High fees pushed hedge fund expansion and brought in talent during the bull market. Contraction is likely on all fronts now that the tide has turned.
By JC de Swaan, lecturer at the Economics Department of Princeton University 20 March 2009
Last year was a disaster for hedge funds. For only the second time in nearly two decades, investors suffered an average loss on the money they put into these alternative assets. And whereas in 2002, the negative average return was 1.5 percent, in 2008, average loss swelled to over ten times that at negative 18 percent. Part one of this article looked at why hedge funds were so susceptible to the financial crisis. In part two, we will look at other industry-wide structural issues that were more easily dismissed during the bull market. Two, in particular, are worth highlighting.
Risk Management in Question
Risk management failed to help most funds preserve capital during the crisis. Many hedge fund managers point to the extra-ordinary nature of the economic event. Ken Griffin, founder of Citadel, one of the largest group of hedge funds in the world, stated in his recent U.S. congressional testimony that the events of the Fall of 2008 could not have been predicted by traditional risk management metrics. This calls to question the entire approach to risk management. To begin with, increasingly sophisticated risk management models appear to have blind-sided fund managers by being too narrow in their scope. In particular, VaR, or Value at Risk, the most widely used methodology to measure portfolio risk, has come under fire. VaR models can generate precise measures of potential losses when markets behave along certain historically and statistically defined parameters, but ignore the tail risks of statistically rare events. As a result, they did not comprise within their range of outcomes a financial system collapse. One argument, most prominently made by Nassim Taleb, holds that these tail events are more common than the statistical models imply. By relying on historical prices and volatility, traditional risk measurement models tend to miss the human psychology element at the core of extreme market movements. Another shortcoming that made the output of these models too narrow is the difficulty in dynamically modelling liquidity contraction during periods of severe market retrenchment.
Risk measurement models might have given hedge fund managers and their investors a false sense of security. On a different level, the risk manager had a tougher job during the bull market, facing a higher opportunity cost for erring on the side of caution. From an organizational point of view, hedge funds also suffer from having the risk manager typically report to and depend on the hedge fund manager. This leaves few checks and balances inside the fund’s organization, a situation driven by the fact that fund hierarchy is often skewed toward the rare investment talent, usually the founding portfolio manager.
The industry’s image of itself had already evolved from that of the proverbial star trader in front of his Bloomberg terminal to that of a complex organization, with risk management as one of its key functions. Investor due diligence on a hedge fund’s risk management will now require much more than simply “checking the boxes” on the existence of adequate infrastructure and processes. A broader approach to risk management will necessitate a rethink. Some of it will be driven by hedge fund investors requiring greater transparency around portfolio liquidity and valuation. In particular, they will seek a deeper understanding of worst-case scenarios for unwinding of positions and a more systematic and independently verifiable methodology for the valuation of non-traded or illiquid securities.
The Case for Smaller Scale
Alignment of incentives between hedge fund managers and investors is typically reinforced by the fact that the fund manager maintains a high proportion of his or her net worth in the fund itself. However, one area where incentives can be misaligned relates to asset aggregation. Growing insures a steady flow of management fees and may lengthen a fund’s lifecycle. There are benefits to scale, such as better access to IPO deals – a benefit when markets are vibrant – and preferential treatment by sell-side brokers and analysts. Successful hedge funds can also beneficially grow into multi-strategy hedge funds, thereby diversifying their sources of revenues and the risk of having a bad year.
However, studies have shown repeatedly that start-up hedge funds tend to outperform established ones and that growth in size – as measured by assets under management, or AUMs – tends to be correlated with lower returns. Fund managers understand that by growing they likely dilute returns. For instance, having a more limited investment universe due to rising scale-driven liquidity constraints would do just this. When liquidity abounds, the temptation to grow appears to be over-whelming to many hedge fund managers. As a result, many hedge funds, buoyed by the recent bull market, reached a scale beyond what might be considered return-maximizing.
