A lot has changed on Wall Street since 2009. One thing that hasn’t is the crop of newly minted hedge fund managers coming to market each year with the hope of making it big.
Hedge fund firms that launched after the financial crisis are closing in on five-year track records that also coincide with one of the largest run-ups in U.S. equities in recent memory. On paper these managers may look as if they have what it takes, but do they really? Can five years be considered a line in the sand anymore? Or will investors want to see how 2016 goes before moving a manager off their “emerging” list?
August was a bad month for the hedge fund industry across almost every strategy. The Preqin All-Strategies Hedge Fund benchmark, published by London-based research and consulting firm Preqin, returned –1.88 percent last month, and year-to-date gains have slipped to just under 2 percent. Markets ended last week mixed after the U.S. Federal Reserve Board decided not to raise interest rates, making it look as if the recent volatility will last.
“We think it’s a good time in the market to evaluate managers,” says Andrew Fishman, president of Schonfeld Group Holdings, a New York–based family office that focuses on hedge funds in quantitative and fundamental equity strategies. Fishman points out that some firms’ difficulties in 2011 could provide a sense of how they manage volatility; recent losses may help tell the tale too.
Fishman and Schonfeld CIO Ryan Tolkin are always looking for managers who offer strategies they haven’t seen before. That search requires plenty of due diligence, but it also means finding a manager who can explain in detail what’s in a portfolio and why.
“We’ve seen a lot of sector dispersion recently,” Tolkin says. “People should have been able to make good picks in recent market conditions, if you’re with sound sector managers. Those choices can be telling even if a manager has been around for only the past five years.”
Risk management can also be a good way to separate luck from skill. Over the past few weeks, as markets tumbled, seasoned managers may have been inclined to buy into the risk, but surprisingly they held off “because of the sensitivity of the market,” says Raymond Nolte, CIO and co–managing partner at New York–based SkyBridge Capital, a $13.6 billion fund-of-hedge-funds firm. That intuition may not always come to newer managers, even if they have been traders before heading their own funds.
Part of developing a sixth sense about the market is learning how to right-size a trade or strategy. For example, event-driven funds were some of the biggest losers in August, according to the latest Alternative Investment Industry Barometer report from Paris-based Lyxor Asset Management. But a number of allocators think these strategies are in a good position to take advantage of market conditions for the rest of 2015. For emerging managers, the key is to avoid overtrading in response to volatility.
“Newer managers in the event-driven space could find these markets more tricky to navigate because they are dependent on stock-specific catalysts,” explains Russell Barlow, London-based head of the $11 billion hedge fund unit at Aberdeen Asset Management. “This introduces the risk of newer managers’ overtrading in these environments, reducing exposure at market lows or increasing position sizing at the wrong time.” The psychological pressure of managing a portfolio, and being judged based on a monthly return when some trades take months to execute, can impact decisions, Barlow adds.
If a fund’s performance starts to slide, allocators warn that it’s important for the manager to explain the situation and dig into each position. “I’m positive on many strategies, although within each area I think you have to stay nimble and be ready to move on,” says Anne-Gaelle Pouille, a member of the portfolio construction group at Pacific Alternative Asset Management Co., a $9.1 billion fund-of-funds firm based in Irvine, California.
When it comes to event-driven strategies, Pouille sees opportunities in merger arbitrage and in some Japanese trades resulting from governance changes. “Macro brings risks from sharp reversals, so I am treading cautiously,” she adds. “Looking at individual positions is really helpful to understanding a manager’s real betas and alphas, as well as their risk management philosophy.”
Stripping out the real betas and alphas can also provide a view into a manager’s use of exchange-traded funds. ETFs and other exchange-traded products gathered $20.8 billion worldwide during August alone, according to London-based ETF industry consulting firm ETFGI, marking their 19th consecutive month of net inflows. Not all of these funds offer the same indexlike exposures that traditional investors are used to; many come with extras such as short exposure, which make them more attractive as investment tools and intriguing to hedge fund managers as a liquid means of getting in and out of positions. But investors bristle at the idea of paying 2 percent management and 20 percent performance fees for something they could buy directly themselves.
“We push for as little ETF use with our fundamental equity portfolio managers as possible,” says Schonfeld’s Fishman. “We want to see single-stock alphas. That said, lately, our portfolio managers have used more ETFs because takeout risk is a real problem.”
But those single-stock alphas are hard to come by during a prolonged equities rally or even in a month like August, when everything was down except volatility. Pouille notes that using a basket of ETFs in the recent rally may have helped managers move directionally when a single-stock short was nowhere to be found. “I also believe some credit should be given to managers who exhibit skill in trading ETFs,” she says. “This is definitely different than just buying and holding an ETF off the shelf.”
Certain strategies will see a larger impact than others from the rise of ETFs. “ETFs are less of a threat in niche strategies, but for more high-beta strategies, ETFs are going to be a bigger threat,” says Stephen Mason, portfolio manager at Coral Gables, Florida–based Collins Capital Investments, a $462 million fund-of-funds firm.
Even if a hedge fund manager starts using more ETFs, they may not face as much pushback from investors if volatility persists. That’s in part because there aren’t many high-return places for allocators to park cash. The low-yield environment could also give newer managers a little extra runway to build a stronger business and hold on to investors.
“There has been some turnover in the small-managers space — that’s really where you see the creative destruction happen in the market,” says Anthony Lawler, London-based head of portfolio management for $132.8 billion Swiss asset manager GAM. “On the other hand, a lot of investors are negative year-to-date on traditional bond and equity allocations. If they have alternatives, they might only be down 1 percent or they could be up 2 or 3 percent, which means they aren’t going to be in a rush to change anything.”