Wilting Hedge Fund Roster: Time for a New Bloom?

Art by Lily Padula

Now comes the great hedge fund consolidation. These once-venerated money machines, whose number expanded 15-fold over the past three decades, are seeing their ranks deplete amid complaints of insufficient returns and too-high fees.

But is this $3.2 trillion industry, founded on claims of analytical savvy and trading prowess, about to go the way of the ticker tape? Hardly. There’s a solid argument that when bad economic times come—and the current coronavirus-driven market rout may be the opening curtain for that—a hardy band of hedge fund survivors will do very well.

“The industry has reached a saturation point,” said Don Steinbrugge, CEO of Agecroft Partners, a consulting firm. And after the shake-out, institutional investors’ quest for diversification will keep hedge operators in business, he argued. “Demand for their strategies will rise because they are not correlated to capital markets.”

The industry’s shrinking is pronounced. After peaking at 10,142 in 2014, the fund count has steadily dropped to reach 9,448 last year, a decline of almost 7%, according to Hedge Fund Research (HFR). In 2019, more hedge funds closed than opened, for the fifth year in a row, HFR says, as investors redeemed almost $100 billion in assets. Among the closures, to the shock of the financial world, were funds helmed by two Wall Street stars, Jeff Vinik and Louis Bacon.  

Vinik, the one-time Fidelity Magellan chief, gave back money to investors after his funds logged piddling increases of around 4% last year. He told clients it was more difficult nowadays to raise money. And Bacon, a veteran hedge manager with more than 30 years in the game, had a comparable blah performance, which he described in a letter to clients as “in the low single digits.”

For too long, such unimpressive returns have dogged the industry, which through the beginning of this year has had a tough time keeping up with the rapidly ascending stock market. In 2019, HFR data indicate, the overall performance of its hedge fund index was 10.4%. Trouble is, the S&P 500 delivered three times that—and charged a lot less.

These lagging records have convinced a lot of clients that they aren’t getting a bang for their buck, meaning the high fees they pay to be in a hedge fund. The standard structure has been “two and 20.” In other words, hedge managers cream off a 2% yearly management fee and 20% of any profits, aka, a performance fee. These fees have come down some, although they have a long way to go.

Under client pressure, the management charge has dipped to an average 1.3%, a survey last year from the Alternative Investment Management Association found. And 40% of hedge funds now use hurdle rates, which set a minimum return before a fund imposes performance fees. While those developments mark some progress, the Vanguard 500 index fund costs just 0.14% annually, still quite a contrast to the hedge offerings.

Hedge fund aficionados point out that the purpose of the asset class is not to surpass the market, but to furnish diversification and downside protection amid bearish spells. Those notions have had scant appeal during the 10-plus-year bull run. The good news, in a perverse fashion: The market’s present terrifying freefall should allow the funds to exercise their oft-touted protective powers.

Hedge Heroes’ Hegemony Hobbled

Hedge funds came into this world fathered by a colorful character named Alfred Winslow Jones, a Ph.D. in sociology and former Marxist who, lore has it, shared a bottle of scotch with Ernest Hemingway during the Spanish civil war. In 1949, Jones launched his invention, a limited partnership that used the technical analysis of the day to suss out market directions and employed short selling in a bid to diminish risk.

Hedge funds really surged in the wake of the 2000-02 dot-com bust, expanding at a double-digit rate in the century’s first decade. They pulled back amid the carnage of the 2008 financial crisis, when some hedge managers gave the funds a bad name by refusing to let their strapped investors cash out.

But the crisis also produced a cast of hedge fund luminaries who prospered mightily amid the financial devastation. Most celebrated was John Paulson, whose eponymous fund earned some $15 billion through betting against the housing market—he shorted mortgage-backed securities via credit default swaps. Another hotshot of the era was David Einhorn, whose Greenlight Capital shorted stock in Lehman Brothers before the firm’s collapse. Before anyone else did, Einhorn deduced that Lehman had enormous exposure to illiquid real estate investments.

Around the middle of the past decade, though, the climate changed for hedge funds. The roaring stock market and competition from passive investing and from liquid alts mutual funds dimmed the appeal of hedge funds, according to a paper by Joseph McCahery, a professor at Tilburg University in the Netherlands, and Alexander de Roode, a researcher at Robeco Asset Management. “The last decade has challenged the paradigm of the hedge fund industry as a unique performer,” they wrote.