Growing AUMs also entails managing a larger organization – hiring new analysts, building up the trading desk, and adding staff in operations, marketing, and support functions. Managers of large funds tend to be brilliant investors whose skill set is very deep but narrowly defined around their ability to make allocation decisions and pick investments. The skill set required to manage large organizations tends to be very different from theirs. Additionally, the crisis created operational stress on hedge fund organizations, often requiring fund managers to spend precious time away from their core investment focus. This is not always true of course – some fund managers make strong CEOs. But little in their investment skill set predisposes them to it.
The Future of the Industry
Some aspects of the future direction of the industry can be inferred from a number of changes already in motion. Some are simply a continuation or acceleration of previous trends, while others are new.
Lower Fees
The “2 and 20” model, whereby funds typically receive management fees of 2 percent and incentives corresponding to 20 percent of profits, is under threat. Many funds have lowered their fees in exchange for longer lock-ups and other forms of withdrawal constraints. According to a recent survey by bfinance, funds, and fund of funds expect to see average management fees fall to 1 to 1.5 percent once the dust settles. Incentive fees are expected to drop 10 to 15 percent.
While outperforming funds and some of the stronger franchises may be able to retain the “2 and 20” structure, many investors will want hedge funds to demonstrate once again their ability to deliver absolute returns to justify the industry’s extra compensation relative to long-only investment vehicles, which typically receive management fees but no incentive fees.
Lower Leverage
Many of the hedge fund strategies that rely on leverage to amplify returns will have a tough time being viable as long as the current deleveraging cycle subsides. That includes strategies that attempt to turn very small arbitrage opportunities into high-return investments by applying large leveraged positions. By the same token, certain long-short equity returns in the recent bull market were driven more by leverage than “alpha,” i.e., the unique stock picking skill of the fund manager. A world in which leverage is scarce will more clearly distinguish superior investment skills.
Accelerated Industry Consolidation
AUMs will shrink and hedge funds will shut down. Hedge Fund Research estimates that AUMs fell to US$ 1.4 trillion at the end of 2008 from their peak of US$ 1.9 trillion, driven by a net investor outflow of US$ 155 billion and the rest of the drawdown driven by performance. In the past 20 years, there was only one instance of net outflows when investors withdrew a net US$ 1.1 billion in 1994. This corresponded to less than 1 percent of total industry assets, while 2008 net ouflows corresponded to a much more significant 8 percent of assets.
The quasi totality of net outflows came through in the fourth quarter – a very small net outflow in the third quarter turned into a flood in fourth, suggesting more is to come once numbers come out for the first quarter of 2009, given funds tend to require investor redemption notices ahead of time. It is also worth noting that net outflows for 2008 are understated due to the various restrictions that have been imposed on investor redemptions – essentially a forced delay which will result in incremental outflows to be recorded at a later time.
These trends will continue. Hedge Fund Research estimates that the number of hedge funds has fallen by about 11 percent from its peak in the middle of 2008. Many believe that AUMs and the number of hedge funds will eventually fall by 50 percent of their peak levels – not an unlikely event.
Fund of funds, which typically charge an additional 1 percent in management fees and 10 percent in incentive fees, are set to shrink dramatically as well. In parallel to the hedge fund industry, they performed poorly in 2008, with an estimated average decline of 21 percent. After experiencing dramatic growth, growing from US$ 84 billion in AUM in 2000 to a peak of close to US$ 800 billion at the end of 2007, Hedge Fund Research estimates that they recorded close to 7 percent of net asset outflows in the fourth quarter only while the number of funds of funds fell by 4 percent in 2008.
The Winning Model
It is easier to pinpoint hedge fund models that will come in disfavour than those that will dominate. In the bull market, many hedge funds were disguised long-only funds that had a structural long-bias and benefited from the higher compensation provided to hedge funds. Funds that provided levered beta – i.e., market-based – returns rather than true uncorrelated returns will likely be in disfavour for some time as investors, weathered by the crisis, will be more discerning.
