is for a truly exceptional manager or for a capacity constrained strategy. Large pension funds that allocate to small and midsized managers should be able to negotiate fee arrangements that are 25-50% below the standard rate.
“NYCERS votes to exit hedge funds. Will other pension funds follow?”
Approximately 18 months ago CalPERS also voted to exit all hedge funds. Although widely covered by the media and discussed across the industry, almost no other pension fund followed CalPERS’ lead until NYCERS’ decision. We do not believe many pension funds will eliminate hedge funds from consideration in their portfolio for two primary reasons. First, most pension funds take an academic approach to their asset allocation which includes formulating forward looking assumptions for returns, volatility, and correlations for each component of their portfolio. These assumptions are based on a number of factors including long term historical returns for an asset class, current valuation levels, and economic expectations. Most institutions are currently using a return assumption for core fixed income of between 2.5% and 3%. Up until last year these investors’ return assumption for a diversified hedge fund portfolio was between 4% and 7%. Even if those return assumptions decline, they should still be higher than those forecasted for fixed income. As long as the expected returns from a diversified hedge fund portfolio, after fees, is higher than those of a traditional fixed income portfolio, most pension funds will continue to invest in hedge funds.
Second, pension funds will not eliminate all hedge funds from their portfolios because hedge funds are not an asset class, but a fund structure comprising many different strategies. Some of these can add valuable diversification to a portfolio. Many pension funds learned, during the market selloff in the fourth quarter of 2008 that they were not as diversified as they thought. Correlations between strategies and individual investments rose closer to +1.0. There is still a valuable place for investments which can improve the risk/reward profile of pension portfolios.
In conclusion, aside from the effects of changes in market value, we expect the hedge fund industry’s total assets at the close of 2016 to be fairly close to where they started the second quarter of the year.