The Hedge Fund Turnaround

Glimmers of optimism keep mounting for the hedge fund industry. The renewed interest follows a brutal 2016, in which investors yanked $106 billion from the asset class, with the fourth quarter seeing the biggest quarterly outflows since the financial crisis as investor frustration mounted.

The questions now for hedge fund managers and investors are whether the industry learned its lessons and how best it can add value to institutional portfolios.

Investors have allocated $30.5 billion to hedge funds through July of this year, according to eVestment. Investors allocated $7.91 billion to hedge funds in July, bringing total assets under management (AUM) to $3.16 trillion–just shy of the $3.168 trillion it reached in May 2015.

“For the fourth-consecutive month, a greater proportion of funds have had net inflows than outflows, indicating a promising turnaround for an industry that had serious challenges in 2016,” eVestment wrote in its research report. “Interest in hedge funds is returning, and we are seeing that trend accelerate,” said Darren Wolf, head of hedge funds at Aberdeen Asset Management.

Wolf said the investor malaise that peaked last year was building for several years. The collapse of some high-profile mergers led to shockwaves in 2014 for many funds. A sudden plunge in oil prices in 2015 also caught the industry off guard. Lackluster performance into 2016 led to rising cries about the high fees the funds charged and the value they delivered.

The market backdrop since the financial crisis, though—where central bank policy tended to dictate the direction of markets—also played a crucial role in the tarnished reputation of hedge funds.

“On the macro side, you have markets that aren’t operating like they used to, with pretty much every major central bank’s influence in asset prices,” said Peter Laurelli, Global Head of Research at eVestment. “When you have a theory based on experience of why security prices or relative prices should react in a certain way, it can get thrown out the window when you add a much larger force.”

As central banks took unprecedented measures to boost asset prices, the value of hedge funds–which aim to protect downside risks–was easy to miss. “There is nothing like an eight-year rally in markets to make people think they don’t need diversifying strategies,” Wolf said. “In environments when markets are going straight up, don’t expect hedge funds to keep up with the S&P.”

“As hedge funds are alternative investments, when conventional equity markets go on extended bull runs, alternatives suffer by comparison,” said Bob Jacksha, CIO of the New Mexico Educational Retirement Board.

But the bull market and economic cycle may be growing long in the tooth. And, as Wolf points out, questions about how effective Fed policy may be as it continually struggles to meet key goals like inflation targets are prompting investors to reconsider hedge funds. “There has been an inability to orchestrate proper growth and meet proper inflation targets, and that is causing institutions to think differently about their inflation targets,” Wolf said.

Moreover, as central banks begin to unwind policies, the markets are returning more to their historical patterns. The dispersions between stocks is rising, and more managers are seeing the long and short sides of their books trade as expected. After researching the holdings of equity managers, Wolf notes that the tendency to pile into the same holdings is also decreasing. “Those are pretty big changes in 2017,” said Wolf.

As investors take another look at hedge funds, one factor determining their relative attractiveness will be how difficult they are to replicate inhouse or for other managers to mimic. More vanilla strategies like equity long and short may be less attractive in this regard.

“On average, it’s very easy to hang out a shingle and call yourself an equity manager, whether you can generate alpha or not,” said Wolf.

Art by Alex Eben Meyer

Those requiring more grunt work like structured credit and activist investing may have a leg up in this regard. “Activist strategies are attractive, because they can create value through their influence,” said Laurelli. “It’s not just ‘this is overvalued’ and ‘this is undervalued’, but ‘this is undervalued and this is what we are going to do about it.’”

Jacksha, meanwhile, prefers to take a broader look at how the vehicles  fit into his profile, and notes investors get too bogged down in nomenclature. “I really don’t even care for the label ‘hedge funds,’ and think that the industry struggles to define what is a hedge fund,” Jacksha said. “We really don’t care, as we are indifferent as to a hedge fund structure versus other structures. The structure must fit the assets and the strategy, including criteria such as liquidity and withdrawal provisions—not too much or too little—and fees—not too much.”