Transcript: Wall Street fell out of love with equity hedge funds

This is an audio transcript of the FT News Briefing podcast episode: ‘Wall Street fell out of love with equity hedge funds’

[MUSIC PLAYING]

Marc Filippino
Good morning from the Financial Times. Today is Tuesday, February 13th, and this is your FT News Briefing.

[MUSIC PLAYING]

Companies in Hong Kong are feeling the pinch from Beijing’s crackdown, and equity hedge funds are losing their shine. Plus, China is kind of known as a black box when it comes to understanding the country’s economy. One company could change all that.

Kaye Wiggins
This is kind of a treasure trove of information about how ordinary Chinese consumers are spending their money.

Marc Filippino
I’m Marc Filippino, and here’s the news you need to start your day. Beijing has been cracking down on Hong Kong a lot lately, and global firms are worried about what this crackdown means for their businesses. Take, for example, Latham & Watkins. It’s the world’s second-highest-grossing law firm, and it told its lawyers in Hong Kong they can no longer automatically access its international database. They’re gonna have to ask for special permission first. Now, this type of behaviour is part of a larger pattern of how companies are doing business in Hong Kong these days, which is a real problem for the city, especially since it’s made a name for itself as an international finance hub.

[MUSIC PLAYING]

The best stock pickers from equity hedge funds used to be treated like financial royalty. For years, the managers using the so-called long-short strategy made big bucks in US markets. But lately, this strategy hasn’t really been working out, and investors are losing patience. Costas Mourselas covers hedge funds for the FT, and he joins me now to discuss. So, Costas, before we get into what’s really afflicting equity hedge funds, maybe just do me a favour and start with the strategy behind them.

Costas Mourselas
So with a traditional equity manager, you would just buy stocks that you like. And those stocks should do better than the overall market. And that’s how they’re adding value. With equity long-short hedge funds they add an additional component. Not only do they buy stocks that they really like, they also sell short, which means bet against stocks that they think shouldn’t be doing so well. Now, this strategy has the potential to protect investors because, during good times when the market is going up, in theory, your stock picks should do particularly well. But at the same time, if you’ve picked correctly, the stocks that you’re betting against should go down in value. Now, when you have a bear market and overall stocks are going down, the higher-quality stocks that you’ve bought should go down less than the overall market. Meanwhile, the stocks that you are betting against should go down even more than other stocks because they are low quality. And so that is how you make money during any type of market conditions, or at least, reduce your losses during difficult market conditions.

Marc Filippino
Got it. OK, so these hedge funds basically help you bet on strong stocks and bet against weak stocks. Costas, when was the, I guess you could call it heyday for equity hedge funds?

Costas Mourselas
So this strategy had its heyday back in the 90s and the early 2000s. In the 90s, it had some pretty incredible returns with many managers returning double-digit returns pretty consistently. And it sort of culminated around 2000, when you had the dotcom bubble which burst or started to burst. And a lot of these managers made quite a bit of money shorting a lot of these overvalued dotcom internet companies. There was also a pretty good period of performance in the 2000s, leading into the financial crisis, with some funds betting against some big losers. But after the crisis, things took a turn for the worse.

Marc Filippino
Yeah. What happened then?

Costas Mourselas
Generally speaking, the strategy started to sour after the 2008 financial crisis, when central banks started intervening in markets. So what happens is that investors tend to keep buying riskier assets like equities because they think that the central banks will step in to support the market. So people keep buying and buying and buying. And this is bad for their strategies because, you know, a big part of this strategy is the fact that they’re selling short. They’re betting against shares. But many of these shares keep going up as well. And so that means that they’re actually taking losses on their short sells, while, sure, making money on their longs. But that means that performance is not brilliant. So over the past five years, we’ve seen almost 150bn worth of outflows for these specific type of funds. And that completely wipes out the sort of investment returns that they’ve gained. So they’ve actually contracted in size, which you cannot say about the rest of the hedge fund industry, which generally has been growing.

Marc Filippino
So with all these major losses and outflows, what are the long-term prospects for these hedge funds?

Costas Mourselas
Well, if markets are going up year after year after year, it does make the case for allocating to hedge funds more challenging, because hedge funds charge quite high fees relative to what you get in a passive index track. But if we have, for instance, a global recession or inflation comes back and stock market is impacted, that could make the case for hedge funds once again because then investors might start to retreat from equities. So I’d be hesitant to call peak long-short equity hedge fund right now. But one thing’s for sure: if the bull market keeps going up and up and up, it’s just gonna get harder and harder for a lot of these hedge funds.

