Hedge fund performance has declined precipitously since the 1990s as assets under management have exploded. The managers are not solely to blame.
While alpha has withered, large institutional investors have piled into large hedge fund managers that are perceived to be safe — an industry transformation beautifully summarized by Blackstone Group:
The original hedge fund clients, wealthy people, were initially attracted to star managers who were able to deliver outstanding performance during the 1980s and 1990s when the Standard Poor’s 500 was compounding at 15 percent or better annually. When the technology bubble burst in 2000, the focus of the industry began to change. Suddenly there was a greater emphasis on protecting capital in difficult markets rather than maximizing profits in good times. Management fees also began to rise and hedge funds changed character. The early funds were organized to produce exceptional performance and they were willing to take higher-than-normal risk to achieve their objectives. The market was rising almost every year, so the risk insensitivity was not critical back then.
All that changed after 2000. With higher fees, hedge funds became real businesses and maintaining the asset base became an important objective. As a result, hedge funds became obsessive about risk control and their new institutional clients encouraged this attitude. These investors were willing to experience underperformance when the market was doing well in exchange for asset protection in declining periods. Volatility became a key area of client focus and monthly drawdowns were carefully scrutinized. Hedge fund managers were willing to give up performance points on the upside to achieve low volatility.
Over 15 years leading the hedge fund programs for two Canadian pension funds, I witnessed all this firsthand. The investor base, from what I saw, is overly focused on relative returns and looking for the perceived safety and comforts of size, past performance, and strong risk management. I suspect the root cause is agency issues: institutional investors incentivized to keep their jobs rather than serve their funds’ best long-term interests.
The hedge fund industry undoubtedly includes many of the brightest minds in the investment universe. It creatively combines the use of equities, fixed income, commodities, derivatives, and private investments unlike any other segment of the investment landscape.
That being said, the value proposition of hedge funds is questionable today. Net of fees, the amount of alpha — or excess returns, adjusting for returns on cash and equity beta — retained by investors has been steadily declining over the last quarter century. This is an important measure as it clearly shows the value (or lack thereof) that hedge funds bring to the table in excess of investing in a passive combination of cash and an equity index. Looking at the alpha generated by hedge funds over four-year periods from 1990 to 2017, the downward trend is obvious.
Hedge Funds’ Shifting Investor Base, 1992–2003
2016 Hedge Fund Volatility Versus Targets
Investor Sentiment Toward Small/Emerging Managers
Where We Are Now
Some changes to the industry eventually began to occur. A few high-profile investors like CalPERS and PGGM announced that they were divesting their hedge fund holdings. Low-cost smart beta (or alternative beta) strategies gained in popularity, often at the expense of hedge funds. The biggest ah-ha moment, though, was in early 2016. After a drawdown of 7.2 percent in the HFRI Fund Weighted Composite Index and seven losing months in nine, significant progress emerged on alignment of interests and fees. A number of hedge funds cut their fees (management and/or incentive), concerned with asset outflows and criticisms of the share of gross returns going to investors. In addition, interest in smaller managers seems to have picked up a bit. Yet much more work must be done to improve the value proposition of the industry.
The Problem, in Short
My high-level analysis of the current state of the hedge fund industry is as follows:
- The makeup of hedge fund investors shifted from return-seeking high-net-worth individuals and family offices to large institutions that had more modest return expectations and were more focused on risk management and diversification benefits.
- The demand for hedge funds by these large institutions altered supply-and-demand dynamics, pushing up fees and diluting returns.
- The focus on risk management and compliance by institutional investors resulted in a pickup in market share by larger firms that have the resources to address the requirements of these investors.
- Large hedge funds took advantage of the demand for their products by capturing significant profit margins from their management fees and reducing volatility to limit business risk.
- For investors, the biggest benefit has been a reduction in funds that have blown up or been involved in fraudulent activity. The biggest negative has been degradation in alpha received from their hedge fund investments.
Due to the uniqueness of hedge funds versus other investment options, and the creative strategies they employ, I believe there will always be a place for them in the investment landscape. However, given the poor alpha generated by the industry as a whole over the past decade, as well as the amount of due diligence required on top of the liquidity constraints, it is difficult to make a strong case for the average investor participating in hedge funds. Blame for the current situation must be shared between both investors and hedge fund managers. Fortunately, stakeholders can take action to improve the industry.
What Investors Can Do
Investors can address the problem and improve their value proposition if they:
- Realistically assess what they can achieve via hedge funds and how they can win given their resources and abilities. If necessary, ensure the quality of the investment professionals researching hedge fund managers is sufficient.
- Stop chasing past performance.
- Take a skeptical view of a manager’s ability to replicate prior successes with higher assets under management.
What Managers Can Do
Hedge fund managers can improve the industry and their clients’ experiences if they:
- Are intellectually honest. Don’t charge incentive fees on returns driven by cash or beta exposure.
- Emphasize alpha generation over asset gathering. Management fees should not be a significant source of profit. One percent management fees are appropriate for most managers over $500 million. That said, incentive fees over 20 percent may be acceptable if there is an appropriate hurdle in place. In fact, better-aligned fee terms can be revenue neutral to a manager if it hits its targeted gross returns. For example, if a manager believes it can generate 16 percent gross, it would do roughly as well with 1 percent management fees and 30 percent incentive fees with a 4 percent hurdle as it would with current common terms such as 1.5-and-20 and no hurdle.
- Don’t sell their firm to an outside organization that can change the culture that helped the firm get them to where they are today.
What Regulators Can Do
Besides investors and managers, regulators can also improve the hedge fund industry if they:
- Regulate sensibly by focusing on eliminating conflicts of interest.
- Are aware of unintended consequences of regulations.
With these kinds of changes, we can restore hedge funds’ value proposition. If we don’t, the industry can expect to go the way of the fund-of-funds model.
David Finstad led the hedge fund investment programs at the Ontario Municipal Employees’ Retirement System and Alberta Investment Management Corp. He is currently a visiting researcher for Bodhi Research Group, and can be reached at firstname.lastname@example.org. This paper was inspired by conversations with Randy Cohen of Harvard Business School.