Alt Investments
Hedge Funds – A New “Golden Age” Beckons?
The author of this commentary argues that the hedge fund sector is due for a strong comeback with a compelling set of opportunities lying ahead.
This news service regularly reports on how well or poorly so-called alternative investment areas perform, such as private equity and hedge funds. Hedge funds, a sector holding more than $3 trillion in assets, have been through tough times. The 10-year bull run in equities after the 2008-09 financial crash, fuelled by massive central bank money printing, meant that traditional long-only investors could capture robust returns for a fraction of what it costs to run a hedge fund. However, the spike in volatility during 2020 as the pandemic hit, and big disclocations to asset prices, created rich opportunities for certain types of strategy. Some recent performance figures from Hedge Fund Research, for example, showed the sector logging a strong 2020.
With all this is mind, Andrew Beer, founder and managing partner of Dynamic Beta investments, discusses the terrain. DBi is a New York-based asset manager that specialises in hedge fund replication. DBi manages more than $427 million of replication-based hedge fund strategies across equity long/short, multi-strategy and managed futures. DBi also manages a variety of fund structures, including the OYSTER SICAV, two US-based ETFs, a Dublin-based UCITS fund, and a Cayman Islands hedge fund built for Japanese investors. The editors are pleased to share these views and invite responses. The usual editorial disclaimers apply. Email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com
Pundits love to beat up on hedge funds these days. The glory days are long gone, they argue, and investors should stick to low cost, passive investments like the S&P 500. For nearly every fund that proved its mettle during March 2020, another two imploded.
A further criticism I myself subscribed to is that hedge fund fees mean that investors are in a heads-you-win-tails-I-lose trap. With so many criticisms being levelled at hedge funds, one might think that rational investors would skip the space altogether. And yet, recent surveys show institutional investors planning to increase allocations.
The golden years
These blanket critiques miss the larger picture. During the
2000s, while the S&P 500 lost 1 per cent per annum – the
“lost decade” – hedge funds returned 6 per cent a year. The
shining periods were 2000-02, when hedge funds made money during
the dotcom bear market by investing in cheap small-cap stocks and
shorting high-flying technology shares.
Within a few years, many of those same hedge funds had pivoted into emerging market stocks and capitalised on the BRIC and commodity wave. 2007 was a banner year, as bets against subprime mortgages paid off. By contrast, 2008 was a bit of a disappointment. Hedge funds declined more than expected, some suspended redemptions and the industry was tainted by Madoff. But by the end of the decade, hedge funds had recovered.
For these reasons, the 2000s are often called the Golden Years. The 2010s, by contrast, were dominated by passive investing. In a world of constant monetary easing, a simple portfolio of stocks and bonds returned nearly 7 per cent per annum. Global investors flocked to US large capitalisation stocks, exemplified by the S&P 500 and later technology monopolists; prices rose accordingly.
This was a brutal decade for active management overall.
Under-loved value stocks suffered historic underperformance and
many strategies were hammered by a market seemingly divorced from
fundamentals. During this decade, hedge funds returned only 4 per
cent – interestingly, about 3.5 per cent above the
risk-free rate.
Beta strikes back
While some hedge funds called the shift into US equities as far
back as 2012 and later embraced future trillion-dollar stocks
like Apple and Alphabet, it was nearly impossible to keep up.
Alpha, a measure of value added, was modestly negative. On a
relative, if not absolute, basis, these may be deemed the Lost
Years.
However, the common thread or lesson from both decades is that hedge funds do one thing very well – shift into the right markets at the right time. In addition to ample talent, the true competitive advantage of hedge funds may be their flexibility.
Most investors, by contrast, have stringent “constraints.” A US large-cap equity manager must still buy those stocks even at sky high prices; pension funds might tilt their portfolios by a few per cent, but no more.
Research on hedge funds shows that they change, and change in a big way, as market conditions evolve. A small-cap value investor in 2000 might have pivoted into emerging markets by 2005 and later to US large-cap quality stocks. In some circles, ‘strategy drift’ is a derogatory term; with hedge funds, it is a plus.
Which brings us to the 2020s. The S&P currently trades at 33x earning and a high percentage of US equity value rests in a handful of stocks with nosebleed valuations; history tells us the easy money has been made. On the fixed income front, treasury yields are alarmingly close to zero and corporate credit appears to be in a bubble. The 2020s may well be a lost decade for simple, passive portfolios.
We see evidence of hedge funds recognising that 2020 looks more like 2000 than 2010. Several investing legends now call tech stocks a bubble. On a relative basis, overlooked or forsaken areas like small-cap stocks, value investments, non-US equities and emerging markets are historically cheap. In fact, our risk models show over the past year that hedge funds have been shifting into many of those areas. We appear to be at an inflection point, although it will take some time to confirm this.
What could go wrong?
The biggest headwind would be if hedge fund fees were to remain
too high. Many investors pay away $6 out of every $10 in returns,
which simply makes it harder to make money in a lower return
environment.
Another issue is that most capital today resides with the largest managers, who may not be as nimble nor as able to capitalise on more esoteric opportunities as their much smaller forebears.
A related concern is that institutionalisation may limit strategy drift, since pension funds place managers in narrower buckets than the family office investors of twenty years ago. Significantly, the rapid and broad dissemination of information means that markets have become far more efficient over time – a headwind not just for hedge funds, but all active investors.
Taken together, despite headwinds, hedge funds may have a more compelling opportunity set today and the hurdle to demonstrate value will likely be low over the coming years. The 2020s, then, might well be a Second Golden Age.
