What's Ahead for Hedge Funds?

Date: Tuesday, January 13, 2015
Author: Nick Summers, Bloomberg Businessweek

Considering all the blows that hedge funds have endured in recent years—from the insider-trading scandal at SAC Capital to stock-focused funds charging astronomical fees only to miss an historic rally in stocks—a simple white paper might not have seemed like a big deal. Yet Hedge Funds: Problems Under the Hood, a 14-page presentation written by industry lawyer Gerald Kerner for an investment conference in January 2014, kicked off another bad year for the most beleaguered asset class on Wall Street.

Kerner, a longtime lawyer for billionaire money manager Stanley Druckenmiller, argued that it was time for investors to read the fine print of their contracts and demand better treatment. Hedge funds often reserve the right to lock up clients’ assets for long periods, for any reason; they also pass on legal costs that should be the responsibility of management and make it easy to amend their own rules with little input. “When these documents are drafted,” Kerner wrote, “there is no one at the table watching out for you.”

Hedge funds have become notorious since the financial crisis for lagging the broader market, and 2014 was no exception. For the sixth year in a row, with a gain of 2.1 percent, the Bloomberg Global Aggregate Hedge Fund Index did worse than both the Standard & Poor’s 500-stock index and a balanced portfolio of three parts equities to two parts bonds. With underperformance becoming almost routine, what set 2014 apart was a growing clamor for the industry to get less complicated and ease up on fees. IFI Global, a London-based research firm, called Kerner’s white paper “the most important contribution to the global alternative governance debate in years.”

The biggest name in finance, Warren Buffett, joined the anti-hedge fund chorus in May. When a board member at the $17 billion San Francisco Employees’ Retirement System pension fund wrote to ask his advice on the asset class, Buffett scribbled back: “I would not go with hedge funds—would prefer index funds.” He underlined the word “not.” Buffett has told his heirs to avoid expensive financial products and put 90 percent of his fortune into a low-cost fund that tracks the S&P 500. Hedge funds typically charge a 2 percent annual management fee on assets plus 20 percent of any profit, allowing some managers to pocket multibillion-dollar paychecks. The Vanguard 500 Index Fund charges a scant 0.17 percent a year.

Another titan broke with the industry in September, when California Public Employees’ Retirement System, the country’s largest pension fund, announced that it was cutting hedge funds from its $300 billion portfolio entirely, saying it couldn’t justify their cost and complexity. Funds in Louisiana, New Mexico, and Texas have reduced or eliminated their hedge fund allocations.

Although it’s impossible to say how hedge funds will fare in 2015—predicting the future is the kind of folly practiced by, well, hedge fund managers—a number of trends weigh against them. One is the continuing U.S. economic recovery. Goldman Sachs (GS) analyst Ben Snider noted in a November quarterly report that hedge funds struggled with the absence of stock market volatility and “low dispersion”—relatively narrow differences in the performance of individual stocks—in 2014. Strong growth of the kind expected this year has typically meant low dispersion, “implying another challenging year for fund performance lies ahead.” Even when volatility did strike markets in October, funds that bet on macroeconomic trends posted their worst results of the year. Paul Tudor Jones lost 1.6 percent in his main fund that month, after bemoaning the “boring” state of play at a conference in May.

While Bill Ackman of Pershing Square Capital had a big 2014, several high-profile names put up disastrous numbers. Billionaire John Paulson lost 27 percent in a key fund through November. Meredith Whitney, who foresaw the 2008 crisis as an analyst, lost 11 percent in her fund through November. Her firm is being sued in Bermuda by a client that wants to get its $46 million investment back.

Don Steinbrugge, the founder of Agecroft Partners, an industry consultant and marketer, says the agitations of Calpers and Buffett will have “very little impact.” Hedge funds are getting more of their money from pensions, endowments, and other institutional clients—63 percent in 2014 from 45 percent in 2008, according to data firm Preqin. These investors are comfortable with mid-single-digit gains that, in theory, come with some downside protection if markets turn bearish.

That shift helped the industry’s total assets under management grow to a record $2.85 trillion at the end of November, according to Hedge Fund Research, with inflows of $71.2 billion. More than 950 hedge funds (and funds of funds) liquidated from October 2013 to October 2014, more than in any year since the financial crisis. And yet so many more are starting that the total number hit a peak in the third quarter, HFR estimates, at 10,119, finally topping the precrisis level of 2007.

Maybe that resilience, and not six years of underperformance, is the proper context in which to view another document that bookended 2014: a set of investing principles released in December by a group calling itself the Alignment of Interests Association (AOI). Founded in 2009, the organization has more than 250 members that invest a combined $75 billion in hedge funds. Many of AOI’s ideas are utterly reasonable: Management fees should cover only costs and not be a source of profit, and they should decline as a fund gets bigger and more efficient to run; new compensation models should distinguish between managers’ “alpha” (gains they are responsible for) and “beta” (what the overall market did); and employees should be subject to the same liquidity and withdrawal terms as clients.

These are not demands, merely “suggested best practices.” Meanwhile, average portfolio manager pay increased 8 percent from 2013, to $2.4 million, according to a report from HFR and the executive search company Glocap. If scandals, exorbitant fees, and six years of underperformance result in an industry that’s larger and better compensated than ever before, insiders might argue that what’s under the hood is an engine that’s purring just fine.