What the Next Decade for Hedge Funds Could Look Like

An analysis of performance, changing investor expectations, and the market opportunity shows fertile conditions for hedge funds to thrive in the years ahead.

Paul Hanna/Bloomberg

Paul Hanna/Bloomberg

It might not be a return to the glory days before the global financial crisis, but the next decade for hedge funds is looking relatively rosy.

Hedge fund research firm PivotalPath argues that a combination of better performance and an investor base with realistic expectations about what hedge funds can deliver is creating conditions for a thriving hedge fund industry over the next five to 10 years.

PivotalPath’s composite index, which includes all of the hedge fund strategies the firm tracks, was up 11.3 percent in 2020, its best year since 2013. Performance for the rolling one-year period ending March 2021 was approximately 26 percent, ranking in the top three performance records going back to January of 1998.

Jon Caplis, CEO of PivotalPath, said that another signal that is informing his optimistic view is an analysis of hedge fund alpha, or the excess returns managers produce over their benchmark. That’s a signal of hedge fund managers’ skill. He said 38 out of 40 strategies that PivotalPath tracks have generated positive alpha relative to the S&P 500 over the last year.

Caplis also pointed to investors’ perception of hedge fund performance in March of 2020 compared to what they thought during the depths of the global financial crisis. Hedge fund performance dropped in March, but quickly recovered. Something similar had happened in 2008. “But most investors would have told you that hedge funds failed in ’08,” Caplis said.

“Today, investors are pretty happy with hedge fund performance,” he added. “I think it’s much more that their expectations are in line. They are more informed and they see, based on historical performance, that hedge funds are doing exactly what we expect them to do given their role in our portfolios.”

During the financial crisis, hedge fund investors were primarily high-net-worth clients. Now institutions make up the majority.

These institutional investors have changed the calculus for the industry, according to Caplis. “Then it was about access,” he said of the pre-crisis period. “There were these magical hedge fund managers. They could do no wrong, make money in any market, beat the S&P, and have almost no risk.”

Absolute performance was better before the financial crisis, Caplis said. “That being said, most investors were high net worth or invested through funds of funds that were telling you, ‘We can get you access to Madoff, Renaissance, Millennium. You’re lucky that we’re even accepting your money.’”

In part, absolute returns were better because of market issues, including the risk-free rate. For example, hedge funds could borrow a stock in order to short it, and then were paid rebates by prime brokers. With interest rates so low, that advantage has disappeared.

“Now institutions demand transparency,” Caplis said. “They are informed and will have better expectations about what hedge funds are supposed to do, and they will hopefully understand the structural components that enabled hedge fund performance to be much better early on.”