Hedge funds was the topic of the latest episode of A Finance Podcast. Listen here
A lot has changed since I started looking at hedge funds early in my career. In March 2000, the going was good: Internet stocks were bubbling away; the NASDAQ was making new highs; and every IPO seemed to quadruple in price on Day 1. As a junior private banker, I shared responsibility for a couple of client accounts with small allocations to hedge funds. LTCM had impoloded a couple of years earlier and legendary trader Julian Robertson had just anounced his decision to close his hedge fund firm Tiger Management. I knew next to nothing about hedge funds, but I was curious and eager to learn.
Fast-forward and today I manage the hedge fund allocations for a small family office. In the space of 14 years, hedge funds have exploded in size, and a few high profile managers have become household names. The asset class is barely recognisable.
A lot of good things have happened in the intervening years: vastly improved investor communications; greater manager accessibility; better compliance and risk management systems. But the growth in the size and number of hedge funds has come with a cost: namely, lower returns.
The “old” hedge fund investors of the 1990’s used hedge funds as high-risk speculative investments to spice-up portfolios mostly invested in bonds. Besides being much smaller in size, the hedge fund industry looked radically different than today. Around 50% of hedge funds were global macro/ CTA’s, and leverage was higher. Investing in hedge funds was very much an insider's club. No one did much marketing. Information was scarce and entry into the top funds was usually through introduction by another existing well-heeled investor.
While there's a lot that's problematic about hedge funds today (too many funds, crowded trades, etc.), there’s been an important shift in the investor profile which has had huge consequences on returns. Enter the institutional investor.
Instead of the old 25%+ net annual return objectives (accompanied by episodes of stomach-churning volatility), this new class of investors was prepared to sacrifice outsized returns in exchange for lower volatility. An 8% net return was just fine, so long as monthly performance was relatively steady.
Since hedge funds were relatively untouched by the bear market in equities between 2000 and 2002, some strategists wrongly concluded that they deserved a large weighting within the asset allocation strategy of the typical institutional investor, even advocating their use as substitutes for traditional fixed income and equity.
As hedge funds grew in size on the back of huge inflows, the old macro funds reached capacity. But plenty of new funds- and new strategies- sprung up to fill the demand. The new pension fund investors were more than willing to pay fees of “2 and 20” but demanded higher standards of professionalism. The message was clear: black boxes were “out”, transparency was “in”. Intense discussions on risk management, limits, and stop-losses became order of the day during due diligence meetings.
And so we reach the present day, where there are thousands of hedge funds, but 80% of allocated capital goes to the largest-sized funds in the top quartile. It is virtually impossible for a start-up hedge fund to attract institutional money without making sizeable fixed investments in risk systems, operational infrastructure and compliance.
Provided returns are steady and moderate (no need for eye-catching performance), investors (mostly pension funds) will not redeem. But when loss aversion becomes more important than profit maximisation, and infrastructure costs are high, earning the 2% annual management fee takes on added importance. In short, it keeps the business running. Why make bold trades which could potentially earn outsized returns for investors (and high incentive fees for the manager) but could equally go wrong, lead to mass redemptions and imperil the business itself?
Much has been gained through greater transparency and more robust risk systems, but something important has been lost. Dare I say it?- the “wow factor”.