3 strategic options for funds to maintain their (h)edge

Credits: www.fotosearch.com
Credits: www.fotosearch.com

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.


Lowering prices

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.

tumblr_m28i6joRpj1qcaagjSuch 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.

Average annual performance for French funds split by asset class type, 2006-2015. Source: Les Echos
Average annual performance for French funds split by asset class type, 2006-2015. Source: Les Echos

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.

Rob Arnott
Rob Arnott

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.

Asset management: is activity bad for your (financial) health? (2/2)

active-vs-passive-investing-300x166This post is the second part of the column I started 3 weeks ago. Having outlined the challenges that independent financial advisors were facing with regards to the fund allocation process, I will now turn to the actual investment process. In this area, a raging debate has been taking place for years between two philosophies, namely active and passive investing.

Definitions are straightforward. Active investing consists in actively managing a portfolio of securities (e.g. stocks) in order to permanently allocate funds to the most undervalued ones. Success of that strategy can be monitored by assessing the relative performance of the active fund against the benchmark index (e.g. the S&P 500 or the FTSE100 for US and UK equities respectively). Conversely, passive investing assumes that beating the market consistently over time is impossible and that tracking the market evolution at the lowest cost actually represents an optimal investment strategy. To do so, passive investors will rely on Exchange Traded Funds (ETFs), whose sole objective is to track “an index, a commodity, bonds, or a basket of assets like an index fund”.

In this video, Fidelity’s Julien Timmer presents the pros and the cons of the active and passive investment strategies. By reaching the end of this post you will  have understood why active investment is presented under a slightly more favourable light.

The myth of successful active investing and the ‘search for alpha’ – in investing jargon, the ‘alpha’ represents positive returns achieved irrespective of market conditions – has been kept going by the asset management industry lobby itself, whose existence relies on the volume of funds dedicated to active investing. A number of magazines and newsletters – such as ‘Investir’ in France – praises the upside potential embedded in the stock markets and share investment tips with their readers – with a different angle depending on the market conditions. More recently, scholars have shown that the rise of social networks has enabled individual investors to share their successes more easily and has therefore increased the level of active trading – dubbed as ‘Facebook Finance‘.

Selected recent 'Investir' covers: markets are always bullish and investors never sell...
Selected recent ‘Investir’ covers. Their readers never sell..

Although the debate is relatively balanced at a retail level, institutional investors have been implementing a significant shift in their investment policies over the last 12 to 18 months, showing a soaring appetite for passive (and cheap) funds. Morningstar estimated that $245bn flowed out of active funds between February 2015 and January 2016 while $408bn flowed into passive funds over the same period. And it appears that the tap is not closed yet: a Greenwich Associates survey reported that nearly 20% of non-ETF users were considering to add them to their portfolios this year.
The hype for ETFs can be dated back to 2013, when Warren Buffett outlined in his annual letter to Berkshire Hathaway’s shareholders the investment strategy he would like his trustee to follow after his death:

warren-buffett2My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.

As made explicit by Buffett, relative cost of active investment is the key driver behind this change, especially in a low-growth and low-inflation market. As active management requires by definition the close involvement of dedicated professionals, those funds charge a higher management fee (up to 2% p.a.) compared with passive funds (which can go as low as 0.15% p.a.). Investors do not really bother when annual growth is reaching 4% and inflation contributes to alleviate management fees in real terms – this was the situation a decade ago. Today, a marginal difference in fund cost structure can have a significant impact on the net return for the investor, especially given that scholars have proven that almost no active fund can overperform – net of fees – its benchmark index over a prolonged period of time. In tough times, any saving counts, and investors are not willing to pay more for meager returns any more.

Percentage of European Equity Funds Outperformed by Benchmarks. Source: Spiva Scorecard as of end 2015.
Percentage of European Equity Funds Outperformed by Benchmarks. Source: S&P Spiva Scorecard Europe as of end 2015.

No surprise then that the lavish lifestyle adopted by some asset managers has been critiqued over the last few months, not only by the general public but by the regulator as well. On top of that, the FCA found that several funds were misleadingly marketing themselves as ‘active funds’ (and charging high fees to do so) while they were using a benchmark-related approach.

The massive inflow generated by ETFs has pulled a series of new entrants which are now competing with the three historical incumbents – namely BlackRock, Vanguard and State Street Global Advisors. The Financial Times reported more than 3,882 tracking funds as of end 2015. This increased degree of competition has led ETF managers to further lower the price of their funds and to offer a wider range of products, making the ‘passive’ proposition even more compelling. This does not go without risk though: the increasing amount of capital gathered by ETFs may add violence to market movements.

Source: Financial Times
Source: Financial Times

Bond ETFs are also finding their way to the market but their relative lack of liquidity makes it a more expensive and riskier investment alternative for the time being. As a consequence, the bond ETF market only grew by $42bn in 2015, equivalent to a tenth of the inflow recorded on stock ETFs.

So is there a future for active investing? Definitely. To survive, active investors need to restore their price competitiveness. This is non-negotiable and actually some funds have recently started to take this path, cutting their fees by up to a third. From there, I personally see two non-mutually exclusive options. One is for active managers to look after securities that indexes do not cover (yet?), and have enough conviction to stick to them, even in difficult times – although in the long-term this path could be threatened by the rise of artificial intelligence which will significantly lower the cost of extensive securities coverage. Separately, active investors should also seek to add value not only in their investment decisions, but in the post-acquisition phase as well. This is the model that some alternative asset providers, such as activist hedge funds and private equity vehicles, have been following for decades by trying to get their voice heard at Board level. In any case, the status quo will rapidly cease to represent a viable option.

