Article / 11 May 2016 at 13:22 GMT

What's haunting hedge funds?

Managing Partner / Spotlight Group
United Kingdom
  • Q1 2016 was dreadful for hedge fund returns 
  • Major investors are withdrawing funds in protest at high fees and low returns 
  • Pace of net growth in hedge funds numbers is stalling 
  • Many investors are now becoming replicators

Breakwater
 Hedge fund investing is under pressure like never before. Photo: iStock

By Stephen Pope

In this low-growth world where interest rates are close to or even below zero, sentiment and conviction are important factors in generating good returns. 

It is, however, important to hold realistic sentiments and to keep one’s convictions under regular review to eradicate blind stubbornness. So the once-glamorous world of hedge fund investing is under pressure like never before.

What is a hedge fund?

The term has been used since 1949 when Alfred Winslow Jones started to buy undervalued equities and short overvalued ones in a market-neutral approach. By using short selling, leverage and performance fees he delivered solid and consistent capital gains while minimising risk.

Simply put, it is a tool that delivers reliable returns for a diverse range of investors, such as institutional asset managers, non-profit entities, public-sector pension funds and university endowments.

Since 1990, the number of funds expanded by an incredible 1,600%, though they are still relatively small compared with the asset segments they invest in. The UK’s Financial Conduct Authority listed hedge funds as the third largest type of alternative asset class.

Hedge funds use a variety of strategies and although most funds will claim that they are unique, these strategies can be grouped into categories to assist the evaluation of how a particular strategy might perform under certain macroeconomic conditions. 

The main styles are as follows:

Equity Hedge

The Equity Hedge strategy, or long/short equity, is one of the simplest strategies to understand.
In this strategy, hedge fund managers can either purchase stocks they feel are undervalued or sell short stocks they deem to be overvalued.

In most cases, the fund will have a net positive, or long, exposure to the equity markets – for instance 75% long, 25% short. 

In this example, the net exposure to the equity markets is 50% (75% minus 25%), and the fund would not be using any leverage, which means gross exposure is 100%, (75% plus 25%).

If the manager, however, increases the long positions in the fund to, say, 80% while still maintaining a 25% short position, the fund would now have gross exposure of 105% (80% plus 25%). This implies leverage of 5%.

Market Neutral

With a Market Neutral strategy, the hedge fund manager applies the same concepts from the long/short strategy but minimises exposure to the broad market.

This can be achieved by having equal amounts of investment in both long and short positions so that the net exposure of the fund is zero. Alternatively, the manager can seek zero beta exposure by having investments in both long and short positions so that the beta measure of the overall fund is as low as possible.

The objective is to remove any impact from market movements and rely solely on the fund manager's ability to pick stocks across a region, sector or industry.

Global Macro

Global Macro funds invest in stocks, bonds, currencies, commodities, options, futures, forwards, and other forms of derivative securities. They undertake directional trades on the prices of underlying assets, and they are usually highly leveraged.

Given the need for a wide diversity of investments, these strategies take a global perspective and can grow to become quite large before facing any capacity constraint. These are the strategies that have the highest risk/return profiles of any hedge fund strategy and two of the most spectacular hedge fund disasters: Long-Term Capital Management and Amaranth Advisors. Both were fairly large, highly leveraged funds.

Relative Value Arbitrage

Relative value arbitrage is a universal term captures a variety of different strategies deployed across a wide range of securities based on their relative value (RV). The hedge fund manager purchases a security that is expected to appreciate, while simultaneously selling short a related security that is expected to depreciate. In effect, fund managers are constantly making spread trades based on standard deviation misalignment.

The strategy can be used between the equity and bond of a specific company, equities in two different companies within the same sector; or two bonds by the same/similar issuers with different maturity dates and/or coupons looking for a curve shift or a duration play.
For each and every RV position one can find the equilibrium or breakeven value, and managers set their own overall profit targets.

Quantitative Funds

These funds use computer-programmed algorithms to determine the assets to be bought and sold, in what volume and at what frequency. They can be associated with high-frequency trading and are sometimes referred to “Black Box” strategies.


Hartford Connecticut
  Many hedge funds are domiciled in the lush state of Connecticut whose capital, 
Hartford, is shown here. Photo: iStocks


So how have hedge funds performed? 

From 1998 to 2011 hedge funds delivered a superior performance in terms of returns when compared with equity or bond indices.

