Last month I had the opportunity to write about the difficult times the hedge funds industry was going through, facing quarterly outflows never seen since the last financial crisis – a downward trend that remained vivid in Q1 2016 – and which does not spare top ‘brands’ such as Pimco. Although the outflow only represents 0.5% of the total hedge fund AuM base, experts have been calling for a change in the way hedge funds operate. In summary, all recommendations do not add anything new to classic strategy textbooks which have taught us for decades that a company could build and maintain a competitive edge in three ways: through (i) lower prices and/or through products offering (ii) higher quality and/or (iii) better fit to customer needs (for instance, think about pack sizes in retail). Hedge funds are no different in that respect and I believe each of those three levers is worth investigating.
The infamous ‘2+20′ mantra which used to drive hedge funds’ remuneration policy (i.e. 2% of annual management fees plus 20% of the share of profits above a certain IRR) cannot be considered as a standard anymore. It should not have become in the first place anyway. The ‘2+20’ was indeed originally designed by private equity fund managers as a reward for the effort they ut into identifying promising investments, negotiating the best deal terms and then developing the companies. The hedge fund manager only adopts a ‘passive’ approach to investing by focusing only on the first point and, to a lesser extent, on the second (although the impact of market timing is limited). As a consequence, one should expect the work of the hedge fund manager to add less value compared with his PE counterpart. In any case, pressure on fees can be felt across asset classes and the ‘2+20’ has left room to the ‘1.5+15’ or even to the ‘1+0’.
Ucits, a regulated and often cheaper alternative investment offering a similar performance to hedge funds, have conversely enjoyed significant inflows since the start of the year – €8bn according to Les Echos. Ucits will come on top of the already mainstream ‘passive’ ETFs to put additional price pressure on ‘traditional’ hedge funds.
Such global pressure on fees has obvious consequences on the way asset managers in general operate: low-performing funds have either tightened their expense policies (think about Goldman Sachs Asset Management for instance) or simply closed.
Enhancing existing products
Hedge funds have often been criticised for all following the same active strategies which can in some cases not even be qualified as ‘active’ – see my earlier post on this point. The ‘herd mentality’ comes with two major drawbacks: first, no hedge fund is truly uncorrelated from the market as a result and, second, each position change triggers massive money flows and thus price fluctuations which can destroy returns even if the investment was originally a good idea. To alleviate that risk, hedge funds will likely reduce their size and focus on ‘niche’ strategies away from the mainstream market. To do so, hedge fund managers need to be allowed to suffer short-term losses if that drives long-term profits, in particular if those profits offer low correlation with the way the rest of the market behaves.
And yet, markets are volatile, relatively undecided and we are currently living in a world of ‘lows’ (low inflation, low growth, low interest rates). Are open-ended hedge funds the highest performing asset class in that context? Volatility leads investors to make frequent changes to their money allocation strategy if they are left free to do so. Hedge fund managers are therefore strongly incentivised to maintain a high level of liquidity in their portfolio and adopt a short-term approach in order to avoid heavy redemption and the detrimental asset ‘fire sale’ it generally triggers – a particularly acute problem for real estate funds, as Standard Life showed us yesterday. This strategy will negatively impact returns. As a consequence, some hedge fund managers have started introducing ‘lock-in’ periods (as PE funds already do) to enable them to follow true long-term strategies even if they prove to be losing in the short-term.
Adding or creating more adapted strategies
Private equity as an asset class which not only solves the issue of ‘lock-in’ and offers additional value creation levers for fund managers but also relatively outperforms other alternative asset classes – see a French example below.
As a consequence, despite the already high number of competitors in the industry, some hedge funds have decided to diversify by adding, explicitly or implicitly, a PE arm to their activities. Elliott’s joint acquisition of Dell’s software division last month – funded from their $28bn main fund – is only the tip of the iceberg.
Quant funds benefit from tailwind as well. Despite average performance, investors appreciate the ‘systematic’ (since algorithmic by definition) approach to investing in turbulent times. The Financial Times reports that commodity-trading advisers (CTAs) received $38bn in capital inflow in 2015.
Finally, hedge funds’ ‘product innovation departments’ have been running full speed over the last few months in an attempt to maintain fees as high as possible – a trick used in retail as well. Factor investing, smart beta, low volatility funds have all attracted money recently but these strategies remain unproven (‘factor investing’ is still nascent given its complexity), non-scalable (what happens to a ‘low volatility’ fund when strong flows generate volatility?) or, worse, dangerous (Rob Arnott, pioneer of ‘smart beta’, recently criticised the excesses of this strategy).
It is unclear which hedge funds will succeed and which ones will be wiped out as a result of the industry transformation movement we are witnessing. Size of the asset base only offers a mediocre indication as in the future the most successful funds may be those able to navigate ‘under the radar’. In any case, investors are becoming increasingly educated and scrupulous on costs – ‘status quo’ is thus not an option.