Lansons Conversations

Bottom of the cycle or tipping point: where next for hedge funds?

“History repeats the old conceits. The glib replies, the same defeats” – Beyond Belief, Elvis Costello

The volume of negative media around hedge funds in the mainstream press seems to have turned up to 11 again. Shrinking assets, crowded trades, challenging performance, high fees – the list of criticisms is ever growing. And let’s face it, if Warren Buffet says he doesn’t like hedge funds, what are us mere mortals supposed to think?

But we’ve been here before. Viewed from the perspective of assets under management, the hedge fund industry has long been on a boom-bust cycle. There have been many times when it has seemed to be on the cusp of obliteration, only to emerge stronger and more diverse than ever before. I firmly believe that this process will unfold again, but simply to say “we’ve been here before, it’s no big deal” would miss a few important points.

First, assets have declined in ‘traditional’ hedge funds but as Ignites Europe pointed out recently, ‘alternative UCITS’ products have benefited from strong inflows. The shift here is in investor preferences around liquidity rather than a massive distrust of what hedge funds offer. But further caution is needed. Neither in Europe nor the US are liquid alternatives the sole preserve of hedge funds. A quick glance down a list of US ’40 Act’ funds seems to reveal as many brands from the long-only world as it does migrants from hedge fund land.

This is important. For years, increasing convergence between the long-only and hedge fund sectors has been debated, but in the world of liquid alts, we are already in a post-convergence environment. Whilst, as demonstrated recently by the FCA, trade asset managers aren’t the greatest communicators going, typically they are better at broader stakeholder engagement than the hedgies. Which, coupled with their established distribution networks and marginally more familiar brands, definitely gives them an advantage. It’s increasingly difficult to point to hedge funds’ greater pedigree in the management of such strategies post-crisis, since trad managers have been on an acquisition spree of alternative boutiques and teams – and there is plenty of supply!

The importance of not just retaining assets but ultimately to build more diversified businesses in this context has not been missed by the hedge fund sector. In doing so, many have shifted their centre of gravity towards long-only. The opportunities are clear cut even if realising them is difficult, time-consuming, burdensome and expensive, at least in the short-term. The European shift to DC is one obvious area where alternative UCITS can grow, but this presents a challenge to the favoured business model and, for most, a leap into the unknown. For investors, however, it has to be worth it – the opportunity to better diversify long-term retirement savings is desperately needed. To that end, I think AIMA has been spot on in trying to take on the burden of demystifying the industry a little for the benefit of the general public.

A second point is around the issue of ‘institutionalisation’ and perhaps even ‘consultification’ (if the two can be considered separate phenomena). Given that the investor base of alternatives is supposed to have shifted to long-term, large scale investors, why has the sector experienced such volatile flows? Surely, the whole point of institutionalisation was that it would ultimately have the opposite effect? Yes and no. Yes – but it won’t happen overnight, and the post-crisis manipulated economic environment probably hasn’t helped, and no – certain managers and strategies will have been beneficiaries, but not most. The intermediation between investor and manager by consultants also needs closer examination. To suddenly have to cover hedge funds en masse necessitates huge development among mainstream consultants -a process which remains fairly nascent in reality. Also, we have to look back to the flows into alt UCITS funds – much of which is from institutional investors who prefer the UCITS brand, and the liquidity and transparency that go with it.

Performance and fees are issues which have been covered before, but the increasing focus on short-term performance among some commentators is more a reflection of how the news cycle has evolved than anything else. Equally, performance and fees are issues which reflect the increasing attractiveness of passive at present, which may or may not be the result of our quantitatively-eased environs. I’ve long been a believer that the emergence of passive heightens the importance of active – the yin and yang of investing. As investors shift into low-cost passive, asset allocation becomes more vital, and therefore the ability to create alpha is an ever more important resource for those allocators. Within hedge funds, the zeitgeist is currently with the systematic investors, particularly CTAs – and in the long-only world we’ve seen a massive shift to passive and to smart beta. It’s just possible that there is a link here somewhere – the quants have it. Particularly when you consider that discretionary managers of long-only or hedge fund hues have been on the receiving end of late, especially those with a value bias.

But the passives have another advantage – perceived simplicity. At a time when the electron microscope of public scrutiny is firmly upon the ‘complex’ world traditionally occupied by hedge funds – international finance centres and such like, it’s hardly surprising that investors gravitate to what they are led to believe is straightforward and transparent. AIMA has taken a bold step in tackling education of “ordinary people” head on, but there is plenty more to be done. Now is not the time for the faint-hearted.