Large multi-strategy funds will likely survive given their long lock-ups, large asset base, and diversification. But investors may favor the dominant hedge fund model of the past, in the form of Global Macro funds. They have recently outperformed, require less leverage, and focus on liquid investments. The onus will be on funds to be nimble enough to quickly switch positioning and take advantage of rapidly changing market conditions.
Regulations and Talent
The industry’s excess returns of past years were predicated on its ability to innovate and to attract talent. Both of these will be tested in the near future.
The industry’s continued ability to innovate will be deeply affected by the nature of new regulations to come out of the current crisis. There is no clarity at this point, although a few options have been widely discussed. A set of regulations might reasonably target capital and liquidity requirements as well as consider leverage caps – these regulations would affect hedge funds as part of a broader group of significant financial institutions, a sensible move given hedge funds have become a core part of the shadow banking system, taking part in many types of economic activities that were once under the sole purview of banks.
Creating greater transparency will be an important aspect of any new regulation, although the form of disclosure will have to be closely tailored to the industry. Four out of the five leading hedge fund managers that testified in front of a U.S. Congressional Committee in November 2008 agreed that hedge funds create some sort of systemic risk. Public disclosure of hedge fund positions would hamper proprietary strategies and possibly increase volatility in the markets. A better solution might be private disclosure to regulators or even delayed disclosure.
There is political momentum in the United States to require mandatory SEC registration for hedge funds above a certain size, after several failed attempts in the past few years. Many of the larger funds currently comply voluntarily, enabling the SEC to inspect them. The effectiveness of mandatory registration is in question since SEC registration, and even probes, failed to prevent Bernard Madoff’s ponzi scheme from developing over a period of many years. More effective perhaps would be a requirement to have third party fund administration, which may have hampered Bernard Madoff’s coverup had it been mandatory.
New regulations will need to walk a fine line. Academic studies have shown that financial liberalization tends to be correlated with higher economic growth. The Sarbanes-Oxley laws legislated in the United States in 2002 in response to the major frauds perpetrated by Enron and other large U.S. corporations are often perceived as having “overshot.” While Sarbanes-Oxley strengthened corporate accounting controls, it has also raised the cost of public ownership and possibly hurt the competitiveness of U.S. capital markets. At a minimum, regulation will impose incremental costs that will be more difficult to absorb for smaller funds, accelerating the consolidation trend already underway, in favour of larger funds controlling a higher percentage of overall industry assets.
Finally, the industry’s ability to continue attracting and retaining talent will remain critical. For highly educated ambitious young men and women driven by a combination of compensation and prestige, a new industry seems to come in favour every few years. Investment banking captured the imagination in the 1980s, followed by private equity, venture capital and start-ups in the late 1990s, and finally hedge funds.
For various reasons, talent will be tougher to keep and attract in the near term. The unusually large draw-downs experienced by a majority of hedge funds in 2008 imply that prospects for generating incentive fees are remote as hedge funds need to meet their high water mark before they can claim incentive fees. The math does not work in their favour – the average return of negative 18 percent for 2008 implies that the average hedge fund will need to post returns of 36 percent before capturing any incentives. By the same token, a hedge fund whose returns were down 30 percent needs to be up 60 percent. Some hedge funds have struck deals with their investors, waving or diluting high water marks, but these are a minority. Without leverage to boost returns, many fund managers and analysts are realistic about the long road ahead to recovery.
This is not the first time that the industry has gone through major dislocation. 1994 was a treacherous year for many existing hedge funds. 1998 saw the Russian debt default and the collapse of LTCM. And 2000 saw the shutting down or restructuring of some of the most prominent funds, notably George Soros’ Quantum Fund and Julian Robertson’s Tiger Funds. But the industry, downsized and beaten up, will continue to attract demand for distinctive investment talent pursuing uncorrelated returns.
