For a long time, many investors have regarded hedge funds as an investment class that generates absolute returns by means of managers’ sophistication in extracting inefficiencies from the complexity of the global capital markets. However, the current financial crisis has forced investors to reconsider this belief. Even before 2008, the hedge fund battlefield had been littered with the bodies of secretive funds such as LTCM, Quantum, Tiger, Niederhoffer, and Beacon Hill, all of which failed spectacularly in comparably much less severe market environments.
The crisis year 2008 saw countless new casualties. Hedge funds have proven to be part of “the system” and even if they enjoy greater flexibility and certain advantages, they were not able to fight against the type of market distress we have recently seen. The average hedge fund has lost around 20-25% in 2008. The industry has subsequently experienced several “worst months in history” only to be topped by one of the next months. October and November 2008 were just the latest “menses horribilis” for hedge funds, months in which even some high flying stars of the scene experienced losses in the range of -25% to -50%.
Finally December brought another major blow of pain to hedge fund investors when the alleged Ponzi scheme of Wall Street icon Bernard Madoff fell apart pulling 50 billion USD out of the hedge fund industry (including high profile funds of hedge funds) and causing a big stain on the industry’s public reputation.
Figure 1 provides an overview of the industry’s returns in the various strategies. (ed: HFRX is an investable index that generally underperforms traditional indexes such as its non-investable sister, the HFRI.)
These losses occurred just as hedge funds had expanded to a broader institutional investor base intrigued by their promise of “absolute returns”. Watching their investments fall short of these promises, these investors are growing increasingly skeptical about what the “traditional hedge fund model” is able to deliver.
As a result, the institutional investors that drove recent industry growth have become less willing to drop billions into a black box and hope for the best. In fact, they have started to pull out their money in unprecedented amounts - leading to another devastating blow: a liquidity trap (which ultimately led to the demise of Madoff’s fund). In their search for returns, hedge funds had recently begun to invest in less liquid investments and apply private equity techniques to public targets (activist investing), thus extending the liquidity features of their underlying investments.
Many, including Partners Group, were concerned about this development since private equity funds had a much more stable and long term capital base. In addition, we were concerned about hedge fund “black boxes”, as readers of our research will surely recall (see previous AllAboutAlpha.com posts). Unfortunately, these concerns proved to be justified much faster than we could have ever anticipated. In 2008, an asset-liability mismatch forces a number of hedge funds to withhold redemptions, and the revelation of the alleged Madoff Ponzi scheme caught many investors off guard (especially fund of funds that put insufficient emphasis on solid due diligence, transparency and active risk management).
2009 and Beyond
In light of the excruciating pain that hedge funds have suffered and a growing consensus - even among hedge fund advocates - that the industry is going to suffer short and mid-term redemptions, many investment professionals are asking themselves about the long term effects on the industry.
In light of these developments, we anticipate the following effects on the global hedge fund industry:
- With the shrunken balance sheets of the banks, hedge funds will have less access to leverage financing. This will obviously affect those strategies that have been employing significant leverage, i.e. the “Relative Value” strategies such as Fixed Income Arbitrage, Convertible Arbitrage, and Statistical Arbitrage.
- Regulatory constraints such as the banning on short-selling coupled with increased regulatory oversight are going to rob hedge funds of the flexibility necessary to exploit their return sources. This will affect most equity related strategies such as Long/Short Equity, Event Driven, and Equity Market Neutral.
- The decline of alpha has been documented on countless occasions even before all the recent trouble started. The majority of today’s hedge fund returns stem from risk premia rather than market inefficiencies, in others words, from “beta” instead of “alpha”. Risk premia have risen across all markets in the ongoing flight to quality. Consequently, declining and negative (alternative) betas have had a detrimental effect on hedge fund returns. However, short to mid-term expected alternative beta returns will likely be significantly above historical averages.
- Significant losses, the introduction of redemption gates, and the largest alleged fraud in the history of Wall Street means that opacity and illiquidity - once considered a source of strength for the hedge fund machine - has turned into a formidable liability. The industry will finally have to give up its black box approach, and the major fund of hedge funds will have to revisit their investment and business model.
- The prototypical 2/20 fee model and possibly higher trading and financing fees from their prime brokers will mean that the fee burden faced by hedge fund investors will have to come down in order for net returns to become attractive again. Indeed, we can observe that this has already begun.
