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Hedge funds: The dinosaurs of the investment world?

The once agile masters of the investment universe have become slow and cumbersome. Could they be facing extinction as new investment strategies take their place, asks Dolfin’s Chief Investment Officer Vassilis Papaioannou

13 March 2017 / Investing

The hedge fund industry is huge and has attracted a lot of talent. It has grown dramatically in the past 20 years. In 2001 it had assets under management of $300bn; now the comparable figure is $3,000bn. But the rate at which it is attracting capital has slowed and research shows that average hedge fund performance has, in general, been flat.

In drawing attention to this, I have to say that in general I am a believer in the original hedge fund ethos of agility and innovation. And at the same time, the term ‘hedge fund’ can encompass a very wide range of investment strategies, including global macro, long-short equity, event driven, and fixed income sub-strategies or even quantitative strategies, among others. This is a very diverse group and not all hedge funds are dinosaurs.

Institutionalised and commoditised

The problem is that many hedge funds have become institutionalised and commoditised as a result of having become part of institutional investors’ asset allocations. Pension funds and insurance companies have allocated a small proportion of their funds to hedge funds under an ‘alternatives’ banner, and have demanded prudent risk management and institutionalised behaviours from them in return

Other asset allocation strategies can produce similar or better returns more cost-effectively.

The point is, if you allocate say, 10% of your portfolio to alternatives, then by definition you want this portion of your portfolio to have high volatility. If you then restrict hedge funds by giving them guidance or a certain mandate in return for the allocation, this constrains their volatility, reduces their level of risk and lowers the return. To prove the point, in the 10 years between 2006 and 2016 the average movement in the hedge fund index was close to 5–6% per annum, yet the average movement of the returns on the S&P500 was three times higher.

It is worth noting one further point. Although some hedge funds have reduced their fees from 2% management and 20% of performance, they are still expensive, and other asset allocation strategies can produce similar or better returns more cost-effectively. There are two particularly attractive ones that I think deserve serious consideration.

New age alternatives

The first of these is ‘liquid alternatives’. These can include mutual funds and exchange-traded funds (ETF) that replicate the sort of hedge fund strategies I’ve referred to above. Although ETF hedge fund replication is still in its infancy, it offers a number of benefits. These funds are liquid and easy for smaller investors to buy into. If you are a smaller investor, you cannot access hedge funds because they will ask for a minimum investment and liquidity constraints will force you to lock up your capital for a couple of years. If you go with liquid alternatives, you will benefit from a better price, better liquidity and transparency, and performance that is at least as good as that of hedge funds with the same strategies.

The second route is via new-age asset managers. These have the potential to replace the bulk of the now lumbering and restricted hedge funds by returning to some of the values that made hedge funds great.

These asset managers offer a blend of quantitative thinking with the macro overlay that characterises many hedge funds. They are committed to technology, in order to be able to bring all these strategic investment aspects on to one platform. This contrasts with traditional asset managers, who tend to conduct their investment management via funds.

We may be witnessing the end of hedge funds as we knew them.

That they are active is important. This was at the core of the hedge fund ethos. They had access to all sorts of different instruments such as cash and derivatives, going long or short and using leverage. They had the widest opportunity set in terms of instruments and strategies and were very active in order to profit from the upsides and downsides in the markets. But new age asset managers can now offer this. They can analyse the quantitative data fast and choose the timing of their investment calls, and this will attract the capital away from hedge funds. They have the technology of hedge funds and they will be able to utilise the relationships they have with different client groups.

To get the best from hedge funds you need to understand exactly what their strategies are and to match them with your portfolio needs. You have to spend a lot of time finding value – and that is not easy to do. For the private or institutional investors who lack such specialist knowledge, the liquid alternative and new-age asset managers are two attractive options. Because both of these are more agile, flexible and cost effective, we can expect increasing amounts of investment capital to flow to them. That is why I contend that we may be witnessing the end of hedge funds as we knew them – they have become victims of their own success.

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