Four Major Hedge Fund Trends from Q1 2016
Each quarter after 13Fs release, we dig through the data to analyze the most recent trends in hedge funds. Read this post to learn more.
Every quarter, a few weeks after the 13F release, we publish the top hedge fund trends gleaned from crunching filings data. This time we’ll do something a bit different. In addition to distilling the major developing themes from 13F data, we’ll look at some general, anecdotal (a feared word at Novus) trends of the industry and add a bit of our own perspective. Let’s jump in.
Headlines Unfairly Negative Towards Hedge Funds
The first trend we’ll talk about is that the negative news on the industry is reaching a feverish pitch. If Buffett’s advice to be greedy when others are fearful is any guide, it should be a great time to consider adding to hedge funds. Most headlines are focused on the negative—fees, performance, excessive compensation, and a few select pensions stepping away from the space. It requires little effort to point out the industry’s obvious challenges and bad news sells better than laborious analysis. Now, even hedge fund managers are issuing warnings about their own industry. But few pundits are actually willing to dive deep under the hype and really assess the situation.
Take, for instance, the fees of the hedge fund industry. Typically, hedge funds charge a portion of the money they make (performance fee) and a smaller portion of the total money investors entrust them (management fees) to pay operational expenses. The most common argument is that fees are too high.
But there is no such thing. We live in a free economy with efficient markets, and if fees were truly “too high,” investors would redeem from their managers and elect to not pay any fees outright, reinvesting the balance into no-fee stocks and bonds. No one’s holding them captive—there’s a product offering and there are buyers for the product at agreed-upon terms. Barring fraud, which is extremely rare, everyone knows the risks going into the agreement.
This is not to say that there are no problems with the embattled 2 and 20 structure. The issue, in my view, is a fundamental misalignment of interests between the manager and investor. For smaller managers, the performance fee is the more meaningful part of compensation and that can encourage excessive risk taking. For larger managers, the management fee swells to an amount where they’re disincentivized to take on large risk and (perhaps unintentionally) switch to asset gathering mode. The Goldilocks area where interest in growing and preserving capital are aligned is tiny and fleeting. The solution to the industry’s dilemma is not straight forward, but negotiations on fees need to be less hostile, more informed, and two sided, versus investors simply demanding lower fees.
Furthermore, investor efforts are better placed in finding managers that will deliver higher future returns than in fee negotiations with less-skilled managers. Too much investor attention is spent on the 2 and 20 and not enough on the 98 and 80.
Speaking of which, yet another criticism found commonly in the media is that of poor performance. Here, we agree on some accounts, but the argument has to be based on alpha, not simply underperformance to US equities, which is usually the case in a bull market. They are hedge funds after all, they run with lower exposure to the markets so bull market underperformance is fully expected. Even if the S&P 500 is used as a benchmark, performance is not so bad when viewed over a longer term (more on this later). Also, there are many examples of hedge funds doing exceedingly well as the dispersion between good and poor performers is widening.
The negative sentiment trend is unlikely to stop soon, since many of the points harped on in the news are rooted in real issues that don’t have clear solutions. But simply attacking the industry misses an important point. There is a lot of value and opportunity in hedge funds, and it takes some effort to effectively measure it. We are privy to the inner workings of hundreds of hedge fund managers and are optimistic towards the future. Continuing in this vein, let’s take a closer look at performance.
Performance Viewed Over the Long Term Will Surprise You
Let’s talk about the 98 and 80 for the next trend. Post-fees, hedge funds indeed fared very poorly since the recession when compared to the US large caps as measured by the S&P 500. Here is the performance of the HFRI Equity Hedge Index against the S&P 500 Total Return for March 1st 2009 through end of April 2016.
Long short equity funds underperformed the market by a wide margin, albeit with lower volatility. But who cares about volatility, right? Well, the same indices viewed over a longer period from 1995 tell a different story.
Now, long short funds annualized in line with the market, but with lower volatility and higher Sharpe ratio. And yes, this is after all fees.
Alpha is Indeed Under Assault
The media is right on at least one thing—it’s hard to ignore the trend of declining HF alpha. For our third trend, we’ll look at declining liquidity as it relates to sliding alpha.
Through our work with thousands of manager portfolios, we’ve learned that the majority of managers DO generate consistent alpha through skill. Unfortunately, all managers have areas of alpha drain in the investment process. Call these bad habits—the things to be acknowledged and avoided—since they account for a continuous drag on manager returns. There are many ways managers leak alpha, and we describe the five most common ones. Lately, however, there has been a new foe. Crowding has been taking ever-growing chunks out of returns, especially during de-risking cycles. And poor liquidity is a primary ingredient in crowding.
In our recent article, “The Liquidity Deception” , we explore the indsutry’s failure to correctly figure crowding into liquidity measures, allowing real liquidity to decline sharply. In the next chart we compare two measures seldom thought of together. The first in blue, is the HFRI Equity Hedge active premium (annualzied) to the S&P 500. The second line, in orange, is the 30-day liquidity of our own HFU comprised of 1,200 HF managers.
To be fair, it’s not an “apples to apples” comparison, since the liquidity metric is point in time and the rolling active premium has a lag built in. Still the general trend is telling.
Managers Divided into Two Camps: Evolve / Double Down
After meeting with hundreds of hedge funds, I can generalize them to two camps, and they’re not divided by performance. Regardless of whether they’re up or down in the last 12 months, some managers truly believe that what got them here will be enough to succeed in the future. The “double down” managers are not really interested in self-analysis, since they believe that time is better spent on researching investment ideas. Even if they’re down massively, they tend to buy more at cheaper prices, and instead of looking critically at their investment process, they isolate themselves in their comfort zones.
The “evolve” managers are constantly looking to improve—even if they’ve been investing for 30 years and are up comfortably for the year. They believe that what got them here will not get them there in the future, and look for new ways to evolve and even shock their current research processes. They tend to question losing positions critically, being brutally honest with themselves when their process can be improved.
Of course, for a portfolio intelligence company, our clients are a biased set of managers, all from the evolve camp. Those are the managers we want to partner with as we grow and thrive alongside them.