Hedge funds are here to stay, but not here to stay the same. While the first three points above are structural rather than cyclical, alternative beta will remain a promising source of investment returns. In other words, there is a tailwind for hedge funds. Market dislocation and investors’ fears will provide for ample return opportunities in form of high “standstill returns” from alternative beta.
This means that 2009 will likely be a strong year for the surviving hedge funds. Those investors and investment managers with cash to invest now are surely going to be richly rewarded.
Whither “Absolute Returns”?
But how about the original hedge fund promise of “absolute returns”? Hedge funds have been marketing their “alpha” while many have actually delivered “diversified beta” (what a few years back we started calling the “alternative beta” game, i.e. diversify across a large spectrum of return drivers that balance the investment risk of each individual underlying risk).
The market distress this year has given a final vindication to this hypothesis. In a painful way hedge fund investors had to learn what some academics and very few hedge fund product providers have told them all these years - that hedge funds delivered mostly (alternative) beta returns.
As a consequence of the recent financial crisis, the motto of hedge funds should now be, “Chase alpha where available, diversify across betas where necessary”. As a result of declining alpha at home, many of the top hedge funds had already moved to where the fields were still green, namely the private capital markets.
Hybrid Hedge Fund Strategies and Liquidity
But there is an important prerequisite for hedge funds “going private” - having a stable and well-secured capital base. In other words, the hedge fund needs to persuade investors to forgo liquidity. In other words, the hedge fund manager needs to know what he is doing with respect to asset/liability management.
That does not mean that the new “absolute return” portfolio will have to mimic a conventional private equity portfolio (requiring, for example, an investment commitment of eight to ten years). Many investors already have that part of their portfolios managed by (pure) private equity players and will expect a different kind of exposure and liquidity from their absolute return investments.
This being said, the short duration end of private market investments such as mezzanine loans and late stage (purely financial) secondary investments offer a wide spectrum of opportunities that the investor with higher liquidity demands can benefit from in his absolute return bucket. Mezzanine and senior bank loans for examples have payback periods of 36 months rather than ten years, and a late stage secondary can return the capital equally fast.
These are areas in which hedge funds have started to become very active in the recent years. While the focus on generating absolute returns through alpha naturally drives investors to private market investments, in practice many investors have liquidity needs. So institutional investors need to find the right balance between maximizing (risk adjusted) return and providing sufficient liquidity. Too much liquidity means foregoing returns; too little liquidity can quickly turn off investors.
A New Approach to Portfolio Construction
Once the right balance between return objectives and liquidity profile is established, investors must turn to these asset allocation decisions. With the traditional (mean variance based) optimization model and related statistical optimization techniques failing to deliver reliable results, we suggest a different macroeconomic scenario based approach for the portfolio construction. (Other investment managers such as Bridgewater Associates have expressed similar ideas.)
Asset class pricing and investment returns are generally a function of expectations of changes in macroeconomic variables such as growth and inflation. However, exact forecasts of these parameters are extremely difficult, if not impossible. For that reason the investor should balance an absolute return portfolio across an entire range of optimal portfolios in each respective scenario. Concretely, this means averaging across the different “scenario portfolios” in order to obtain the final balanced asset allocation. By balancing risk across the different environments, the investor is able to earn various asset class returns while minimizing the portfolio’s susceptibility to any one environment.
The “Relative Value” Approach
Once the general scenario based portfolio is determined, allocations to different segments should be based on current relative value assessments (e.g. alpha opportunities in private equity markets are bigger than they are in public equity markets), fees (e.g. fee-efficient access to certain hedge fund strategies via alternative beta strategies) and liquidity.
In fact, while the overall asset mix across private markets, alternative beta, offshore hedge funds, and other asset classes and risk premia can be kept rather static, there is room to manoeuvre within each. For example, it makes a difference whether one accesses leveraged buyout returns through a direct investment in a limited partnership or in the secondary market. In addition, the relative attractiveness of hedge fund strategies fluctuates over time - demanding a tactical allocation process.
The final step in this asset allocation process is to conduct solid bottom up investment research (i.e. finding the best companies, the right structures, and the right types of instruments to extract the highest possible return from in a given market environment).
In summary, what is really needed for effective absolute return asset management is a holistic perspective on investing instead of one contained to particular asset classes and return drivers. The key to absolute return investing is to combine all available asset classes and investment strategies. Some of the smartest money managers in the world have already executed this successfully (and silently).
The new challenges and opportunities presented by the recent financial crisis require just such an integrated business model and investment approach. Alternative asset managers with highly focused capabilities will struggle in 2009 and beyond.
- L. Jaeger, January 15, 2009
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