
Hedge fund net flows will hold up much better if we see another 2008 type market decline |
Date: Thursday, August 25, 2011
Author: HedgeWeek
After the market decline of 2008, the hedge fund industry experienced a significant contraction that was driven by negative performance, heavy redemptions and almost a complete seizing of inflows. The major question running through the hedge fund industry today according to Don A Steinbrugge, managing partner of Agecroft Partners is – to quote Yogi Berra, the famous New York Yankee catcher – is it “déjà-vu, all over again”?
Agecroft Partners is in contact with over a thousand investors per month and
they see two major trends developing within the hedge fund investor community
based on the recent sell off in the equity market and the increase in
volatility, that are very different than what was experienced at the end of
2008. The differences include expectations for hedge fund net capital flows and
changes in investor demand for various strategies and types of managers.
Currently, investor’s appetite to make new hedge fund allocations and to meet
with managers has seen very little change. Approximately 5% to 10% of investors
have said they are on hold until they see how things play out, which is very
different than the end of 2008 when a vast majority of investors were on hold or
redeeming. Although we have had a dramatic increase in volatility, the S&P 500,
as of August 19th, was only down about 10.5% year to date, which has made many
investors nervous, but has not caused their behavior to change. The big question
is what happens to hedge fund net capital flows if the market continues to
decline? There is obviously a correlation between net fund flows and the
performance of the capital markets, but Agecroft believes that the magnitude of
change relative to net flows has declined dramatically since 2008. If we have
another 40% plus sell off in the equity markets net flow should be significantly
better than experienced in 2008 for several reasons.
1. The make-up of the hedge fund investor base is very different from 2008 and
is dominated by institutional investors who are much more long term oriented and
stable. Pension funds over the past few years have been responsible for a
significant percentage of positive net flows to the hedge fund industry. This
trend could actually be enhanced by a market decline as pension funds strive to
reduce their unfunded liability by enhancing returns and reducing downside
volatility. Pension funds need to generate a return equal to their actuarial
assumptions which typically are in the 7.5% to 8% range. This is difficult to
achieve when the fixed income portion of their portfolio is yielding around 3%.
Endowments and foundations, which were criticized for their redemptions after
the 2008 market correction, have repositioned their portfolios to better
withstand “liquidity” events. These liquidity issues were primarily driven by
the private equity portion of their portfolios, where common practice was to
over allocate to private equity in order to maintain a targeted allocation. This
caused significant issues when capital calls increased while return of capital
came to a halt. Most of these liquidity issues have now been resolved. Going
forward endowments and foundations will be much more active allocators to hedge
funds given a similar sell off. Finally, the fund of funds market place is much
more stable. These organizations are using less leverage and their investors are
better educated on what they are buying. Before 2008, many fund of funds were
selling their funds as a t-bills plus 400 basis point product. Many investors
didn’t realize that they could experience material negative returns. When
investor’s experience is dramatically different than their expectations, they
are much more likely to redeem.
2. Significantly less leverage utilized by hedge fund investors and managers. In
2008 a majority of the highly leveraged fund of funds either went out of
business, suffered heavy withdraws, or had their leverage reduced by their
lenders. This in turn led to significant redemptions from the underlying hedge
funds. Today there is much less leverage used by fund of funds. In addition, the
average leverage used by individual hedge funds has declined, which should help
their performance in a down market and reduce the amount of withdrawals.
3. Lower probability of another Madoff. The Bernie Madoff fraud caused total
losses, including fabricated gains, estimated at USD65 billion and the
court-appointed trustee estimated actual losses of USD18 billion. This caused a
ripple effect throughout the industry which led to massive redemptions from
investors in fund of funds that had Madoff exposure, and it temporarily reduced
investors’ confidence in the hedge fund industry, leading to further redemptions
and reductions in allocations. Since that terrible event there has been a
significant enhancement in the due diligence process of many investors to reduce
the probability of fraud, including a greater focus on transparency, operational
due diligence and the quality of service providers.
