Opportunities and Challenges for Hedge Funds
Hedge funds transitioned from a niche industry in the 1980s catering to small number of wealthy families to an almost mainstream asset class in the portfolios of most large institutional investors (pension funds, endowments, etc.). By the 2000s, these funds reached a magnitude nearly commensurate with traditional assets, equities, and bonds—managing about two-and-a-half trillion dollars by 2014. Today, there are nearly as many hedge funds as there are mutual funds.
But hedge funds’ move from the margins to the center of the investing world poses new challenges for the industry. This chapter briefly outlines several of the main challenges and opportunities hedge funds will face in the coming years.
Performance
Any investment product’s raison d’etre is performance, or at least risk-adjusted performance. In their original incarnation under A. W. Jones, hedge funds hedged, compensating for issue-specific risk by hedging away systematic (market) risk. For example, a fund might go long on a particular stock and sell short on the market index that drives that stock’s beta. Many funds aspire to be “market neutral,” or to achieve absolute return—positive returns above the rate of inflation regardless of the market’s direction.
As a group, hedge funds have failed to meet this standard. The HFRI index that tracks aggregate hedge fund performance lagged the S&P 500 for 8 of the 10 years prior to the 2008 market crash. A low-cost stock index fund would have produced superior results. While hedge funds did not fall quite as far as indexes in 2008, they still were soundly drubbed. For the 5 years from the summer of 2008 through 2013, the composite HFRI index produced 3.4 percent annualized returns, versus 7.3 percent for the S&P 500 and 4.9 percent for the Barclay’s U.S. Aggregate Bond Index. This 5-year period includes the 40 percent+ swoon in late 2008 and the subsequent sharp recovery in 2009 and thereafter. For the 15 years from 2000 to 2014, the HFRI Composite trailed a standard 60/40 indexed portfolio such as Vanguard’s Balanced Index Fund by 28 percent (72 percent cumulative return for HFRI versus 100 percent for the balanced fund). Poor average performance need not be the death knell of an investing style—if it did, few actively managed stock mutual funds would still be in business. But it will probably lead to shorter holding periods for investors (as they change funds in search of performance). More skeptical investors will lead to shorter fund life spans. It can bring significant bifurcation in pricing: downward pressure on prices for the substandard performers and great pricing power for the rare strong performers.
Pricing
“Two and twenty”—the classic hedge fund fee structure is already an endangered species. Many hedge funds are already segmenting their customer base; offering superior terms—lower prices or a shorter lockup period—to early or large investors. As an example, in July 2013, Merchants’ Gate Capital lowered its assets under management (AUM) fee from the 1.5 to 2 percent it had charged since its founding in 2007 to 1.25 to 1.75 percent. It manages $2 billion in its equity fund. Koper-nick Capital’s long–short fund launched in 2013 charges a 0.25 percent AUM fee. Even firms with superior pricing power aren’t immune: Caxton Associates’ AUM fee has been cut from 3 percent to 2.6 percent.
Incentive fees have likewise been under pressure. The aforementioned Caxton lowered its fee to 27.5 percent of profits from 30 percent previously. Industrywide, average incentive fees have slowly fallen from the low 19 percent range of annual profits to 18.4 percent in the first quarter of 2013, according to HFR. A Goldman Sachs survey for 2012 reports nearly identical findings: 1.65 percent AUM fee and 18.3 percent performance fee.
Fund company profitability may not be declining proportionate to performance fee rates, because financial repression—artificially low interest rates engineered by central banks—has also lowered the “hurdle rate” above which excess investing profits are calculated and fees exacted.
Nevertheless, the frequency with which hedge fund management generates new billionaires among those managers probably peaked before the 2008 crash. Achieving high absolute profits will probably require the gathering of more assets, since both excess performance and high performance fees will be increasingly rare. Clients are already demanding less pay for poor performance. This may lead to a long-overdue industry shakeout and consolidation.
