For more than a decade the hedge fund industry has been going through a major transition where increasingly defensive fund strategies and lower investor expectations have converged to support tremendous net asset inflows. But superior returns can still be found by allocators who do their homework and aren’t exclusively obsessed with brand-name management.
The hedge fund industry has gone through seismic change due to institutionalization starting at the turn of the century.
It’s hard to remember, but before the tech meltdown of the early ’00s, hedge fund investing was dominated by high net worth individuals and family offices. About 20 percent of hedge fund assets came from institutional investors like pension and sovereign wealth funds, endowments, foundations and funds of funds. But in the past decade, the sources of hedge fund money have changed dramatically. As hedge fund assets have grown from $1.6 trillion in 2009 to $3.2 trillion in 2018, according to BarclayHedge, the percentage of institutional money has surged. Sandy Kaul, global head of business advisory services at Citi, says over two-thirds of that $3.2 trillion now belong to institutional investors.
Institutionalization has produced greater disclosure and discipline. But for a large segment of the industry, this change has significantly altered fund mandates. “Several decades ago, the majority of funds were largely characterized by an aggressive search for performance,” recalls Jon Hansen, managing director at the investment firm Cambridge Associates. “Since [and because of] the financial crisis, there’s been increased emphasis on more risk-averse asset management that prizes consistency and capital preservation.”
This shift largely explains why the vast majority of funds have trailed the market over the past 10 years. Poor investing also hasn’t helped matters.
But in slighting funds’ protracted underperformance since the financial crisis, many industry observers are conflating the monolithic, swashbuckling vision of managers past, who were willing to make outsized bets on the British pound or distressed bank or sovereign debt, with the majority of today’s managers, who instead are providing various strategy exposures to help investors diversify away from long-equity books.
According to BarclayHedge, 16 of the 18 leading strategy categories lagged the market’s 13.12 percent annualized returns over the last 10 years through 2018. And over the past five years, all trailed the S&P 500’s total annual returns of 8.49 percent, with more than half these strategies having earned less than 3 percent a year over this time.
Feeling challenged by the new normal since the financial crisis, many managers have opted for more defensive postures that have collided with external variables, including accommodative central bank policies. They’ve been fueling steady stock and bond rallies, without serious correction, and reducing equity and debt-market volatility. The VIX in 2017 saw record low volatility, nearly half its historical average.
Then came 2018 and the return of volatility, for which many managers had been clamoring. The majority of strategies did outperform the market, which lost 4.4 percent. But when tallying the average return of each individual fund, the industry still trailed the S&P 500 by 75 basis points.
BarclayHedge Indices and Averages Ending December 2018
Many managers could certainly be doing a better job. And this is taking a toll on the number of active funds, which, according to Preqin, declined for the first time in 2018 since the financial crisis as liquidations exceeded launches. At the same time, the steady rise in hedge fund allocations slowed in 2018. For some allocators, the hedge fund industry argument for diversification and uncorrelated market returns haven’t been enough, especially when managers are collecting healthy fees while passive stock exposure continues to rally and an increasing number of ETFs are providing inexpensive market hedges........MUCH MORE
