“There are basically two types of people,” said Mark Twain. “People who accomplish things, and people who claim to have accomplished things. The first group is less crowded.”
Hedge fund managers take note. The rapid contraction of their industry over the past year has increased the pressure on firms to prove they can accomplish what they claim. They will have their work cut out: from a peak of about $1,900bn of assets in late 2007, the industry will probably fall to about $750bn of assets this year. That these losses occurred at the same time as major market declines and a global economic crisis does not excuse them, for it is during such times hedge funds are supposed to preserve investors’ money. So what has gone wrong?
Somewhere along the way, hedge funds lost sight of their original purpose. When Alfred Winslow Jones set up the first hedge fund in 1949, he had the goal of disaggregating individual share performance from market movements by also shorting shares. But, the industry has seemed to forget the aims of hedging as equity bull markets led to a ferocious appetite for ever- increasing performance and a disregard for risk. The result was a hedge fund bubble that burst when markets collapsed.
But bubbles are not all bad. Their bursting can bring positive outcomes. Many managers hope the end of the hedge fund bubble will help create better times ahead.
The research group Gartner tried to prove the potentially positive outcomes of bubbles in its theory of the “hype cycle”, in which mass adoption of any product begins with a “technology trigger” that generates significant interest. This leads to a “peak of inflated expectations”. When reality fails to live up to these hopes, the industry enters a “trough of disillusionment” in which many businesses leave. Those that remain continue through to a “slope of enlightenment” in which a more practical understanding of the technology’s potential is reached. The final stage is the “plateau of productivity”.
One key factor missing from Gartner’s analysis is capital. The surge to the “peak of inflated expectations” can only occur if capital is cheap and freely available. And this is a key point to remember when analysing the hedge fund bubble of 2008.
From 2002 until late 2007, a growing wave of capital, combined with a five-year upwardly trending market, fuelled a massive expansion of the hedge fund industry from about 4,000 funds and $700bn of assets to almost 8,000 funds and nearly $2,000bn of assets. At the same time, hedge funds became highly correlated with equities as many managers relied too heavily on rising markets to generate returns, with disastrous consequences in some cases.
However, one should recognise that some hedge funds did profit and meet expectations in 2008. These managers (largely Macro and Managed Futures strategies) had often not been the best performers in the bull market as they controlled risk and correlation and hence were often overlooked. Their time has now come as they have shown an ability to offer clients a non-correlated return which provides important portfolio diversification.
So, while 2008 was very painful for most hedge funds, it is unlikely to herald their demise. There will always be investors seeking absolute returns with low correlation to equity markets and low volatility. As the losses incurred by many hedge funds last year show, to achieve all these simultaneously is difficult. However, firms with investment talent, strong research capabilities, appropriate due diligence and risk management are discovering a wealth of opportunities as they develop a better understanding of the financial crisis and adapt accordingly. The positive returns achieved by many hedge funds so far this year suggests a rapid evolution is taking place.
The huge amount invested in hedge funds between 2002 and 2007 brought the industry to maturity quicker than expected. This maturity will likely lead to a re-focusing of priorities as funds return to their original purpose of hedging risk and protecting against market falls. Ultimately, that is the method by which they may generate consistent absolute returns.
The writer is chief investment director of GAM’s fund of hedge fund business.
