The hedge fund party is over, but the hedge fund business is thoroughly intact. The business has been experiencing a period of stress in which weaker players (both managers and investors) are being washed out, while the stronger players are enjoying even greater opportunities than before.
The period of stress has already been very painful for many people, and some of that pain will continue, but what will emerge at the end is a better and stronger business.
We all know the basic facts. Returns in 2008 were generally disappointing: the average hedge fund was down 19 per cent. Many funds closed, and many others angered their investors by imposing ‘gates’ on redemptions. Ironically, the better-performing funds that did not impose gates experienced disproportionately large redemptions as their investors scrambled for assets to sell during a global flight to liquidity.
The net result was a major contraction of the business. And that contraction is even more dramatic if you include entities that trade like hedge funds but do not have the formal legal status of a hedge fund. For example, the proprietary trading desks of the major commercial and investment banks have withdrawn massive amounts of trading capital.
Although it’s natural to worry about the future of hedge funds, obituaries would be premature. The party is over, but the business is alive.
In the early 1980s, when I first became involved with hedge funds, they were an exotic backwater of the investment business. The number of funds was small, assets under management were small and there were lots of people who didn’t know or care what a hedge fund was.
Then the business started to grow, and the growth became dramatic after the bursting of the tech bubble, when institutions developed an insatiable demand for ‘non-correlating strategies’. Unfortunately, new investors often had unrealistic risk/return expectations, and new managers often had unrealistic ideas about their level of skill. Everything looked easy — which usually means that it’s about to get very hard. And that’s exactly what happened.
Why did hedge funds do so badly, and what is the outlook for the future of hedge funds? Before we get into the details, let’s quickly note three positive points:
- although most hedge funds failed to deliver ‘positive returns independent of market conditions’ in 2008, they did much better than the standard equity benchmarks. The average fund was down 19 per cent, but many equity benchmarks posted losses from 30 per cent to 60 per cent;
- performance in 2009 has already shown signs of recovery, with the average fund up about 4 per cent through April 30; and
- hedge funds were victims of the global financial crisis, not the cause of it. Before the credit crisis unfolded, hedge funds were generally regarded as the Achilles’ heel of the global financial system, the most likely source of systemic risk. That anxiety drove widespread calls for tighter regulation of hedge funds. Ironically, it turned out that the real trouble spots were the large commercial banks and investment banks, which were among the most tightly regulated businesses on the planet.
Why did hedge funds lose money in 2008? Because they couldn’t cope with a universal flight from risk. The basic pattern in 2008 is that investors dumped all risky assets (stocks, corporate bonds, commodities, etc) in order to acquire safety assets (mainly government bonds). The correlation among risky assets approached 1, while the correlation between risky assets and safety assets approached -1.
This flight to quality created two big problems for hedge funds:
- many hedge funds weren’t fully hedged: they were net long some risky assets that lost value. For example, many equity-oriented funds were net long equity, and many ‘credit funds’ were net long credit risk; and
- even when a fund is ‘fully hedged’, the hedge will come under pressure during an extreme flight to quality. The problem is that in many ‘hedges’, the long position is more risky and less liquid than the short position. For example, an equity hedge fund might be long small cap ‘under-researched’ companies and be short large cap ‘household names’.
In the fixed income arena, many hedge funds pursue carry trades, where the basic strategy is to own a higher-yield instrument (‘spread product’) while shorting a lower-yield instrument (often a government bond). When the long position is more risky and less liquid than the short position, the aggregate trade is net long risk and net short liquidity. Such hedges are bound to lose money during a global stampede to quality.
The current situation of the hedge fund business contains a powerful irony. As the business approached its peak, many people worried that there was too much money chasing too few opportunities. Now that so much money has been removed from the playing field, the opportunities for survivors are better than they were before the shakeout. Indeed, we may now have too little money chasing too many opportunities.
Despite the current stresses, the fundamental supply/demand factors that drove hedge fund expansion are still in force. On the demand side, investors still have a deep-seated interest in strategies that have the potential to deliver positive returns when the standard markets are negative. As for supply, there will always be smart managers eager to escape the constraints of the long-only money management business.
What’s different now is that both investors and managers are much more sensitive to risk than they were before. The hedge fund business is brutally tough, but for a while it looked easy. That appearance was an illusion, and it led to trouble. That illusion is now dead, waiting for another illusion to take its place.
The hedge fund universe presents some excellent opportunities for the sophisticated institutional investor. However, the smaller retail investor is in a more difficult position. The smaller investor faces two problems: fees and access. Retail hedge fund products are encumbered with much higher fees than institutional funds, and those fees erode return. As for access, smaller investors often don’t have access to ‘institutional quality’ managers.
The access problem may get even worse as the surviving hedge fund managers try to ‘upgrade’ the quality of their investor base, eliminating ‘hot money’ in favour of more stable assets.
Just as Groucho Marx didn’t want to join a club that was willing to admit him as a member, the smaller investor should wonder about the business motivations of a hedge fund that is actively courting retail investors.
Robert Jaeger is senior market strategist at BNY Mellon Asset Management.
The statements and opinions expressed in this article are those of the author as of the date of the article, and do not necessarily represent the views of The Bank of New York Mellon Corporation, BNY Mellon Asset Management International or any of their respective affiliates.
