Comment and Analysis: William Keunen reflects on the future of hedge funds
In an environment where performance has been challenging, the mainstream media continues to ramp up its negative rhetoric about the future of alternative investments. The gist of it seems to be that the 2/20 fee model is not generating the requisite value and that the day of reckoning is nigh.
Any high-profile investor that has decided to withdraw becomes the so-called bellwether of the future of the industry. So when the New York City Employment Retirement System (Nycers) announced that it intended to withdraw from alternatives, and AIG announced it was cutting its allocation in half, there was a similar reaction to when Calpers announced the same thing a couple of years ago; i.e. the industry is set to collapse.
Certainly, the data we are seeing reflects that 2016 asset flows are negative, broadly following negative performance on a quarter-lag basis. But to say that this is endemic would be a stretch.
There is no indication of a repeat of the carnage that followed the financial crisis when we saw assets drop by 40% and when investors used many of the more liquid funds as ATMs. So, I would like to set out the opposite view; that in fact the industry remains on a long term growth parabola.
Strong evidence for this lies in the numbers. Even if the net annualised outflow rate climbs from its current $60bn to $100bn, that represents only 3.33% of the total $3trn in AuM. This after a five-fold growth period since 2000.
The most important reason for this optimism is that the industry now “gets it” when it comes to investors. Since the financial crisis, we have seen managers invest heavily in investor retention and the results show that these efforts have been fruitful. The primary drivers of this are:
Fees: the largest and stickiest investors no longer pay 2/20; once they have completed their extensive due diligence and picked a manager they are comfortable investing in and sticking with, they will usually pay much less than 2/20, more likely around 1.5/17, sometimes even less for strategic investors.
Exposure and risk reporting: investors crave data. The industry has responded by providing a plethora of information and analysis that covers one-time due diligence related needs, monthly risk and exposure metrics and daily performance output.
Transparency: following Madoff, the industry fell in line with the universal adoption of the independent administration function. In addition, it worked closely with industry associations such as Aima, the MFA and the HFSB not only to educate the community about what alternatives offer, but also to create a suite of standardised reports generated independently, covering areas such as counterparty balances, asset confirmation and price verification.
Liquidity matching: to avoid a repeat of the side-pocket surprise of 2008/9, investors want to understand the parameters of their investment in hedge funds.
Funds have accordingly re-structured their investment vehicles to match the liquidity of their strategies and, moreover, established investor level gating to ensure managers are not forced to sell their best positions to meet redemptions and any wind-down situation is handled equitably.
Investor demographics: the industry has worked intensively to create a more balanced investor base to minimise exposure to investors that are themselves handicapped by liquidity constraints; the ability to attract investors that are comfortable with a longer view enables funds to lock investors in for longer periods and seek strategies that can optimise complex trades and illiquid markets.
Finally, the ongoing ability of the industry to adapt has resulted in the development of products which suit a diverse investor base that operates right across the liquidity spectrum. This, plus the recognition that a more mature, disciplined organisational culture is required to navigate the investment and investor landscape, creates a compelling future for alternative investments.
Will there be a shake-out? With more than 8,000 hedge funds competing for capital, quite possibly; but give sophisticated investors cred-it for selecting the good guys, who still seem capable of growing and performing.
Published in HFM Week
26th May 2016