The hedge fund is as versatile as a beast as it is a secretive one. For many, the word sparks visions of their portrayals in popular culture as ominous, all-powerful organizations with endless pockets and influence. The reality is that the industry is a spectrum. A hedge fund is simply defined as a limited partnership where investors aren’t limited in the avenues by which they can pursue return, they generally trade in liquid, public markets and they will be the subject of this week’s edition of our series on the alternative investments industry. Even in more basic terms, think of a hedge fund as an unconstrained form of a mutual fund.
These largely unregulated investment pool structures were first introduced in the 1950s but did not rise to prominence until the 1980s. While some regulation within the industry has changed, the strategies and markets in which they operate, at their core, remains the same: to pursue unconventional, complex, and high skill methods of return while, ideally, hedging their positions so as to perform independently of market gyrations... A key word here is “skill”. One way to think of hedge funds and the skill deployed within their strategies is to think of a spectrum where on one end is the most passive of strategies; an index fund. Think of this as the far left of the spectrum where strategies rely on diversification, simplicity and low costs. On the far right is the realm of the active manager, the most active would be those focused on hedge funds and private equity. At this end, skill matters and investors should pay for the presumably greater performance benefits, thus the higher costs. The problem is that sometimes an active manager may not be as active or skillful as advertised. If their results are more similar to that of broad benchmarks, investors are left to question the value of such “closet indexers”. This phenomenon of being highly correlated to market returns is actually a common result in the mutual fund space but with the far higher fees of hedge funds, such behaviour should not exist. Still, the rarity of truly skilled managers providing long-term track records of strong performance with relatively low correlation to the broad markets, despite higher fees, is a key rationale for the growth of the ETF industry over the past couple of decades.
As an aside, it’s key to note that passive instruments (ETFs, index funds, equity index futures or options) are tools. There’s no reason why an active manager including a hedge fund manager can’t apply these instruments as part of their toolkit to get the job done. So when we talk about passive and active management, we don’t do so to enter an “active versus passive” debate. There’s a time to be more passive (long bull markets) and a time to be more active (2020’s likely a good example). It’s our contention that knowing when to bias this general decision of being more active or more passive is something many investors do not consider carefully. In simple terms, it’s another dimension beyond asset allocation.
When times are uncertain or for markets where the likelihood to outperform the broad benchmarks is reasonable, then skill especially matters. There have been many market environments of high uncertainty where proven managers are not only rare or inaccessible but provide their services in what is deemed to be justifiably higher priced. The challenge for investors, large or small, are not only the difficulty to access such managers but also an important bias. With regard to access, a key driver for these managers is the ability to apply their craft. Being too big does not allow for the nimbleness needed to truly wield their weapons of choice. Think of an index fund like a sledgehammer. It does the job so long as you can swing the lumber. Hedge funds are more like a scalpel. It’s about precision from a trained hand.
The concept of a justifiably higher price is another dimension for investors to consider when seeking a highly active and specialized manager. Can the hedge fund manager, their technologies or models sustain their operations and performance? More so than plain long-only mutual fund managers, one must reflect in what marketing material disclosures highlight in often small font size: Past performance is not indicative of future performance.
Poor investment performance happens to every fund including those run by sophisticated models. The reality is that successful hedge fund managers often close their fund to new investors as their strategies often do not persist in outperforming. Sometimes it’s the fact that their larger size does not allow them to execute as before. Sometimes, their market of focus has become so “market efficient” that other competitors have taken away the opportunity set.
For those analyzing past performance, the concept of survivorship bias should be considered. Given many hedge funds close their operations and shut down their funds, analyzing a pool of hedge funds will not consider these closed funds and that left who have been successful. For any investor considering hedge funds, the nature of such investment requires the analysis of the fund company itself, the managers and operational integrity of their overall operation. In reality, their fund performance is a by-product that, while evidence of skill does not take into consideration other risks one enters when employing the services of a hedge fund. That is: manager risk. It is because of this consideration of risk that we visualize the concept of passive and active investments, the risks associated with each and the spectrum that allows one to think where they ought to be based on what they believe about the pros and cons for each.
Passive Active
Beta Alpha
Market risk Manager risk
Market exposure Manager skill
Low cost High cost
ETFs Mutual funds Hedge funds
As investment vehicles, hedge funds have normally only been available to institutions and accredited investors, however in recent years, securities regulation has been eased to allow for “liquid alts” which in their most common form are a hybrid between mutual funds that provide hedging capabilities and hedge funds that use underlying exchange traded instruments allowing for daily liquidity. Although in the past, hedge funds usually employed a lockup period of up to several years, large institutions negotiated such terms out of their agreements and this has trickled down to other smaller and less sophisticated investors. On top of that, the industry’s famous ‘2+20’ fee structure, where these fund companies charge 2% of the assets they manage as well as 20% of the outperformance versus a benchmark or beyond some “high water mark” is less common today in a world where cost-conscious investors know that they can get the S&P 500 and other quick market exposures for management fees well under 10bps if not nearly for free.
In recent times, hedge fund investments have been facing a multi-front war for capital allocations due to an assortment of elements. First, the explosion of different investment methods in which new funds and strategies have formed around such as the private equity, venture capitalist and algorithmic and quantitative trading strategies that have chipped away at their market share. The draw towards these high fee funds decreased for a while as their alternatives became more alluring. While private equity funds mastered their ability to offer yield enhancement and income to their investors, hedge funds were faced with increasingly volatile waters to trade. Hedge funds that managed to use algorithmic trading systems as a tool in their strategy claimed to accomplish more with less, being able to automate aspects of the job and continue to quickly revolutionize as technology became more powerful, they too have established themselves as a subset of the industry.
However, primarily quantitative based trading funds have successfully established themselves as competition for traditional hedge funds. Some of the largest hedge fund companies today such as Bridgewater and AQR have been based on more quantitative methods. Other younger firms such as Renaissance Technologies and Two Sigma are well known for their incredible performance and often inaccessible funds. It’s a certainty that ongoing innovation in the use of machine learning and other forms of data science will be further incorporated and combined with the human manager bringing the best of each. [We will be discussing primarily quantitative and algorithmic funds in an upcoming post.] For example, Quantedge, a leading firm based out of Singapore that operates a primarily quantitative strategy, lost 30% in the market blight of March 2020. This praise being shown to these up and coming quantitative strategies could be more so the result of false credence that bred during a time of unprecedented prosperity. The silver lining here and saving grace for traditional funds is that 90% of them beat the market during the march decline. It is in times of growth that one of their prime value-adds is forgotten, that they are hedged and better protected against downside than the benchmarks they sometimes fall short of. It is a result of this that the hedge fund industry will remain largely relevant as a suitable alternative investment for both accredited and institutional investors alike.
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