Marc Filippino
That was the FT’s hedge fund correspondent Costas Mourselas.

[MUSIC PLAYING]

Bitcoin had a big day yesterday. The cryptocurrency’s price hit $50,000 for the first time since 2021, and it’s got exchange traded funds to thank for all this enthusiasm. Some of Wall Street’s biggest names launched spot bitcoin ETFs earlier this year after US regulators gave them the green light. Analysts said the surge of new money through these ETFs could mean that bitcoin is turning the corner for the long run now.

[MUSIC PLAYING]

A high-profile financier in China has started a company that, on its face, seems pretty straightforward. It’s a small business lender, and it’s called Micro Connect, but it turns out Micro Connect is actually filling a pretty big gap in China’s economy: a lack of real-time consumer spending data. Here to talk to me about it is the FT’s Kaye Wiggins. Hey, Kaye.

Kaye Wiggins
Hi Marc.

Marc Filippino
So can you give me a bit of background about Micro Connect. I mean, who’s in charge there, and how was it originally set up?

Kaye Wiggins
So the main character is a guy called Charles Li, and he was the head of the Hong Kong Stock Exchange for about a decade until 2020. This is his big new project. So basically, I mean, at the very simple level, he’s providing finance to thousands of small shops in China. This is like, you know, noodle shops, car washes, karaoke bars, mostly so small companies that have maybe a small chain of a handful of coffee shops or hair salons, whatever, and they want to expand to a slightly bigger chain. And the sort of unique thing about the model is that because China is kind of almost entirely cashless now, he can use software to take a percentage of a shop’s revenue automatically, like in effect, out of a store’s till every day. So he would invest some money in a small shop, and then every day, a percentage of the money that they make will automatically be repaid.

Marc Filippino
Tell me a little bit more about that model. Like, what’s it all about?

Kaye Wiggins
Crucially, it’s getting data, right? So these shops make an agreement with Micro Connect, where they say they’re gonna hand over a certain percentage of their revenue, which means that the company can see exactly how well all these shops are doing. And it’s doing this at like more than 10,000 shops across China. And it’s making that data public at a time when lots of economists say that China is increasingly a black box in terms of kind of understanding what’s really going on in China’s economy and getting hold of reliable economic data. This is kind of a treasure trove of information about how ordinary Chinese consumers are spending their money.

Marc Filippino
Treasure trove — I love that, because yeah, I mean, it’s incredibly valuable to have. But how does Micro Connect plan on using all that information that they’ve gathered?

Kaye Wiggins
What they are doing with the data is using it to enable them to do the next stage of their business plan, which is to package up all of the revenue streams from all of the repayments from all these small businesses and turn them into securities that can be traded between investors, such as hedge funds and asset managers. So kind of the way to think about that, I think, is kind of how mortgages were bundled up and sold on as securities before the 2008 crisis. You’d have like a whole bundle of mortgages, some good, some bad. They’d all be bundled together, and then there’d be securities that would be issued based on that sort of package. The model here is quite similar.

Marc Filippino
OK, so I think I get it. Instead of repayments coming from mortgages, they’re coming from the small businesses that you mentioned: noodle shops and small stores. So how have investors reacted to this package, Kaye?

Kaye Wiggins
There are a couple of schools of thought. You know, economists would say that they like love that this data is available, right? Because it’s really hard to know what’s going on in China a lot of the time. But on the flip side, there are people who say they’re concerned about what might happen here. It’s that, kind of, a lot of people will stop buying or investing in these bundles of securities without really understanding the risks they’re taking.

Marc Filippino
OK. So Kaye, you said earlier that Chinese data is kind of like a black box, which isn’t really that surprising, right? Like we hear all the time about how opaque the country is. How does Beijing feel about Micro Connect?

Kaye Wiggins
So at the moment, this sits in kind of a grey area when it comes to regulation. It’s unclear how regulators will end up treating this very new product. But certainly, there are risks, right? Like the most obvious one perhaps being that if Beijing decides that it doesn’t like this data being out there about China’s economy — particularly if that data isn’t telling a very positive story — then that could cause real problems for the company.

[MUSIC PLAYING]

Marc Filippino
Kaye Wiggins is the FT’s Asian financial correspondent. Thanks, Kaye.

Kaye Wiggins
Thanks, Marc.

Marc Filippino
You can read more on all these stories at FT.com for free when you click the links in our show notes. This has been your daily FT News Briefing. Make sure you check back tomorrow for the latest business news.

[MUSIC PLAYING]