Hedge Funds Reach New Highs, and Lows in 2016

Hedge funds reported gains of 7.4% for the year, but net outflows of $102 billion.

Michael Katz

For hedge funds, 2016 was the best of times, and the worst of times, as the industry reached record levels of assets under management - and investor disappointment.

Hedge funds reported gains of 7.4% for the year, which was its best showing in three years, and reached a record $3.22 trillion in total assets under management, according to Preqin’s 2017 Global Hedge Fund Report.

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But at the same time, there were net outflows $102 billion, and a record 66% of hedge fund investors said that their portfolios had performed below their expectations for the year.

“Hedge fund managers are likely to remember 2016 as a difficult year for the industry,” said Amy Bensted, head of hedge fund products for Preqin, which provides data and information on the alternative asset industry.

And even more investor capital is expected to be redeemed in 2017, as 38% of investors plan on reducing their hedge fund exposure this year, while only 20% plan on increasing their exposure, according to the report.

“There could be a plateauing, or even a contraction of the industry in terms of size in the next couple of year,” said Bensted.

One of the main reasons many major investors are being turned off of hedge funds is because of concerns over high fees. Bensted said the industry needs to “address issues over fees in order to win back the growing group of investors skeptical of the value of the asset class.”

Although hedge funds had their largest gains in three years, their performance in recent years – or lack thereof – has also been cited as a factor that’s putting off potential investors. The report found that the proportion of hedge funds delivering positive annual returns has declined sharply since 2014. In 2014, approximately 80% of hedge funds added gains during that year, while only 49% of funds show positive returns in 2016.

The report also said that the largest public pension funds with the most money allocated to hedge funds were ABP of the Netherlands, which has $19.5 billion invested in hedge funds, Canada’s CPP Investment Board, which has $13.5 billion in hedge fund assets, and South Korea’s National Pension Service with $923 million.

Preqin said that at the start of 2017, investor dissatisfaction with hedge funds remains high, and that the pace of capital redemptions has been accelerating. However, many fund managers said they’re confident returns for this year will surpass those of 2016.

However, “if outflows continue in 2017,” said Bensted, “we may continue to see a shakeout of those funds that have failed to meet investors’ return expectations in recent years and a contraction in the size of the industry.”

By Poonkulali Thangavelu

The stock market’s optimism under President Donald Trump was seen in the Dow Jones Industrial Average’s passing the 20,000 mark during his first week in office. However, his temporary ban on the citizens of seven Muslim-majority countries followed and took the DJIA down from that high. Overall, the long-term impact of Trump’s policies on the market, is difficult to say.

According to Sam Stovall, chief investment strategist, CFRA Research, New York, “We see price-to-earnings ratios that are at the second highest since World War II. So I think we would need to see very strong growth in GDP, followed by an increase in corporate earnings, to keep this bull market alive.” He noted that some of the impact of Trump’s policies has already been priced in. For instance, bank stocks have been rallying since his election on hopes for financial sector deregulation. The industrials and materials sector has done well in anticipation of a boost from infrastructure spending.

On the other hand, technology stocks could be hit as a result of immigration tightening over speculation that it could limit technology companies’ access to overseas labor, which has a big presence in this sector. And retailers that look overseas for a lot of low-cost inventory could feel the impact of Trump’s trade policies, along with carmakers, if their imports are hit with taxes.

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Ken Winans, president and chief investment officer at Winans Investments, Novato, Calif., is more optimistic. He said, “Stocks are not cheap if you look at a price-to-sales basis. But if you lower the tax rates, which means companies have more money go to the bottomline, you have a dramatic shift in valuation, which means stocks have more room to run over the next four years.”

Winans believes that the pendulum of financial regulation had swung too far in one direction under the Obama administration and expects deregulation, including laxity on environmental regulations, to be beneficial. And as economic growth expands and the Federal Reserve starts raising interest rates, that bodes well for a strong dollar.

Winans expects that a strong dollar will lead wealthy overseas investors to buy U.S stocks to benefit from U.S growth, while protecting themselves against a decline in their own currencies. Moreover, if individual tax rates go down and there is less interest in the tax shield that municipal bonds offer, wealthy investors could also redeploy money from these bonds towards stocks. Stovall however, expects that international equities offer better prospects from a price and valuation perspective in the next four years than U.S equities.

Another positive for the Trump administration is the Republican-controlled Congress, which should make it easier for the president to move forward with his policies. However, Winans sees trade protectionism as a wild card, considering that a trade war that escalated amongst different countries and pushed tariffs higher, which could impact the stock market.

Overall, Winans expects that the Dow could hit the 30,000 mark by the next four years, at the end of Trump’s term. Stovall on the other hand is bracing for a recession sometime in the next four years, which would not be beneficial for the long-term stock market outlook, considering that the current economic expansion is already well into its run, at 92 months. That is twice as long as every other period of expansion in the 1900s.

Moreover, Stovall points out that every Republican president since Teddy Roosevelt has run into a recession during his term in office. “Prepare for a recession in the first four years, prepare for a bear market in the first four years. Maybe some of Trump’s efforts might end up delaying when the recession starts, but I think it will certainly happen before his first term is out,” according to Stovall. However, he doesn’t expect a recession to hit in the next six to 12 months.