Regulation: Fund Registration and Marketing
U.S. regulators generally have a bias against hedge funds, and have only allowed them so much freedom because of protection provided by their allies in Congress. Some restrictions have lately been lifting. For example, the 2013 Jumpstart Our Business Startups (JOBS) Act liberalized the terms under which new firms may seek investment capital, allowing some start-ups to bypass financial intermediaries entirely. (The most common manifestation is Kickstarter campaigns.) The U.S. Securities and Exchange Commission (SEC) regulations promulgated in the summer of 2013 pursuant to the JOBS Act will permit hedge funds to advertise. A registration requirement has been nominally extant for several years, but never really enforced by the SEC.
However, in time, hedge funds may face an increasingly onerous regulatory environment. Mutual funds are governed by the “40 Act” (Investment Company Act of 1940), and similar laws may be brewing for hedge funds. This will probably be a salutary development: It will force standardization of reporting that has been advocated by authorities such as the CFA Institute, but cannot be mandated. The expense of meeting these regulations may prove to be too much for smaller hedge funds. On the other hand, greater transparency should accelerate some of the client-friendly developments mentioned elsewhere in this chapter.
Finally, this new regulatory climate may eventually lead to broader investor access to hedge funds. Currently, they are prohibited from accepting monies from other than accredited investors. But this is a largely meaningless restriction, since there are many retail products offered by financial services institutions that already invest in hedge funds, including employer-sponsored retirement plans. Millions of nonaccredited investors already have exposure to this asset class, at least indirectly. Pimco, for instance, which runs the world’s largest bond mutual fund (Pimco Total Return Fund, assets $262 billion), recently announced a new fund that will employ hedge fund strategies, but have a minimum investment of only $1,000 and $50 for additional investments. Morningstar reports that the assets in “alternative” mutual funds more than tripled between 2008 and August 2013: from $35 billion to $118 billion. Thirty-six alternative mutual funds were launched in the first 8 months of August 2013, more than during the same period in any of the previous 10 years.
Regulation: Insider Trading
Stung by charges of laxity during the buildup to the 2007 to 2008 financial crisis, the government has become far more aggressive in prosecuting securities violations. The crime most pertinent to hedge funds is insider trading. Hedge funds that practice event-driven or macroinvesting strategies have a particular need for insight into how key corporate and governmental actors think and will act. Sometimes fund personnel have engaged in schemes, many quite elaborate, to compensate insiders for investment-relevant information. As this book is being written, two senior officials at SAC Capital have been convicted of insider trading, and the firm itself is under indictment. Founder Steve Cohen has not been charged. But even the taint of suspicion can deal a mortal blow to a financial institution, because it can scare away lenders and counterparties. This has been the story behind the precipitate fall of many institutions, including LTCM in 1998 and Lehmann in 2008. SAC has announced it will return all outside investors’ capital and reestablish itself as a family office.
Hedge funds whose “edge” depends on superior privileged information flow will find their competitive advantage deeply eroded by more rigorous enforcement of the law. Even for those not directly affected, they may find their access to capital severely impaired.
Regulation: Systemic Importance
The 2007 to 2008 financial crisis did not originate in hedge funds: Mallaby argues that in fact the funds exercised a moderating influence. Arguably, it was a banking crisis, with the epicenter being those who originated subprime mortgages or who leveraged holdings of mortgage-backed securities (MBS). The extent of these banks’ interconnections with other financial counterparties was such that several were deemed “systemically important”—their failure would bring down other, sounder institutions. Being “too big to fail” engendered a multi-hundred-billion-dollar rescue, the Troubled Asset Relief Program (TARP). But ongoing attempts at regulatory reform may also address the “shadow banking system”—institutions that lend, yet are not banks—like hedge funds.
The 2010 Dodd-Frank financial reform law made only marginal changes to the legal environment for hedge funds. But there is a growing backlash in policy circles that it and other reform measures preserved too much of the status quo. Arguably, one of the first casualties of this backlash was Larry Summers’s expected nomination to be the next chairman of the Federal Reserve System, to succeed Ben Bernanke. Summers withdrew his candidacy in mid-September 2013 in the face of evident opposition from Democrats who planned to use his hearings to air multiple grievances about the financial deregulation he supported in the late 1990s and the extremely limited reforms he helped enact in the late 2000s.
Hedge funds have friends in high places, so it would be foolish to assume that they will be seriously harmed by a rising tide of re-regulation. But it seems like that at the margin the climate will become more constraining, especially regarding leverage levels or use of derivatives in trading strategies—both seen as key culprits in 2007 to 2008.
