A Reprieve for Hedge Funds - But Challenges Remain

We all know the story. The hedge fund industry grew from a handful of funds on a relatively small asset base in the early 1990s to over $2 trillion in assets today. What really spawned the explosive growth were hedge funds’ positive returns which were uncorrelated to the equity market in the post-2000 Tech Bubble bear market.

Since then, the chart below of the HFRX Global Hedge Fund Index and the S&P 500 shows that hedge funds returns have become highly correlated to the S&P 500. In the current equity market downturn, hedge fund returns have fallen with the S&P 500 but the level of correlation has decreased in the last few months. (Click chart to enlarge.)

Challenges remain for the hedge fund industry

Despite the near term recovery, several challenges remain for the hedge fund industry. Firstly, no doubt many hedge fund investors feel chastened by their experience, and caution will be the watchword going forward. In addition, various studies have shown that hedge fund returns can be replicated using factor betas. Larger sponsors that I have spoken with echo the sentiments of Russell Read, chief investment officer of the $225 billion California Public Employees Retirement System: “We can get average market risk very cheaply. We hate paying a performance fee for something we can get very cheaply.”

The industry is getting more institutional

These problems are well known and many commentators have given their views on how the hedge fund business is likely to evolve, so let me throw me my two cents' worth.

• The industry needs to move away from a strict absolute return based focus and needs to better understand clients and customize solutions
• Fee compression pressure will intensify as a result.

Understanding the client

For most of their history, hedge fund managers have marketed themselves as absolute return vehicles, with low correlations to other asset classes. As returns came down, they clung to the low correlation idea, but that line is wearing a little thin these days.

Low correlation, in and of itself, has limited value. Supposing that I told you that I had access to a fair roulette game, i.e. the house didn’t have an edge. Returns would be uncorrelated to virtually any asset class that you could think of. Would you fund me on a 2% and 20% fee structure?

I believe that the key to surviving and prospering as an alternative asset manager is to learn to listen more to clients and understand how sponsors put together portfolios. You represent a piece of a jigsaw puzzle to them and know what benefits you offer.

This William Mercer study for the State of Arizona is typical of the new thinking. Mercer suggests, among other things, that sponsor portfolios should be optimized to alpha exposure. Expected alpha, alpha volatility and alpha correlation all matter in how you pick managers. This is part of the move toward the “portable alpha” concept where a sponsor moves towards a liability driven investing framework. He builds a passive portfolio based on that benchmark and then overlays a “portable alpha” on top of the passive portfolio.

Fee compression pressures to rise

If the concepts in the Mercer study become accepted and widespread, then fee compression pressures are likely to rise. Reading between the lines, the terms of “expected alpha”, “alpha volatility” and especially “alpha correlation” sound suspiciously like the hedge fund factor betas concept that Bridgewater Associates and others have documented in their studies. The obvious conclusion is, you shouldn’t be paying the same level of fees for beta as alpha.

Further fee pressures could come from portable alpha implementation. A sponsor can gain access to a portable alpha in two ways. The high cost route would be to buy it from a hedge fund or a hedge fund of funds. The cheaper way would be to synthetically create an alpha stream by hiring a traditional long-only manager and shorting the manager’s benchmark against the long portfolio. As an example, the sponsor could hire a small cap equity manager and then simultaneously short the Russell 2000 using derivatives. The hedge fund solution would cost 2% and 20% or more. The synthetic alpha solution would run around 0.5% and 1.0% for a reasonably large sponsor.

If you were a pension fund or endowment fund, what would you choose?

Comments

[gordon]

I hope they all go BK. They are responsible for the volatility which is driving small investors away, the boomer generation is realizing it's a game they want all their own, funded by credit lines only available to them, thanks to their buddy Paulson.

[WilliamPlace]

All hedge funds should be OUTLAWED! They are just another instrument to siphon off more money from the working class to transfer to the wealthy. I pray all of the parasites involved with them take a dive to the sidewalk from a thirty story window!

[Carroll B]

Hedge Funds used to be run by a few particularly brilliant people, and were few in number. Their unique approaches actually contributed to the smooth functioning of the markets. After the Tech Rout of 2000-2003, hedge funds heavily shorted the very companies they shot up to the sky, took many individual buy and holders' money, and became the saviors of the world. It was no longer "plastics" for young, ethically-challenged youth, but "hedge funds". Their explosive growth led to more and more leming-like behavior, with more followers than leaders. They attracted money by maintaining they were necessary to the orderliness of the markets by taking the other side of the trade. The problem is they WERE and ARE the trade. They claimed superior intelligence to deliver Alpha, and it is only now that the Wizard's curtain has been torn away to reveal ordinary folk with extraordinary greed. Many of the their gimmicks, i.e., CDO's, SIV's, quantitative arbitrage, "distort and short" schemes, after-hours trading, naked short selling, taking short positions prior to PIPE deals they participated in, and simply the massive amount of speculation (that has hurt U.S. consumers at the gas pump and the grocery store), have swamped the financial and commodity markets in general, and has sucked capital out of the system, from the masses into the hands of a few. Their financial gimmickry has produced profits for their firms, and for the investment and commercial banks they have been in bed with, but have not contributed to the growth of the economy. Jobs from long-term investment in U.S. corporations have not been created. Fledgling companies have been snuffed out by short-sellers selling more shares than the companies' float. That is counterfeiting! The SEC has been the great enabler, by initially instituting the "grandfather clause" in Reg SHO, then allowing Fails-to-Deliver to continue for months and years on end. Try buying a stock and not paying for it for years. When Gary Aquirre, an SEC attorney tried to supoena John Mack, he was fired. Finally, last summer, they dropped the uptick rule created in 1934 to curb the short attacks prevalent today, for the feeble reason that they didn't think it was necessary any more, so "old-fashioned&qu... It is so "vanilla" to actually invest in a company for the long-term, to take one's fiduciary duty seriously. Nascent rallies since 2000 have been snuffed out, as short interest contiues its upward trend. As John Bogle put it, we must recapture the soul of capitalism, as contrasted to the short-term casino mentality by the very institutions that should maintain a steady hand on the trigger.