Last but not least, Sensible Investing, an organisation promoting passive investing, released a (very subjective) documentary highlighting the shortcomings of active investing. This is a good summary of the points exposed above if you have almost an hour to spare (!).

Asset management: is activity bad for your (financial) health? (1/2)

‘Active’ asset management took another hit yesterday as the Financial Times revealed that Q1 2016 turned out to be the worst quarter for active investors over the last two decades. Beyond alarmist headlines, although the topic of asset management has already benefited from extensive coverage, I believed a simple reminder of the notions at stake could be useful. Given the complexity of the issue, I have thus decided to split this post into two parts – the second will be published in the coming days.

blackrock-logo-white-on-blackFirst and foremost, it is important to note that the phrase ‘asset management’ in a retail context often mixes up two distinct steps of the asset allocation process. The first step is the fund allocation process, which is typically the only one fully transparent to the customer, who can decide, on his own or with the help of an Independent Financial Adviser (IFA), how he would like to split his wealth between financial instruments, including shares, bonds, funds and cash – either directly or through a fund mix. The second step is the proper investment process which is made at fund level and not fully communicated to the customer. For instance, when I decide to buy a share of the BlackRock Global Equity Fund, I know by having a look at the fund’s spreadsheet that the fund will be primarily invested in developed economies and IT companies will roughly weight 15% of the total portfolio, but the average individual cannot have access in real-time to the full portfolio composition – probably made of hundreds of positions. And yet, both parts of the chain have been under attack.

Credits: www.havenrm.com
Credits: www.havenrm.com

In the UK, the retail financial advisory industry indeed trembled on its bases in 2013, when the recommendations of the Retail Distribution Review (RDR) got enforced. One of the consequences of this work was to prevent financial institutions from implicitly charging customers for investment advice – through higher product fees – and to have them make the financial advice fees explicit and separate instead. The regulator’s primary (and laudable) aim was to enhance market transparency; by splitting out the cost of advice, the customer would be able to assess whether he got ‘value for money’ from his IFA and, if relevant, he would be able to ‘shop’ for alternative advice and/or investment solution. In practice, however, the cost of ‘standalone’ financial advice proved too high for many simple customers – 85% of whom are not willing to pay more than £200 for online advice – who decided to move away from all forms of financial advice. For the regulator, the situation became perilous, leaving on one side IFAs fighting for a disappearing market and, on the other side, the vast majority of the population converting itself to ‘DIY investing’ and playing the mad chemist with their savings. This situation is even more worrying when we know that nearly half of people over 50 admit they do not understand stocks and shares ISAs, and only 14% of people feel confident planning their retirement goals without financial advice.

Unfortunately, unless the RDR is revoked – a very remote scenario -, the role and importance of IFAs will keep shrinking at fast pace. In the long-run, IFAs will likely be needed only to deal with very complex, high-stake situations (e.g. high net worth individual with assets in multiple jurisdictions) and, to a lesser extent, to reassure customers who are ready to pay a high price for the ‘human touch’. For instance, RBS announced last month that its financial advisory services would be dedicated to customers with at least £250k to invest.

Credits: www.forbes.com
Credits: www.forbes.com

For the remainder of the population, the advice gap has been progressively filled by ‘robo-advisers’. A ‘robo-adviser’ asks the customer a series of simple questions in order to assess his risk profile and the investment period length and in return suggests a range of funds that the customer could be interested in investing in. Not only does it prove to be a cost-effective and efficient solution – Italian adviser MoneyFarm is not charging customers for advice related to investment considerations up to £10k -, but the cold-blooded feature of the machine also prevents human biases which led to underperformance – including herd sell-offs in bear markets. Pioneers in the area have attracted significant appeal. Decimal Software for example now holds $3bn of ‘funds under advice’. Big names are now entering the game, starting from the US, with BlackRock acquiring FutureAdvisor in August 2015 and Goldman Sachs buying Honest Dollar, a ‘robo-advisory’ start-up targeting savings accounts for retirement. In the UK, all the major banks have expressed interest, including Barclays, RBS, Lloyds and Santander UK.

In this context, there was little surprise in the Financial Conduct Authority’s decision to help banks set up robo-advisers as part of the Financial Advice Market ReviewThe rise of the ‘robo’ era does not put an end to possible fraud and mis-selling threats though. As the algorithms will be ultimately defined by humans, the regulator will have to ensure that the most profitable products for the bank are not artificially pushed by this new kind of advisers – but in this case, at least, the algorithm produces by definition an auditable written trace which should make the settlement of complaints relatively easier.

active or passive activity and passivity time for action act now dont sit still

In the second part of this post, we will discuss the investment process, highlighting the debate between ‘active’ and ‘passive’ investing. In this arena, the blood has been flowing for years, if not decades, and has opposed the most highly recognised investors and scholars, including Warren Buffett himself – that’s it for the trailer, more to come in the coming days.

In the meantime, a report from CBS bringing the role and functioning of ‘robo-advisers’ to life, including an interview of Betterment‘s CEO.