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The Future of Hedge Funds (Part Two)
High fees pushed hedge fund expansion and brought in talent during the bull market. Contraction is likely on all fronts now that the tide has turned.
By JC de Swaan, lecturer at the Economics Department of Princeton University
20 March 2009
Last year was a disaster for hedge funds. For only the second time in nearly two decades, investors suffered an average loss on the money they put into these alternative assets. And whereas in 2002, the negative average return was 1.5 percent, in 2008, average loss swelled to over ten times that at negative 18 percent. Part one of this article looked at why hedge funds were so susceptible to the financial crisis. In part two, we will look at other industry-wide structural issues that were more easily dismissed during the bull market. Two, in particular, are worth highlighting.
Risk Management in Question
Risk management failed to help most funds preserve capital during the crisis. Many hedge fund managers point to the extra-ordinary nature of the economic event. Ken Griffin, founder of Citadel, one of the largest group of hedge funds in the world, stated in his recent U.S. congressional testimony that the events of the Fall of 2008 could not have been predicted by traditional risk management metrics. This calls to question the entire approach to risk management. To begin with, increasingly sophisticated risk management models appear to have blind-sided fund managers by being too narrow in their scope. In particular, VaR, or Value at Risk, the most widely used methodology to measure portfolio risk, has come under fire. VaR models can generate precise measures of potential losses when markets behave along certain historically and statistically defined parameters, but ignore the tail risks of statistically rare events. As a result, they did not comprise within their range of outcomes a financial system collapse. One argument, most prominently made by Nassim Taleb, holds that these tail events are more common than the statistical models imply. By relying on historical prices and volatility, traditional risk measurement models tend to miss the human psychology element at the core of extreme market movements. Another shortcoming that made the output of these models too narrow is the difficulty in dynamically modelling liquidity contraction during periods of severe market retrenchment.
Risk measurement models might have given hedge fund managers and their investors a false sense of security. On a different level, the risk manager had a tougher job during the bull market, facing a higher opportunity cost for erring on the side of caution. From an organizational point of view, hedge funds also suffer from having the risk manager typically report to and depend on the hedge fund manager. This leaves few checks and balances inside the fund’s organization, a situation driven by the fact that fund hierarchy is often skewed toward the rare investment talent, usually the founding portfolio manager.
The industry’s image of itself had already evolved from that of the proverbial star trader in front of his Bloomberg terminal to that of a complex organization, with risk management as one of its key functions. Investor due diligence on a hedge fund’s risk management will now require much more than simply “checking the boxes” on the existence of adequate infrastructure and processes. A broader approach to risk management will necessitate a rethink. Some of it will be driven by hedge fund investors requiring greater transparency around portfolio liquidity and valuation. In particular, they will seek a deeper understanding of worst-case scenarios for unwinding of positions and a more systematic and independently verifiable methodology for the valuation of non-traded or illiquid securities.
The Case for Smaller Scale
Alignment of incentives between hedge fund managers and investors is typically reinforced by the fact that the fund manager maintains a high proportion of his or her net worth in the fund itself. However, one area where incentives can be misaligned relates to asset aggregation. Growing insures a steady flow of management fees and may lengthen a fund’s lifecycle. There are benefits to scale, such as better access to IPO deals – a benefit when markets are vibrant – and preferential treatment by sell-side brokers and analysts. Successful hedge funds can also beneficially grow into multi-strategy hedge funds, thereby diversifying their sources of revenues and the risk of having a bad year.
However, studies have shown repeatedly that start-up hedge funds tend to outperform established ones and that growth in size – as measured by assets under management, or AUMs – tends to be correlated with lower returns. Fund managers understand that by growing they likely dilute returns. For instance, having a more limited investment universe due to rising scale-driven liquidity constraints would do just this. When liquidity abounds, the temptation to grow appears to be over-whelming to many hedge fund managers. As a result, many hedge funds, buoyed by the recent bull market, reached a scale beyond what might be considered return-maximizing.
