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Hedge fund investors must be forgiving types. Inquests on 2013 are under way, showing that the funds endured yet another year in which they failed to come anywhere close to the returns available on simple equity index tracker funds, which has been the story throughout the rally since 2009.
And yet big institutions are planning to send them more money this year.
Indeed, a survey by Barclays’ capital solutions group, covering 220 investors with $490bn invested in hedge funds, found that only a minority felt that funds had underperformed their expectations, and that more than 90 per cent planned to send more money to hedge funds this year.
This is great news for hedge fund managers bearing lacklustre results. But life is not all easy for them. They are now obliged to compete on price. According to Chicago’s Hedge Fund Research, the classic “2 and 20” fee structure – with managers taking an annual fee of 2 per cent of assets, along with 20 per cent of profits – is beginning to come under control. Funds that launched last year charged an average of 1.38 per cent for management (the lowest since 2001), and a 17.17 per cent “incentive” fee, the lowest since 2003.
In another sign of concern over charges, funds of hedge funds, which charge a fee for their own management on top of the fees charged by the underlying funds, are shrinking. The number of funds of funds has steadily reduced since 2007, while HFR estimates that some $20bn was pulled from the sector in the fourth quarter alone. But fees remain breathtakingly high.
The bald facts are these. Hedge funds massively outperformed during the bursting of the dotcom bubble more than a decade ago, largely avoiding any losses. They continued to outperform during the rally of almost five years that followed it. This brought money from a whole new field of institutional investors into the sector. For pension fund managers, hedge funds appeared to be the ideal diversifiers.
During the credit crisis, things were tougher. They beat the market during the crash year of 2008, but still suffered losses: an average of 19 per cent according to HFR, with equity hedge funds dropping 26.7 per cent. Since then hedge funds generally, and specialist equity hedge funds have lagged the S&P 500 every year.
Why so poor? Three broad explanations were offered to Barclays. One is that there are too many hedge funds now. Many strategies have a limited capacity. If too many try to do the same thing, all chances of gains are eliminated. Some 47 per cent of investors named this problem.
Others (40 per cent) blamed macro factors. Market turns over the past five years have been driven by political factors that are hard for hedge funds to predict. And 28 per cent said it was simply a bad time to be running a hedge fund strategy: when the market does well, the ability to sell stocks short – a key advantage for hedge funds – is not much help.
The most popular explanation, named by 54 per cent, was that hedge fund managers were not good at their job, failing to take on risk at the right time, and showing poor market timing. That may have been because they were trying to show transparency in the wake of the Madoff scandal, and to make their offering more convenient for institutions.
One insurer complained there were too many hedge funds, particularly in “strategies that are easier to enter (and thus, fail at)” like long-short equity strategies. One family office complained that “hedge funds became preoccupied with proving they could provide transparency and liquidity”. This often came “at the cost of risk-taking, which ultimately means that returns suffered”.
Despite all of this, Barclays found that only 9 per cent of those unhappy with their hedge funds’ performance intended to cut allocations this year. For the time being, hedge fund managers are being given the benefit of a very large doubt.
This does come at a cost to them. Institutions may be raising the amount of money they give to hedge funds, but they are cutting the total number of funds they hold, rewarding size. Many now want hedge funds to organise their own separate managed mandates. And of course they are bargaining harder on fees.
Where will the money go? Barclays, which thinks the sector could realistically attract another $2tn, finds that trend-following futures funds and multi-strategy funds are out of favour. The most popular strategies are equity “long-short” – which rewards good stockpickers, and “event-driven” – making money around special events such as mergers and acquisitions.
This looks like a bet that 2014 will see the much-anticipated “stockpicker’s market”. It is a popular prediction that 2014 will see more muted equity gains, and a return of the wider dispersion of returns that allow stockpickers to outperform. Such a view rests on the notion that monetary conditions will tighten, while the US economy recovers.
If that happens, then hedge funds could attract yet more money. They will have far fewer excuses if they fail to beat the market. For the time being, the big institutions who have helped the sector swell to a record size are prepared to forgive them for the past five years.
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