Front-Running
As noted in earlier chapters, some of institutions’ competitive advantage comes from early access to market order data (the order book), by collocating servers at exchanges and having dedicated high-speed communications that shave milliseconds of order processing. This allows these institutions, including hedge funds, to “see into the future” (albeit by only microseconds) to exploit that information to front-run the market. Such an advantage is tiny and fleeting; however, if the hedge funds trade fast enough and often enough (turbocharged by leverage), profits can accumulate into significant sums. Experts estimate that 70 to 80 percent of the daily trading volume on major exchanges is HFT.
While it is argued that HFT increases the market’s efficiency, it has two deleterious side effects: First, it sometimes aggravates volatility. At least two recent major incidents have been traced to HFT: the October 1987 crash, caused by “program trading” (the then-current term for what is now called HFT), and the May 2010 “flash crash.” (Several other lesser known hiccups, such as the NASDAQ’s three-hour suspension of trading in July 2013, were caused by software or user problems, not HFT.) Volatility can provide a profit opportunity for financial engineers (such as derivatives salesmen) and traders, but it scares off individual investors.
Second, HFT delegitimizes financial markets. This is a key tenet of Michael Lewis’s recent book on HFT, Flash Boys. A pillar of legitimacy is investor belief in a level playing field: That relevant information is readily available to anyone smart enough to seek and use it. This is why exchange listing privileges have financial reporting requirements so that all investors can see a company’s true financial condition before investing. But an individual investor trading in an HFT world is like a poker player who knows that some other players can see his cards: There is an information asymmetry to the disadvantage of the individual.
For example, a common technique for limiting losses is a stop loss rule. An investor may specify that an investment should be sold automatically if its price falls below some relative value threshold. For example, he or she might sell when the asset’s price falls 25 percent below his or her entry price, or 25 percent below the last peak price (the latter is called a “25 percent trailing stop”). The width of the stop can be expanded or contracted to account for the asset’s expected volatility and the investor’s risk tolerance. Such rules can be very effective for limiting losses. But because of the prevalence of HFT, investment advisers counsel against entering stop losses into the market (i.e., placing a contingent sell limit order with your broker). Advisers argue that HFT traders who see the order book can place sell orders to drive an asset’s price below your stop threshold, triggering your stop (and those of other investors). They can then buy the asset at this depressed price. The HFT trader has taken advantage of an information asymmetry: knowing your trading rule.
But serious regulation of HFT seems unlikely. Trading volume can migrate across borders quite easily and will flow to the most lightly regulated exchange. And such a technical process as HFT cannot avoid “regulatory lag”—the fact that regulators, who are reactive, will always be behind financial innovators, who act opportunistically.
Private Exchanges and Dark Pools
Dark pools are individual firms or groups of firms that trade shares among themselves to avoid exchange fees and to accelerate trading. They are largely unregulated and therefore less transparent than major exchanges.
These pools are extensions of the internal markets that brokerage firms have long maintained. If Client A wishes to sell a stock and Client B wishes to buy the same stock, the broker performs a service by matching them up internally, without using a stock exchange. Dark pools widen the trading universe to the clients of all the firms in the pool, but far less than all the firms that trade on the exchange.
Any regulatory attempt to force all trading onto regulated exchanges will be nullified by technology and the inventiveness of intermediaries. Instead, it is likely that in time SEC and other regulators’ reach will extend into dark pools. But it is also certain that brokers and investors will innovate new forms to stay ahead of the reach of regulators.
Abandoning Active Management
As we have noted earlier, very few active managers (under 5 percent) beat benchmark indexes over long periods. In general, any positive alpha produced by active managers is far less than active management’s higher costs in portfolio turnover (commissions and taxes) and management fees. Burton Malkiel’s A Random Walk Down Wall Street first popularized this theme in the mid-1970s and led John Bogle to found the first stock index fund, Vanguard’s S&P 500 fund. Bogle has relentlessly promoted indexing and attracted a core of passionate followers who call themselves Bogleheads.
