Where Do Hedge Funds Go from Here?

Family Office Alpha Report

By Keith Danko

October 17, 2016

It is our strong view that hedge funds can add significant benefits in terms of risk/return profile, volatility and diversification to any institutional portfolio or to the portfolios of very high net worth individuals. However, it’s no secret that poor performance currently plagues the industry, which has too many funds and strategies that ultimately disappoint.

Recent news of a significant slowdown in new fund launches and a slowdown in overall net allocations is a welcome sign. But will these be enough to solve the current predicament? Is hedge fund oversupply truly the main issue?

It is one of them. However, there are two other issues that are equally to blame for the current hedge fund malaise: the lack of unique and differentiated product, and the relentless focus on liquidity.

The Edge

First a step back in time: In the early “glory” days, what made hedge funds special was that the managers could pursue investment ideas, strategies and specific opportunities that were generally not available to the average high net worth investor or institution. Many strategies were so esoteric they were only done by a handful of Wall Street broker-dealer trading desks who specialized in such things. They were “wholesaler” activities, executed by insiders with information and access based on size and expertise.

There was also often a discovery advantage through deep research or sophisticated knowledge; the hedge fund manager in such an instance could put on a trade, even tell others about it, and ultimately be confident that the exit would be selling the trade to retail, at a higher value of course. It was classic smart money running ahead of less-smart money. Shorting securities was the most specialized trade of all, done very little by retail (and certainly never pushed by brokers, who were under implicit pressure to assure their clients that markets generally moved in upward directions).

The key to hedge fund investing was having an edge, an advantage, or leg up on the market, or within a specific sector or class of securities. But another key was being allowed the necessary time to exercise that edge. Hedge funds were places where managers could execute their ideas generally without fear that at month-end or quarter-end their capital would flee. Although not guaranteed, it was understood that hot money was not desired, and in many instances acknowledged that a hedge fund manager’s acceptance of your capital was tantamount to an invitation to an exclusive, private party. Redeem your capital and a future invitation might not be forthcoming.

Leaning on Liquidity

Today the situation is reversed. Liquidity is the most common demand from investors, and the hedge fund industry has been happy to provide it, most notably through the proliferation of liquid alternative products—hedge fund strategies in a ’40-Act mutual fund structure.

Liquid alternatives or any structure that provides liquidity to hedge fund investors essentially introduces an outside distraction to managers: limited time. Specific ideas or opportunities must succeed quickly or else be abandoned. And if they veer too far into negative return territory, an exit from the trade is soon to follow.

High liquidity is not a beneficial component of hedge funds. In fact, it is an impediment to high returns. It introduces a third-party decision-maker to every trade: the weakest investor in the fund. And in the case of managed accounts, it empowers the most risk-averse constituents of the account owner.

Something Special

What we would like to see is for hedge funds to return to being unique and differentiated strategies, with controlled liquidity such that committed investors, not the least committed, would have the most sway. Such a development in lessening the need for liquid opportunities would also reduce the “crowded trade” effect that often hampers returns.

Uniqueness is being enforced in the emerging manager market. New managers stand little chance of success unless they can demonstrate that they bring something special—something that investors do not already have—to the table.

If some element of discipline as to the number of industry players were to come about, combined with an understanding by institutional investors that an easing of liquidity constraints would be well rewarded, hedge funds could return perhaps not to the glory days, but certainly to where they could live up to their once-supported reputation as the smartest players in the market, delivering those smarts directly to end investors. Other salutary elements such as lower fees and very high operational stability are already moving into place.

With fees compressed to such low levels, probably close to one-third of what investors were paying in 2007, funds of funds are offering very good value right now, providing expertise in hedge fund selection. This consideration along with more of a regular dialog within the institutional investment community will be important drivers that indicate in what direction hedge funds will move going forward, and may help to reclaim the “edge” in hedge.