The number of funds closing after the peak in 2007 was somewhat more significant than the decline in assets. About 22% of the funds operating that year closed over the next three years while the funds under management only declined 16%. There are several reasons for this. First, with increased regulation, a greater emphasis on risk control and increased client pressure for transparency and contact, it became more expensive to operate a hedge fund and the critical mass of funds under management to be profitable escalated. In the early days of the industry, back in the 1970s and early 1980s, it was possible to start a fund with less than $10 million, and Julian Robertson and Steinhardt, Fine, Berkowitz both did so. There is considerable debate about what the critical start-up mass is today. Even though management fees have doubled to 2%, you probably need $50 million, although many go into business with less than that hoping for a strong performance year which will provide substantial incentive fee income and attract new clients. The implementation of the so-called Volcker rule will result in some brokerage firms closing or spinning out their proprietary trading operations, internal hedge funds and private equity activities. As a result we may see more hedge fund start-ups over the near term run by managers with impressive records.
Second, and probably more important, there has been a shift in the hedge fund client base. For a long time the major investors were high net worth individuals and funds of funds in Switzerland known as much for their propensity to withdraw money quickly when performance was disappointing as for their secrecy. Today hedge funds are accepted as respectable investments for institutions and many have as much as 25% (some more) in various types of alternatives. The objective of these institutions is to achieve more modest (perhaps 8%) but consistent returns over time with low volatility. Many of these don’t feel comfortable selecting individual funds even with the advice of qualified consultants and so they invest in alternatives through funds of funds that have a proven record of analyzing funds thoroughly, selecting them well and terminating relationships when conditions change.
The original hedge fund clients, wealthy people, were initially attracted to star managers who were able to deliver outstanding performance during the 1980s and 1990s when the Standard & Poor’s 500 was compounding at 15% or better annually. When the technology bubble burst in 2000, the focus of the industry began to change. Suddenly there was a greater emphasis on protecting capital in difficult markets rather than maximizing profits in good times. Management fees also began to rise and hedge funds changed character. The early funds were organized to produce exceptional performance and they were willing to take higher than normal risk to achieve their objectives. The market was rising almost every year so the risk insensitivity was not critical back then. All that changed after 2000. With higher fees hedge funds became real businesses and maintaining the asset base became an important objective. As a result hedge funds became obsessive about risk control and their new institutional clients encouraged this attitude. These investors were willing to experience underperformance when the market was doing well in exchange for asset protection in declining periods. Volatility became a key area of client focus and monthly drawdowns were carefully scrutinized. Hedge fund managers were willing to give up performance points on the upside to achieve low volatility. A hedge fund that had significant withdrawals as a result of poor performance had difficulty rebuilding its asset base unless the manager was a one-time superstar.
If you observe all rolling 12-month periods since the inception of the HFRI Fund Weighted Composite Index (January 1990), hedge funds outperform the S&P 500 Total Returns Index 58% of the time (including dividends). This number increases to 70% when the rolling window is expanded to a 5-year time period. When 10-year rolling windows are observed, hedge funds outperform equities 97% of the time. Meanwhile, over the period from January 1990 to August 2010, hedge funds have been less than half as volatile as the S&P 500 (7.1% versus 15.1% annualized standard deviation). So hedge funds have basically delivered on their promise of providing equity-like performance with bond-like volatility. Over the past 5 years, on a month when the S&P has been positive, it has returned on average +2.98% (38 out of 60 months) versus +1.51% for the HFRI Fund Weighted Composite. When the S&P has been negative, it has averaged -5.01% versus -1.44% for the HFRI Composite. This results in monthly capture of 51% of the upside with only 29% of the associated downside. Since 1990, on a month when the S&P has been positive, it has returned on average +3.31% (157 out of 248 months) versus +1.91% for the HFRI Fund Weighted Composite. When the S&P has been negative, it has averaged -3.76% versus -0.69% for the HFRI Composite. This results in capture of 58% of the upside, with only 18% of the associated downside.
According to Justin Fredericks of the capital introductions unit of Merrill Lynch (a division of Bank of America), the largest funds are attracting capital. More than 90% of the $9.5 billion net inflows into hedge funds in the second quarter went into funds with more than $5 billion under management. During the first half of 2010 nearly all of the $23 billion invested in hedge funds has gone into funds with more than $5 billion in assets. These firms control 60% of all hedge fund assets, according to Hedge Fund Research. Fredericks said that 12 of the 15 largest U.S.–based hedge fund managers grew their assets significantly over the past year. More than half of the total of 7,000 hedge funds at the end of June managed less than 2% of total hedge fund industry assets. The market decline of 2008–2009 lingers on; 40% of all hedge funds are still under their high water mark and not earning incentive fees; many of these have only earned management fees for the past three years. Hedge Fund Research reports that the global hedge fund industry has returned less than 2% into the middle of September, but recent market strength may have improved that. Since hedge funds were quite cautious at the end of August, with net exposure of 41%, it is likely that most funds had difficulty outperforming in the strong September market.