Over time, this disparity in net-of-fees returns between active and passive management came to be well understood among finance academics. What was puzzling was retail investors’ surprising loyalty to active management. This began to dramatically change in the aftermath of the 2008 to 2009 bear market. Active managers generally performed about as poorly as stock indexes, refuting the claim that their higher costs purchased protection from down markets. Superiority on defense was, of course, one of the original rationales for hedge funds; but as noted earlier, the HFRI hedge fund index’s poor performance in the 2008 market drop roughly mimicked the broad stock index.
In the years following the downturn—an historic bull market, in which the S&P 500 has risen more than 200 percent—mutual fund investors’ resources have flowed out of active funds and into index funds in massive amounts, approaching trillions of dollars. In some years, flows into index funds have been twice as large as flows out of active funds. In other words, index funds are not only gaining market share from investor switching, but also receiving all net new funds invested.
Indexes have had an exceptional run since the bull market began in March of 2009, so it isn’t surprising that their popularity has grown. It is a matter of debate whether the active-to-passive migration has been due to a fundamental change in investors’ attitudes following the debacle of 2008, or mere performance chasing. Studies by Dalbar have demonstrated that retail investors’ actual trading of mutual funds produce returns of only about 1/3 of buy-and-hold fund returns, because investors buy after funds have risen sharply and sell after they have fallen sharply—buying high and selling low.
This migration trend, which has persisted through the 2010s decade, is not confined to retail investors in mutual funds.
Institutions Retreat from Hedge Funds
Accreditation has restricted individuals’ eligibility to invest in hedge funds, so retail investors have never been significant direct investors. Institutions such as charitable endowments or pension funds have been hedge funds’ main direct customers. These institutions’ commitment to hedge funds expanded for decades, as part of a general emphasis on “alternative investments” (other than stocks or bonds).
Beginning in the mid-2010s, institutions began reducing their hedge fund exposure considerably—by more than 25 percent in 2017 versus the 2014 peak. As a result, the number of hedge funds also peaked in about 2015 and is now down by double digits.
The Bet
In 1980, free market economist Julian Simon and environmentalist Paul Ehrlich made a bet about human ingenuity versus resource depletion. Ehrlich believed that continued consumption of natural resources would make them far scarcer and more expensive. Simon argued that efficiency improvements would attenuate these trends and cause prices to fall, not rise. Ehrlich chose a basket of ten commodities and noted their 1980 prices. They agreed that at a later date any price differences would be awarded to the one who bet in that direction. If prices rose, Ehrlich would win the difference, with the win going to Simon if prices fell. In 2016, Simon’s estate received a check for several hundred dollars, representing the amount that their prices had fallen—all of the ten commodities were more abundant than they were a generation earlier. It was a largely unremarked demonstration of the power of markets and innovation to overcome resource depletion.
In 2005, Warren Buffett made a similar offer to the hedge fund industry: He would bet $1 million that a hedge fund or collection of funds could not beat the S&P 500. The proceeds of the bet would be donated to a designated charity. Ted Seides, the manager of Protégé Partners, who took Buffett up on the bet, chose a group of five funds of funds. Ten years into the bet as of the end of 2016, the funds are lagging the index substantially: by at least 22 percent cumulatively for the best performing of the five, and by 82 percent for the worst performing. These were not randomly chosen hedge funds, but were selected by Seides because he presumably believed they would be most likely to outperform the index.
The five funds each outperformed the index during the disastrous year 2008, falling on average about half as far as the index’s 37 percent. But they significantly underperformed over the full ten year period.
There are persistent incentives to innovate in finance: in products, in business forms, and in regulatory avoidance. Hedge funds experienced a heyday in the 1990s and early 2000s, as new investing styles (e.g., quant arbitrage) made superior profits and new technologies (e.g., collocated servers and fiber optic communications) allowed more front-running. But financial markets are also highly efficient, and these profits are being competed away—in part because the 2008 meltdown called into question the cost-effectiveness of many hedge funds. Pricing trends follow those of other asset classes such as brokerage commissions or mutual fund expense ratios.
While there will always be successful new funds boasting of exciting new strategies (such as LTCM in the mid-1990s), the average fund will be a less profitable place than it has been for the past few decades. Hedge funds may increasingly resemble mutual funds, which, as noted earlier, may present more good than bad to individual investors.