4. Better alignment of liquidity terms and underlying investments. Back in 2008
there was less regard for the mismatch in liquidity terms of a fund and its
underlying investments. It didn’t matter if the fund strategy focused on asset
based lending, distressed debt, or some other type of illiquid investment as
long as the fund allowed for monthly or quarterly liquidity. This mismatched
worked fine as long as there were positive flows to the fund, however, the large
redemptions at the end of 2008 lead to many funds raising gates and suspending
redemptions. This also reduced confidence in the hedge fund industry and
unfairly penalized liquid strategies by turning them into ATM machines for many
investors that needed liquidity. Since then there has been a much greater focus
by investors on liquidity terms and their alignment with the underlining
investments. Investors are much more willing to accept longer lock-up provision
and redemption cycles for less liquid strategies and are avoiding those funds
with mismatches in liquidity terms. In addition, those managers who investors
perceived self-servingly employed a gate provision at the end of 2008, have been
banished from future consideration. We should see the reduced use of gates and
suspension redemptions in the future.
5. Lack of good investment alternatives. After the market correction in 2008
there were many alternatives in which to invest to protect capital. Today the
options are not as compelling. Money market funds are yielding close to zero and
generating a negative real return. The 10-year US treasury is yielding
approximately 2% and could sustain a large market value decline if interest
rates rise. Gold has seen a significant rise in value and now is at an all time
peak and investors obviously don’t want to increase their equity holdings if
they expect a major decline in the equity markets. Hedge funds are a much more
attractive option than they were at the end of 2008.
Hedge fund investors rethinking the type of hedge fund strategies and type of
managers they are interested in investing in. The increased volatility and world
equity market sell-off are causing many investors to rethink the types of hedge
fund strategies and managers they are interested in placing money with based on
their scenario analysis of the future. Many investors are looking for strategies
that provide diversification benefits, downside protection or a focus on less
efficient areas of the market. We will see continued strong demand for global
macro funds and CTAs because of their historically low correlation to long-only
benchmarks. In addition, there will be an increase in demand for market neutral,
arbitrage and trading oriented-strategies. Within the long short/equity area
there will be less demand for very long biased managers and greater demand for
managers that can move their exposure around. Investors will continue to
diversify their equity portfolios away from managers that focus on large-cap
European and North American companies to those that focus on companies in
emerging market economies which exhibit stronger growth rates, trade surpluses
and lower national debt, such as China. Within the fixed income space, spreads
on all non-treasury securities have contracted significantly since the start of
2009, creating a golden opportunity for those positioned correctly. Market
participants have noted the recent expansion of spreads, but argue the beta
trade is over. There will be a greater focus on managers that actively trade
their portfolio and invest in less efficient parts of the fixed income market
space, for example structured credit.
The volatile markets are causing significant deviations in performance across
mangers in similar strategies, which will increase manager turnover. Those
managers who significantly underperform their peers will be heavily punished by
experiencing large withdrawals; in turn, that will benefit other managers who
successfully navigate through these difficult markets by protecting their
investors’ capital. Unlike 2009 and 2010 when performance was a secondary
consideration in net capital flows to the size and “brand” of a manager, due to
their perception of providing safety, expected future performance will be a
major factor in investors’ decision making going forward.
We will not see a vast majority of inflows going to hedge fund managers with
assets greater than USD5 billion, which for a period of time after 2008 was over
100% of net flows. Recently there have been a number of large high-profile hedge
fund managers generating very poor performance, which is causing investors to
question whether these large managers have morphed into asset gatherers at the
expense of performance. Some of the most well-known hedge fund managers will
experience heavy withdrawals in the coming months as investors continue to shift
their assets to smaller, more nimble managers.
In conclusion, if we experience a major market correction, Agecroft believes net
flows will be negative, but nowhere near the extent that was experienced in
2008. Most of the redemptions will be recycled within the industry to managers
and strategies that provide downside protection for their investors.
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