The large number of hedge fund closures over the past few years have made institutional clients wary of funds that have only been in business a short time, where the major owner is an active manager who is getting along in years and where the money under management makes the fund only marginally profitable unless the performance is outstanding. A fund that closes can tie up some proportion of the invested capital for a year or more until all the investments are liquidated and the final audit is complete. Because institutions are looking for hedge funds that have proven themselves over time, more new investment money is flowing into the larger funds. This trend is not likely to reverse. As the regulatory environment becomes more intense, costs will rise, making starting a fund more difficult and raising questions in the minds of investors about small to medium-sized funds with uneven records. Alternatively, as the established funds grow larger, their ability to perform may be hampered. Size continues to be an enemy of performance and institutions will be wary of funds that appear to be asset gatherers rather than organizations focused on identifying outstanding investment opportunities. There is some evidence that institutional investors are looking more at funds managing between $1 billion and $3 billion.
What is really fascinating is the flow of funds data for hedge funds. In 2007, the last year of heavy positive cash flows, hedged equities, event-driven and relative value (mostly fixed income) strategies each had roughly 30% market share with macro having the remainder. So far in 2010, relative value has gotten 43% of the flows, event-driven has 26% and hedged equity and macro have split the remainder equally. As in the case of mutual funds, money is flowing into more conservative fixed income strategies.
The difficult markets of the past few years have caused some other evolutionary changes in the hedge fund industry. In addition to becoming more institutional in nature hedge funds have become more client friendly. Lock-ups have become less onerous. Fewer funds are closed to new investors. Where there are lock-ups the investor is usually given a discount on either the management or incentive fee or both. Side pockets are less prevalent, and when a fund manager decides to make an investment of this type, he often gives the investor the option to decide whether to participate.
Perhaps the biggest changes in the hedge fund industry have come from the market itself. Today computers play a major role in the trading activity in the market. High frequency trading and program trading account for more than half of all trading volume, and fundamental research-based investors wonder whether they are at a disadvantage against quantitative-oriented funds seeking small profits on thousand of transactions. When individuals were the major investors, there was a focus on after-tax returns, and funds with mostly short-term profits were frowned upon unless their performance was exceptional. Today with the client base mostly tax-free institutions there is less emphasis on whether the profits are long- or short-term. With the poor performance of equities over the past decade absolute return strategies are more popular.
Another difference is the use of Exchange Traded Funds (ETFs). The earliest hedge funds often used “pair-trades” where the fund was long a good company in an industry and short a weaker one. Today making the right sector or concept decision is important. If a manager believes semiconductors will benefit from an improving demand for technology products, he can buy an ETF to become exposed without doing the research on individual stocks. ETFs are very liquid and a decision can be implemented quickly. Individual stock selections can be made later or not at all. This procedure is used frequently in establishing short positions. There are almost 1000 ETFs now covering almost every sector, market and concept in the business and trading in them represents 30% of New York Stock Exchange volume, up from 15% in 2005. The ETF industry has $825 billion now and is growing continuously. In 2005 only $302 billion was under management. In the second quarter of this year 47 new funds were started. Three providers account for almost 80% of assets and twenty funds represent 50% of the funds under management. For 2009 and 2010 year-to-date the largest net cash flows have gone into fixed income, international equity and commodity ETFs.
Both hedge funds and ETFs have taken their toll on mutual funds, which have stagnated at around $10 trillion since 2006, six times the size of the hedge fund industry. At that time equity funds represented about 60% of assets; today they are about 47%. Bond funds have gone from 16% of total assets to 23%. The majority of money under management is still at long-only investment management firms and mutual funds whose most talented people are continually being sought out by hedge funds. This raises the question of who will manage the big money in the future. Global financial assets are $180 trillion; ETFs, mutual funds and hedge funds are a small fraction of that. We are seeing some crossover of disciplines. Lone Pine, arguably one of the best stock picking long/short funds, now has more money under management on the long side than hedged. Wellington, Morgan Stanley and other traditional managers have hedge funds under their roof.
Hedge funds are here to stay. While long-only fund managers haggle with clients over fees of less than a percentage point, hedge funds are earning substantially higher fees. As a result the most talented portfolio managers have been migrating to hedge funds for two decades. I believe this will continue. The fact that a typical hedge fund manager has his own capital (which can be substantial) invested alongside the clients’ money is reassuring to investors. The hedge fund industry is facing some significant challenges and will continue to go through an evolutionary process in response to them. A large fund has yet to prove that it can institutionalize itself and pass management responsibility and ownership from the founder to a successor. Whether that can be done effectively will be resolved in the coming decade. We should also learn whether the business value of a large hedge fund can be capitalized through a sale or public offering. Several of these have been done but it is not yet a widespread practice and whether the deals will be successful for the buyer is still uncertain.
The Blackstone Group L.P.
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The Blackstone Group
345 Park Avenue
New York, NY 10154