Growing AUMs also entails managing a larger organization – hiring new analysts, building up the trading desk, and adding staff in operations, marketing, and support functions. Managers of large funds tend to be brilliant investors whose skill set is very deep but narrowly defined around their ability to make allocation decisions and pick investments. The skill set required to manage large organizations tends to be very different from theirs. Additionally, the crisis created operational stress on hedge fund organizations, often requiring fund managers to spend precious time away from their core investment focus. This is not always true of course – some fund managers make strong CEOs. But little in their investment skill set predisposes them to it.
The Future of the Industry
Some aspects of the future direction of the industry can be inferred from a number of changes already in motion. Some are simply a continuation or acceleration of previous trends, while others are new.
Lower Fees
The “2 and 20” model, whereby funds typically receive management fees of 2 percent and incentives corresponding to 20 percent of profits, is under threat. Many funds have lowered their fees in exchange for longer lock-ups and other forms of withdrawal constraints. According to a recent survey by bfinance, funds, and fund of funds expect to see average management fees fall to 1 to 1.5 percent once the dust settles. Incentive fees are expected to drop 10 to 15 percent.
While outperforming funds and some of the stronger franchises may be able to retain the “2 and 20” structure, many investors will want hedge funds to demonstrate once again their ability to deliver absolute returns to justify the industry’s extra compensation relative to long-only investment vehicles, which typically receive management fees but no incentive fees.
Lower Leverage
Many of the hedge fund strategies that rely on leverage to amplify returns will have a tough time being viable as long as the current deleveraging cycle subsides. That includes strategies that attempt to turn very small arbitrage opportunities into high-return investments by applying large leveraged positions. By the same token, certain long-short equity returns in the recent bull market were driven more by leverage than “alpha,” i.e., the unique stock picking skill of the fund manager. A world in which leverage is scarce will more clearly distinguish superior investment skills.
Accelerated Industry Consolidation
AUMs will shrink and hedge funds will shut down. Hedge Fund Research estimates that AUMs fell to US$ 1.4 trillion at the end of 2008 from their peak of US$ 1.9 trillion, driven by a net investor outflow of US$ 155 billion and the rest of the drawdown driven by performance. In the past 20 years, there was only one instance of net outflows when investors withdrew a net US$ 1.1 billion in 1994. This corresponded to less than 1 percent of total industry assets, while 2008 net ouflows corresponded to a much more significant 8 percent of assets.
The quasi totality of net outflows came through in the fourth quarter – a very small net outflow in the third quarter turned into a flood in fourth, suggesting more is to come once numbers come out for the first quarter of 2009, given funds tend to require investor redemption notices ahead of time. It is also worth noting that net outflows for 2008 are understated due to the various restrictions that have been imposed on investor redemptions – essentially a forced delay which will result in incremental outflows to be recorded at a later time.
These trends will continue. Hedge Fund Research estimates that the number of hedge funds has fallen by about 11 percent from its peak in the middle of 2008. Many believe that AUMs and the number of hedge funds will eventually fall by 50 percent of their peak levels – not an unlikely event.
Fund of funds, which typically charge an additional 1 percent in management fees and 10 percent in incentive fees, are set to shrink dramatically as well. In parallel to the hedge fund industry, they performed poorly in 2008, with an estimated average decline of 21 percent. After experiencing dramatic growth, growing from US$ 84 billion in AUM in 2000 to a peak of close to US$ 800 billion at the end of 2007, Hedge Fund Research estimates that they recorded close to 7 percent of net asset outflows in the fourth quarter only while the number of funds of funds fell by 4 percent in 2008.
The Winning Model
It is easier to pinpoint hedge fund models that will come in disfavour than those that will dominate. In the bull market, many hedge funds were disguised long-only funds that had a structural long-bias and benefited from the higher compensation provided to hedge funds. Funds that provided levered beta – i.e., market-based – returns rather than true uncorrelated returns will likely be in disfavour for some time as investors, weathered by the crisis, will be more discerning.
