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Monday, February 24, 2020

Hedge funds cut down to size

Date: Friday, February 13, 2009
Author: Money Management.com

Unquestionably, 2008 was a very poor year for fund of hedge funds.

Even though the average falls of 20.7 per cent were significantly less than the 40 to 50 per cent falls in equity markets, most investors in fund of hedge funds would clearly have been disappointed with the results.

Indeed, returns were even worse for leveraged fund of hedge funds and some funds also lost money when they were unable to maintain full currency hedges.

Structured products investing into fund of hedge funds offered no haven in the short term despite offering capital protection over the long term and may well be more burdensome for some investors who accessed these via 100 per cent gearing arrangements with expensive ongoing interest requirements.

As a multi-asset, multi-manager investor across the full spectrum of traditional and alternative assets and strategies, failing to foresee the poor performance of fund of hedge funds was probably our most costly (although certainly not only) mistake in an exceptionally difficult 2008.

Further, while we anticipated and largely avoided liquidity issues across a range of other investment areas (such as direct property and high yield funds), we clearly underestimated the potential for these same issues to affect fund of hedge funds.

While it was perhaps too optimistic to expect positive returns from funds of hedge funds given what has arguably been the worst financial crisis in history, the size of the negative returns has rightly raised questions about the value and diversifying role hedge funds play in investment portfolios.

Compounding concerns over returns and risks, structural changes to the fund of hedge fund industry primarily relating to liquidity could end up limiting the accessibility and suitability of this asset class to retail investors in the future.

Still, as with other investment areas punished in 2008 (and in some cases forced to restructure), it is important that investors and advisers assess the situation objectively and unemotionally to ensure they don’t blindly take on the wrong lessons. Changes to portfolios will be needed, but approached haphazardly there is a risk of throwing out some good investment ideas and possibly replacing one set of problems with another.

So what went wrong in the hedge fund industry and, particularly, fund of hedge funds?

Firstly, this was no ordinary equity bear market, which most hedge funds have historically navigated quite well. Apart from its size and scope in including most asset classes, it encompassed a broad deleveraging and rush for liquidity that was unprecedented and which then fed on itself as investors redeemed from struggling funds.

Many hedge funds (particularly in the market neutral and relative value space) tend to be more illiquid by nature and their performance can be more vulnerable to redemptions and deleveraging.

Much of this damage was sparked by the behaviour of the banks. While it was one thing to foresee some of the looming issues facing major financials globally, it was another to properly understand these implications for the hedge fund industry. As bank balance sheets imploded given their exposure to toxic debt and their need to deleverage, hedge funds were a major casualty given their reliance on bank finance for leverage, prime brokerage arrangements, FX lines and the creation of structured products.

The short-selling bans impacted some hedge fund strategies more than others, but the controversy surrounding them (much of it in my view misinformed) probably added to investor scepticism and accelerated redemptions.

Government and regulator support for the short sale bans fuelled the tendency to see hedge funds as scapegoats for market weakness despite little evidence they had contributed to this.

Indeed, the bans may actually have increased market volatility and decreased liquidity. For what it’s worth, the S&P/ASX 200 Accumulation Index has fallen almost 30 per cent since the short sale ban was implemented in September, and the financials sub-index around 35 per cent.

Given the scale of business, financial and investment disasters (including frauds) around the world in 2008, the obsession with constraining short-selling seems misplaced. As Michael Lewis pointed out in a recent article in The New York Times, about the only task the US regulator, the Securities and Exchange Commission (SEC), has applied itself to diligently in this crisis is “to question, intimidate and impose rules on short-sellers – the only market players who have a financial incentive to expose fraud and abuse”.

The bigger problem was that the hedge fund industry had grown too dramatically and become bloated in recent years, diluting away or reducing many of the alpha opportunities that it depended on. In hindsight, its own growth had been partially instrumental in generating the returns/risk trade-off the industry delivered by narrowing spreads across a range of areas.

This growth also created a perception that many areas were much more liquid than they really were. When redemptions started this set up a self-reinforcing cycle in the opposite direction.

The Madoff scandal of late 2008 has compounded the situation by creating a huge blow to trust and confidence in the investment industry generally, and hedge funds particularly.

While the majority of the more established fund of hedge funds with substantial due diligence teams avoided investment in Madoff, it has impacted a broad investor base and investor perception even more so.

I would be surprised if there were other large-scale scams to emerge, although some smaller scams have already come out. It seems Madoff needed near perfect luck and conditions – and inaction by the SEC – to survive for so long. In any case, the fear of further frauds will inhibit further investment in opaque strategies for some time (or perhaps forever). It will take time to regain that trust.

While there are some very smart people in the hedge fund industry, it was clear the growth in recent years was attracting plenty of mediocre participants. Many of these will disappear. It is difficult to set up a new hedge fund (or fund of hedge fund) now and that is a good thing. Competition for the available investment ideas will decline, improving the return prospects for remaining investors going forward.

Of course, hedge funds are not a homogeneous asset class (or even strictly an asset class at all) and it must be recognised that some hedge fund categories and individual funds did very well in 2008. Managed futures performed well with returns in the double digits for most funds (the Barclay CTA Index, a broad measure of funds in this category, was up an estimated 13.8 per cent in 2008).