Since mid-decade, a drip-drip-drip of exits and partial withdrawals ensued from public pension programs. An anti-hedge labor union movement, called Hedge Clippers, was a vocal supporter of the divesting. The first big blow to hedge funds came in 2014 from the nation’s largest pension fund, the California Public Employees’ Retirement System (CalPERS), which yanked its entire $4 billion hedge fund position. CalPERS cited high fees and overly complex investments. In 2014, the New York City Employees’ Retirement System pulled out its $1.4 billion hedge stake.

Last year, New Jersey’s State Investment Council halved its hedge fund exposure. Gov. Phil Murphy, a former Goldman Sachs executive and hedge fund critic, complained that the state had paid $95.5 million to hedge providers and received returns in the low single digits over the previous five years.

A Shot at Redemption

Wars are good for the military, which gets showered with appropriations and public good will, provided that it is winning. The same may well be true for hedge funds, now that stocks are diving, with baleful repercussions throughout the financial terrain, as oil prices plummet and supply chains freeze up.

Rapidly accelerating market volatility creates a classic opportunity for hedge managers, because they can take advantage of price discrepancies, among other things. Not long ago, the Vix index, which measures volatility, was at a quiescent 15. Now, it is up to a rollicking 54, giving sharp traders lots of openings.

With the market deteriorating and the hedge fund world consolidating, the stellar performers should shine all the more. “The industry will likely live on as a place where the best survive and the belief in emerging stars persists,” a recent eVestment report declared. “But 2019 also seems to have marked the point where one can no longer ignore that broadly felt success is a thing of the past.”

Those that did well in recent years are prime candidates for the 2020 winner’s circle. Tiger Global Management, for instance, scored 22.4% annually from 2016 to mid-2019. Founded by the legendary Julian Robertson, now retired, Tiger has a well-deserved reputation for prescience. Right before the dot-com bubble burst in 2000, it bailed out of tech stocks. Since then, the organization has taken private positions in the likes of Facebook and Alibaba, which paid off handsomely once these went public.

The secretive Renaissance Technologies, which uses quant-based techniques, has long delivered the goods for its investors. A recent book about the firm and its math genius founder, Jim Simons, contended that its flagship Medallion fund generated an average 39% annually since 1988. In The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution, author Greg Zuckerman detailed how the fund focuses on relations among different investments, not simply betting on whether they will rise or fall independently.

As these cases demonstrate, funds that stand a chance of romping in the future have a special sauce. Last year, riding the strong stock market, the largest—and least complex—hedge strategy did the best, HFR data indicate. Long-short funds delivered a gain of 13.9% in 2019. The second largest fund type (up 7.5%), relative value, is more quant-oriented: It seeks to pounce on mispricing among securities. Less of that occurred until this winter’s mayhem, so now should be a happy hunting ground for this approach. Paulson’s main fund, Credit Opportunity, benefited superbly from the same kind of disarray in the financial crisis.

The third largest category (rising 7.4%), event driven, plays in the ever-shifting mergers and acquisitions (M&A) arena. Due to high stock valuations and fizzled tech public offerings, such as those of Uber, Lyft, and Peloton, M&A fell off last year. The last hedge fund group, macro (up 6.2%), is another stats-heavy strategy, which attempts to divine large market trends. Once the trajectory of the coronavirus is knowable, then macro stands a decent chance of doing well.

No matter how these hedge funds fare in unsettling times, they are sure to have a steady corps of detractors. Billionaire investing sage Warren Buffett is prominent among them, believing that hedge strategies are over-hyped hokum. In 2007, he made a $1 million bet, against asset manager Protégé Partners, that a Vanguard S&P 500 Index fund would out-do a collection of five hedge funds over 10 years.

Buffett won the wager, when the stock index scored 7.1% yearly versus the hedge funds’ 2.2%. If he makes a similar bet up ahead, however, he may have to pay up. 

Related Stories:

Quant Hedge Funds Trail Old-School Ones, But Reap All the New Money

More Hedge Funds Close in 2019 than Opened

Investors Redeemed Nearly $100 Billion from Hedge Funds in 2019