Large multi-strategy funds will likely survive given their long lock-ups, large asset base, and diversification. But investors may favor the dominant hedge fund model of the past, in the form of Global Macro funds. They have recently outperformed, require less leverage, and focus on liquid investments. The onus will be on funds to be nimble enough to quickly switch positioning and take advantage of rapidly changing market conditions.
Regulations and Talent
The industry’s excess returns of past years were predicated on its ability to innovate and to attract talent. Both of these will be tested in the near future.
The industry’s continued ability to innovate will be deeply affected by the nature of new regulations to come out of the current crisis. There is no clarity at this point, although a few options have been widely discussed. A set of regulations might reasonably target capital and liquidity requirements as well as consider leverage caps – these regulations would affect hedge funds as part of a broader group of significant financial institutions, a sensible move given hedge funds have become a core part of the shadow banking system, taking part in many types of economic activities that were once under the sole purview of banks.
Creating greater transparency will be an important aspect of any new regulation, although the form of disclosure will have to be closely tailored to the industry. Four out of the five leading hedge fund managers that testified in front of a U.S. Congressional Committee in November 2008 agreed that hedge funds create some sort of systemic risk. Public disclosure of hedge fund positions would hamper proprietary strategies and possibly increase volatility in the markets. A better solution might be private disclosure to regulators or even delayed disclosure.
There is political momentum in the United States to require mandatory SEC registration for hedge funds above a certain size, after several failed attempts in the past few years. Many of the larger funds currently comply voluntarily, enabling the SEC to inspect them. The effectiveness of mandatory registration is in question since SEC registration, and even probes, failed to prevent Bernard Madoff’s ponzi scheme from developing over a period of many years. More effective perhaps would be a requirement to have third party fund administration, which may have hampered Bernard Madoff’s coverup had it been mandatory.
New regulations will need to walk a fine line. Academic studies have shown that financial liberalization tends to be correlated with higher economic growth. The Sarbanes-Oxley laws legislated in the United States in 2002 in response to the major frauds perpetrated by Enron and other large U.S. corporations are often perceived as having “overshot.” While Sarbanes-Oxley strengthened corporate accounting controls, it has also raised the cost of public ownership and possibly hurt the competitiveness of U.S. capital markets. At a minimum, regulation will impose incremental costs that will be more difficult to absorb for smaller funds, accelerating the consolidation trend already underway, in favour of larger funds controlling a higher percentage of overall industry assets.
Finally, the industry’s ability to continue attracting and retaining talent will remain critical. For highly educated ambitious young men and women driven by a combination of compensation and prestige, a new industry seems to come in favour every few years. Investment banking captured the imagination in the 1980s, followed by private equity, venture capital and start-ups in the late 1990s, and finally hedge funds.
For various reasons, talent will be tougher to keep and attract in the near term. The unusually large draw-downs experienced by a majority of hedge funds in 2008 imply that prospects for generating incentive fees are remote as hedge funds need to meet their high water mark before they can claim incentive fees. The math does not work in their favour – the average return of negative 18 percent for 2008 implies that the average hedge fund will need to post returns of 36 percent before capturing any incentives. By the same token, a hedge fund whose returns were down 30 percent needs to be up 60 percent. Some hedge funds have struck deals with their investors, waving or diluting high water marks, but these are a minority. Without leverage to boost returns, many fund managers and analysts are realistic about the long road ahead to recovery.
This is not the first time that the industry has gone through major dislocation. 1994 was a treacherous year for many existing hedge funds. 1998 saw the Russian debt default and the collapse of LTCM. And 2000 saw the shutting down or restructuring of some of the most prominent funds, notably George Soros’ Quantum Fund and Julian Robertson’s Tiger Funds. But the industry, downsized and beaten up, will continue to attract demand for distinctive investment talent pursuing uncorrelated returns.
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