Hedge Funds Back on the Winning Track
Hedge funds, vilified for years due to high fees and sub-par performance, have staged a comeback. The funds have hit a record for assets under management, as new investment inflows rebounded.
“We had a perfect storm in a good way in 2016, with almost every hedge fund strategy up,” said Hossein Kazemi, senior advisor to the Chartered Alternative Investment Analyst Association (CAIA), which studies hedge funds and other alternative investments.
Assets tumbled during the 2008-2009 financial crisis and have slowly built back. And last year, they put on a special kick, rising $59 billion to a record $3.21 trillion, according to the HFR Global Hedge Fund Industry Report. Net inflows of almost $10 billion testified to the new allure of hedge funds—a reversal from the $70 billion in net outflows in 2016, a year when the average return was three percentage points lower.
Investor fund flows never move in a straight line, of course. But the chart shows how, on a monthly basis, 2017 had more inflow months than 2016, and its outflow months were smaller. And 2018 is off to the strongest start in nearly a decade. “Investors allocated an estimated $14.12 billion into hedge funds in January, the industry’s largest start to a year since before the Financial Crisis,” research firm eVestment noted.
Why the turnaround? One big catalyst: Solid returns last year averaging 8.6% for the entire category, although a number of funds showed flashy performance high in the double digits. A strong stock market was the booster rocket, with almost all world economies growing nicely, a rare occurrence.
Also, investors realized that with high asset valuations in their portfolios, they needed to protect their downside better, which for hedge funds has been a longstanding selling point. And that means better diversification than the traditional 60-40 stock-bond asset allocation. The good 2017 result is an improvement on 2016’s 5.4% gain, not to mention 2015’s 1.1% loss.
Consider the Santa Clara Valley Transportation Authority’s $590 million retirement fund. Barring the unexpected, interest rates are on the way up, which typically is not healthy for the fixed-income portion of a portfolio. “So, we decided to diversify away from 60-40,” said Sean Bill, investment program manager for the pension plan.
One solution was to sign up with SkyBridge, a hedge fund that exposed the Santa Clara plan to mortgage-backed securities, collateralized debt obligations, and structured credit, which have a base of collateral that should help them retain their value.
Certainly, hedge funds as a class haven’t surpassed the Standard & Poor’s 500 lately, which gives their critics ammunition against them, and has helped propel past investment outflows. In 2017, the S&P 500 had a total return of 21.8%, far eclipsing hedge funds’ 8.6%. For that matter, a strategy of a 60-40 split—-combining the S&P 500 and the Bloomberg Barclays US Aggregate Bond Index—did better than the hedge funds. A calculation by The Economist put that performance at 14.8% last year.
Time was, hedge funds as a whole regularly booked returns north of 20% annually, and sometimes above 30%. To be sure, the category had fewer players then. Don Steinbrugge, CEO of investment consultant Agecroft Partners, has lamented that the field today is “over-saturated.”
That said, a decent number of hedge funds still churn out spectacular showings. Whale Rock Capital and Light Street Capital last year racked up 36.2% and 38.6%, respectively, according to the Financial Times. That apparently stemmed from their heavy positions in tech stocks, particularly Alibaba. Another reported double-digit scorer was Tiger Global, at 27.5%.
To be sure, hedge funds and their investors often say beating the market is not what they are all about. Rather, they aim to offer diversification and buffer against market slumps. To take an extreme case, a 60-40 portfolio in woebegone 2008 was down about 30%, while hedge funds were off just 19%.
“I hear the argument,” that stock indexes do better than hedge funds and other alt strategies, said Bob Jacksha, chief investment officer of the New Mexico Educational Retirement Board, which oversees $12.8 billion in assets. “That may be true for the past five years, but what about the next five years, when stocks crawl up your collar again?”
In 2017, hedge funds were helped by a robust stock market, yes, yet also by a lowering of correlations to other assets, argued Darren Wolf, head of alternative investment strategies at Aberdeen Asset Management. This made crowding into stocks very popular.
Another component to the hedge funds’ 2017 performance, Wolf went on, was the suffering of short sellers, who make a living through betting on tanking stock prices. Their racing to cover their positions while prices escalated only added to the buying pressure.
What strategies are doing well in the new era of 2018, where interest rates are rising and protectionism may roil international finance?
By the reckoning of CAIA’s Kazemi, quant funds may be looking at trouble. They averaged 9% last year, yet in February as stocks hit correction territory, and were off 7%. That downdraft owed a lot to investor emotions—never a strong suit for quants—owing to fears of interest rates and inflation rising more rapidly than forecast.
The likely winners up ahead, he said, include stock-picking funds, which should benefit from more price volatility nowadays, and merger arbitration funds, thanks to the burgeoning amount of deals.
To Santa Clara’s Bill, long-short funds could be problematical. Reason: Because of still-heavy central bank intervention (with the exception of the Federal Reserve), “there’s a lot of liquidity, and that distorts markets.” In 2017, long-short funds clocked a nice 13.3% increase, amid bulls’ gains and bears’ pains.
Nevertheless, to many CIOs, it’s a comfort to have some good hedge funds with commendable track records in their portfolios. “They can give us close to equity returns with less volatility,” Bill said. “And as we’re small, we get a deeper team. It makes sense.”