‘Free Upside’ and Easier Access: How Hedge Fund Investors Can Play the Downturn

With many hedge funds losing money amid volatile markets, the ball is in allocators’ court.

Illustration by II (Michael Nagle/Bloomberg)

Illustration by II

(Michael Nagle/Bloomberg)

As some allocators prepare to redeem from underperforming hedge funds, others are sniffing out opportunities.

In the June edition of its monthly hedge fund newsletter, TD Securities discussed how allocators are thinking about the upcoming redemption cycle — a period when investors are expected to withdraw money from hedge funds. Typically, investors have to wait between 45 and 90 days to liquidate their hedge fund investments, meaning that a spike in outflows can occur about a quarter after hedge funds report poor performance.

According to TD Securities, the “most sophisticated allocators” believe a large wave of redemptions could result in easier access to hedge fund managers that have previously been closed to new clients, as well as lower fees and greater leverage in negotiations.

“We try to take a contrarian viewpoint,” said Joshua Leonardi, head of U.S. prime services, sales, and capital introduction at TD Securities. “With negative performance, the general perception is that performance leads to redemption…I think investors are actually less likely to redeem than you would think.”

Leonardi said that negative performance alone doesn’t necessarily lead to more redemption requests; it also depends on other factors. For example, Leonardi said that if a fund has underperformed for three consecutive years, a redemption request isn’t out of the blue. But if a fund is undergoing an anomalous draw-down, he argued that investors understand that “people don’t become dumb overnight.”


By this, Leonardi means that even though hedge funds have posted disappointing numbers — hedge funds have collectively posted a year-to-date loss of 1.1 percent this month — allocators aren’t likely to suddenly redeem, unless managers have drastically changed the fund’s strategy or there are questions about the viability of the fund.

In fact, allocators that stick with their hedge fund managers through the downturn are “basically getting free upside,” Leonardi said.

“If the fund is down 20 percent, I don’t have to pay an incentive fee until we hit the high watermark again,” he explained. “So I’m just paying a management fee to get me back to where I was before.”

Allocators also don’t want to crystalize their losses by pulling out of underperforming funds too early.

At any rate, not all hedge funds are losing money right now. Jon Caplis, chief executive officer and founder of PivotalPath, a hedge fund research firm, emphasized that while some of the largest hedge funds have experienced losses over the past year, the downturn is by no means an industry-wide trend. Large tech- and healthcare-heavy and equity long-short funds have seen massive losses that have dragged industry indexes into the negatives. But hedge funds with other strategies like multi-strat, macro, and equity quant have seen positive performance over the same time period.

“It’s a very specific set of funds [that are underperforming],” Caplis told II. “And in fact, the rest of the industry at large is actually doing quite well and probably is not losing that leverage to other investors because they just don’t need to.”

For those allocators whose hedge fund managers have seen massive underperformance in the past year, the downturn gives them leverage to negotiate lower management fees and better terms of liquidity.

“The pendulum of leverage is going to swing [investors’] way when managers aren’t doing what they expected to do or they just have such large drawdowns that they want to stay in business,” Caplis said.

The ball landing in allocators’ court may also offer them better access to notoriously exclusive asset managers. According to TD Securities, the redemption cycle may provide investors with the opportunity to work with managers that were previously closed to new capital.

Still, some allocators may be wary of betting on managers when they’re down.

“Some of the marks are so bad that I think, psychologically, [allocators question if these managers] will be able to get back to where they were,” Leonardi said.