Hedge Funds
 
Sources: Factset, Hennessee Group, Dow Jones, Credit Suisse, Hedge Fund Research, Barclay Hedge

The chart shows that over the 13-year period hedge funds were able to deliver a superior return at a considerably lower level of risk. In effect, the hedge strategies had arbitraged away much of the standard deviation risk while consistently delivering superior returns.

However, since 2011, there has been a turnaround in the relative performance results as the S&P 500 has gained some 50% whereas as most hedge fund strategies have failed to make much headway, if any. (See second chart)

At the end of last year, there were almost 9,000 funds with about $3 trillion of assets under management. However, a mounting series of poor returns has led to several high-profile investors withdrawing their capital and a series of fund closures. On February 20 this year, The Economist said that while one used to be able to match one fund closure with another start-up, the balance is now tilting in favour of closures.

In 2015, by the end of the third quarter, 785 new funds were launched and 674 were closed, according to Hedge Fund Research, compared with 814 new funds and 661 closures over the same period in 2014. In 2016, for the first time since the worst of the financial crisis, closures may outweigh launches. 

Hedge Funds Source: Arbour Research

The chart above tells all that is needed about why many funds are closing as investors withdraw their capital.

In 2014, the California Public Employees’ Retirement System (Calpers) divested the entire $4 billion that it had placed in 24 hedge funds. It said they were proving to be too expensive, underperforming and mired in complexity.

"We concluded that we would eliminate the hedge fund program in order to reduce the complexity, reduce the costs in the program, particularly in relation to our view that given the scale of Calpers, we would not be able to scale a hedge fund program to a size that would really move the needle, …” said Ted Eliopoulos, Calpers interim chief investment officer at the time

The California pension system invested in funds run by Och-Ziff Capital Management Group LLC, Bain Capital LLC’s Brookside Capital, Lansdowne Partners LP and Canyon Partners LLC. Calpers’ rate of return goal is 7.5%, whereas the annualised rate of return on its hedge fund investments over the last 10 years is 4.8%.

Worst quarter

Hedge funds suffered their worst quarter in seven years in the first quarter of 2016. Investors continued to pull funds out to the tune of $15 billion in the first three months of the year.

The total capital invested in hedge funds dropped to $2.86 trillion in the first three months of the year, marking the first time since 2009 that the sector has suffered two consecutive quarters of net outflows, according to Hedge Fund Research.

As the second chart shows, the main reason investors are pulling money out of hedge funds is the funds' poor returns. Hedge funds delivered their worst annual performance in years in 2015, posting a small loss. In contrast, the US equity benchmark, the S&P 500, returned 1.4%, including dividends.

Time to replicate and avoid the fees

Certainly this year has not looked any brighter as hedge funds lost about 2.0% through February, with a small recovery seen in March as equity and commodity markets rallied. A broad index of hedge fund performance compiled by Hedge Fund Research fell by 0.7% in the first quarter, and given that money has no emotion, the inadequate performance focuses investor attention on the high level of fees. Hedge funds typically charge a 2% fee on assets under management, as well as taking 20% of any profits.

Replication involves creating an investment product that generates returns similar to hedge funds and should offer the benefits of hedge fund investing, including diversification and return enhancement, without the relatively high cost of fees, lack of transparency, and other risks of hedge funds. The basic tool used in replication is a returns-based style analysis, originated by William F. Sharpe and refined by William Fung and David Hsieh.

The method requires an ability to decompose the returns of a group of hedge funds into a relatively small number of different predictive factors. The most common replication approach is to focus on a specific factor that characterises a given asset class, for instance value, size, low volatility, high yield, quality or momentum.

The drawback is that while the aggregate alpha from the hedge fund industry has declined, several independent firms will be able to deliver superior results. Of course, they are not always the same firms, and hopping from one fund to another is far too expensive an exercise to be taken seriously. 

Still, hedge funds would claim that replication can at best capture a fund's beta but never its alpha. However, this would be countered by replicators saying they should be measured against the broad hedge fund universe for the type of strategy they are following.

What is becoming ever clearer is that the days of the standard “2 and 20” fund are undoubtedly numbered as an increasing number of investment banks and asset managers are venturing toward internal hedge fund replication as they seek to change their investment approach and keep money in house and haunt the hedge funds by managing money themselves.

Pergola
 Replication is now the name of the game for many asset managers. Photo: iStock


— Edited by John Acher


Stephen Pope is managing partner at Spotlight Ideas

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