“Bloomberg – At Milken, Hedge Fund Managers Swap Ideas on Staying in Business”
Won’t somebody please think of the fund managers!
I wanted to write a blog about how out of touch this group of millionaires is that they felt it necessary to take to a public forum to complain about how difficult it is for them to make money. Because when you’re blaming your own investors, stating their risk aversion has “sowed the seeds of very mediocre returns and high fees”, you’re not doing yourself any favors.
The truth is, though, they’re partially right. Now before we get into it, it’s important to understand that while the average American probably views fund managers as overpaid leaches, sucking economic value from the public system for their own private gain, they serve an important role in a modern economy. Traditionally, fund managers have offered three key benefits to investors and the market as a whole: (i) they assist institutional investors such as pension funds and insurance companies diversify their portfolios across different sectors and strategies, creating a more predictable return profile to match their long-term liabilities, (ii) they offer other sophisticated investors the opportunity to invest in more illiquid strategies like real estate, commodities and derivatives, and (iii) they provide liquidity to the broader market and enhance price discovery. Historically speaking, hedge funds have been pretty good at generating benchmark-beating, uncorrelated, risk-adjusted returns, and they collected fat fees for doing so. After all, investors were generally beating their benchmarks, even after the funds collected their fees, so nobody cared. Times are different now, though, and that’s where the plight of the hedge fund comes into play.
The rise of passive/index investing has been pretty detrimental to the traditional hedge fund model for a number of reasons, however it’s not just the strategy itself, but the time in which it came to prominence which ended up being the perfect storm for hedge funds. According to EY, the ETF market increased from $700B under management in 2008 to over $4.5T at the end of 2017 – for the people at home, that’s an increase of 543%. What’s more, 2017 alone saw inflows of $464B into passive vehicles. The explosion in passive products and their AUM has either democratized or socialized the markets, depending on who you ask. Either way, they have given all investors the ability to target as broad or narrow an investment strategy as they like, from simply buying the S&P 500 or small cap energy stocks, to shorting the VIX and beyond. As more and more money flows into these products, the asset managers need to go out and buy more stocks to replicate the underlying indices, therefore inflating individual stock prices in the process.
This is the problem for hedge funds. We’ve been on an almost ten year tear after bottoming out in the financial crisis, with the S&P 500 up +259% over that period. When you combine such strong, broad market performance with the explosion in passive capital basically bidding up individual stocks on a daily basis, it is nearly impossible for traditional fund managers to generate any alpha – and ladies and gentleman, if there’s no alpha, there’s no fees to collect for the fund managers. As a result, you’ve seen many large investors wonder out loud why they’re paying fees to managers who can’t beat the market, which has led to an all-out exodus from the hedge fund model. Even behemoth pension funds such as CalPERS are ditching managers for the passive life. Doing away with fund managers in the name of saving money on fees may prove to be penny wise and pound foolish though, as any deep correction in the market would likely be amplified by the fact that so many investors have plowed money into these products. At the end of the day, these guys are called hedge funds. They aim to provide appropriate risk-adjusted (i.e., hedged) returns. If you’re just super long energy stocks through an ETF and there’s another 2015-2016 episode, you’ll wish you had paid some fees and been hedged through an experienced energy fund manager who would’ve had proper risk management systems in place to mitigate downside risk.
Regardless, at this moment the hedge fund model is broken and if they want to survive, they’ll need to adapt. I saw an interesting piece in Bloomberg the other day that encouraged managers to ditch 2/20 and actually pay all their LPs a guaranteed fixed rate over the benchmark returns to manage their assets. Anything generated over that fixed rate would remain with the fund manager. The investors would generate a guaranteed return, similar to a fixed income product, and the manager would retain any alpha generated. It’s an interesting idea, but not likely. It’s good to at least see people thinking outside of the box.