Most long volatility focused funds had an exceptional year with returns as high as 200 per cent. There were many long biased equity based hedge funds that, while negative, were being used as equity alternatives and did considerably better than conventional equity funds.

Unfortunately, the fact that some specific hedge funds and hedge fund strategies did meet expectations was hidden by the performance of the hedge fund industry as a whole and the large positions many held in fund of hedge funds.

This suggests that it is not necessarily the concept of investing in hedge funds that has been called into question but rather the mechanism that most investors used to gain the bulk of that exposure to this area (ie, large, diversified fund of hedge funds).

This 12-month period has raised some questions about the standard fund of hedge fund approach that seeks to always gain broad exposure across the full range of hedge fund strategies and then across a number of managers in each strategy category to achieve diversification. Correlations of most (but not all) of these strategies and managers have gone to one in a liquidity crisis.

Further, some fund of hedge funds had become so large that their flexibility and willingness to move between strategies they had when they were small (and a smaller part of the hedge fund industry) just a few years ago had dissipated at the very time such flexibility was essential.

As fund of hedge funds became institutionalised, they became a much bigger client to the hedge funds they invested in; they often seemed to follow each other into the same funds and ultimately looked (and performed) much the same.

There are also questions as to whether fund of hedge funds will be able to offer access to the best managers given the redemption pressure from fund of hedge funds that exacerbated the pressure and forced many individual managers to liquidate or gate their funds. Long years of relationship building may now be less important than underlying investor stability.

So where to now for the hedge fund industry?

The industry will clearly shrink dramatically, perhaps by 50 to 75 per cent. A number of fund of funds will go out of business or be forced to restructure. The hedge fund industry will simplify.

Indeed, the strategies that dominated in the early days of the hedge fund industry in 1990 (global macro/CTA and long short equity) may well dominate again, particularly given their higher liquidity.

Less liquid strategies will be a much smaller part of the industry and subject to more onerous liquidity constraints. Fees will be lower and performance fees more aligned with investor experiences over the long term.

In this environment, fund of hedge funds will have a tough job convincing investors they offer value, especially given the structural challenges faced by the retail investor.

Fund of hedge funds with significantly less liquid hedge fund strategy exposures will only be accessible with longer lock ups and/or more extended redemption periods or through listed closed end funds. Platforms will be reluctant to offer them with more onerous liquidity constraints given disappointment over recent returns.

In this environment, fund managers offering fund of hedge funds need to be totally practical and consider what investors and advisers require. We suspect many will offer switches/restructuring into more liquid products or simply return clients’ money as it becomes available.

Importantly, 2008 should highlight that the alternative investment universe is much broader than just fund of hedge funds. Apart from the managed futures and volatility funds discussed above, some alternative investment areas did well, including some direct investments such as infrastructure.

Gold bullion and some commodity exposures also did well in most currencies. Importantly, some of these areas also offer very good underlying liquidity.

So what should investors do? While fund of hedge funds in 2008 were a poor defensive investment in 2008, does that mean you should replace them with bonds or fixed interest funds now?

While it may make sense to reconsider the role and means of getting exposure to hedge funds, I doubt loading up on government bonds (or fixed interest) now at yields of little more that a few per cent will turn out to be a wise strategy, and if rates move up sharply at some point we could see losses reminiscent of (or perhaps worse than) those experienced by bond investors in 1994.

There is no point compounding one mistake with another based simply on looking backwards to what worked last year.

Fund of hedge funds are likely to have a reasonable pick up in returns at some point in the near future given the carnage of 2008, the exceptional value across a range of strategies and the easing of redemption pressure (albeit produced partly by the number of funds closing to redemptions).

The fact that so many funds are below their fee high watermark means investors won’t be charged performance fees on returns for some time. However, the forced deleveraging in some cases means that some losses will never be recovered.

But what about the longer term outlook, especially given what is likely to happen with the liquidity arrangements of fund of hedge funds?

In a world looking for more transparency, many institutional investors are likely to access hedge funds directly, attempting to cherry pick the better ones and the ones that make sense for their particular portfolio, thereby reducing some of the issues involved in investing in commingled fund of hedge fund vehicles.

Some fund of hedge funds may even have a role in helping institutional investors get to this point from a consulting perspective.

However, the generic fund of hedge fund will be increasingly threatened if all institutional investors go down this route. This is compounded when investors consider the liquidity constraints many fund of hedge funds will need to offer.

Fund of hedge funds clearly disappointed in 2008 and the industry will be much changed and much smaller going forward. But there will continue to be some attractive investment opportunities in the hedge funds space.

Many disappointed retail investors will probably abandon the area entirely, either because of disappointment on returns or because they (or their advisers’ platforms) cannot handle the stricter liquidity arrangements that will be required on most fund of hedge fund products.


But some will gain exposure through broader-based multi-manager alternative funds investing in the full range of alternatives, including hedge funds, across varying degrees of liquidity, which can skew towards the best opportunities over time. These are likely to prove more robust vehicles for retail investors to gain exposure to hedge funds (and other alternatives) in the long term.

Dominic McCormick is chief investment office at Select Asset Management.