Federal Street Advisors discusses the role of hedge funds in our marketplace, along with the risks and opportunities presented by the alternative strategies currently available.
By E. Douglas Huber
For the past five years ending in 2013, U.S. public equity markets returned between 16 percent and 23 percent annually. In one of the strongest-ever periods for equity markets, investors’ portfolios benefitted from core equity investments, while allocations to anything else became a drag on performance and an opportunity cost for portfolios.
Alternative investments—including equity-oriented long/short hedge funds—have struggled to keep pace with the U.S stock market. In this accelerating equity market, hedging equity market risk has hampered performance, and making money from buying and shorting mispriced stocks proved difficult for most of the period.
Is the hedge fund really dead? We don’t think so.
Is there validity to media claims that the hedge fund is dead? If so, then why have we seen an emergence of alternatives to hedge funds where access to “hedge fund-like” strategies can be achieved through mutual funds and other daily liquid structures? As equity valuations have risen and bond funds face lower returns, is a “hedge fund-like” mutual fund better than no hedge fund at all?
Despite the performance dispersion between hedge funds and traditional equity strategies over the last five years, we still believe that hedge funds play a critical role in investors’ portfolios, reducing risk and volatility while, over time, offering equity-like or greater returns.
If we look back over a more complete market cycle that includes multiple up and down markets, hedge funds have outperformed the public equity markets with less risk. In fact, if we look at preliminary returns from January 2014 when markets lost 3 to 5 percent, the hedge fund peer group was down just 0.7 percent, with many strategies within that group performing positively for the month. This performance pattern has not been isolated to just January 2014 either; we have also seen hedge funds offer greater downside protection during periods of market stress over the last five years.
Hedge funds aren’t all alike, and they can prove challenging for some of the same reasons they are beneficial to a portfolio.
Hedge funds are traditionally offered to investors in a private, limited partnership structure, which gives them access to opportunities that historically have been inaccessible in other structures like mutual funds. This includes the ability to invest both long and short, where an investor can benefit not only from the price appreciation of purchased securities, but also from losses in securities that are sold short.
Hedge funds can invest with more flexibility, having the ability to invest in both debt and equity instruments across corporate capital structures. Hedge funds can make larger macroeconomic bets, use derivatives and portfolio insurance and also leverage above the levels allowed by mutual fund regulation.
Also, these structures are meant to be longer term and more exclusive in nature, excluding investors who do not meet certain net-worth requirements. They have much higher fees and minimum required investments, and they carefully control when investors can make contributions and redeem their investments. They have much less liquidity than traditional mutual funds and, because of their private nature, are less transparent.
Their exclusivity and limited liquidity are intended to protect these funds from the negative impacts that mutual funds experience when investors actively trade their investments and disrupt the fund’s portfolio management. But limited liquidity can make investors feel less in control of their assets, and if the fund is not managed properly, investors can experience long-term lockups of capital similar to what can happen in private equity structures.
The ability to charge higher fees has traditionally drawn the best and brightest managers to the space, but high fees (especially if the fund is not performing well) can quickly eat away at returns. Finally, high-net-worth requirements and high minimum investments limit access, making it difficult to build a diversified portfolio of hedge funds.
So how can all investors get the benefit of hedge funds without these shortcomings?
Over the past several years, traditional mutual fund and hedge fund managers have started to launch mutual fund vehicles that address these shortcomings by opportunistically investing both long and short in a variety of strategies and securities. Currently, there are more than 400 alternative mutual funds with over $530 billion of assets.
The pace of launches for these vehicles has tripled since 2009. Goldman Sachs predicts that alternative mutual funds could represent a $2 trillion opportunity for asset managers, capable of growing 15 to 20 percent per year over the next five to 10 years.
To put this into perspective, the hedge fund industry as a whole is currently just over $2 trillion. Much of this growth has been focused on long/short equity and multi-manager strategies as retail and institutional investors search for mutual funds with lower correlations, better risk adjusted after-fee returns, and enhanced yield and protection from a poor bond market outlook.
On paper, these new mutual funds fix many of problems often associated with the traditional hedge fund structure. The liquidity of a daily liquid mutual fund is attractive to investors who do not want to lock up their capital. Further, their access is greatly enhanced as these funds are often carried on mutual fund and broker platforms, have no minimum net worth requirements and can be accessed for thousands of dollars rather than millions. Given the regulations applicable to mutual funds, transparency is often greater and strict mandates are placed on leverage, concentration, investment focus and holdings. Finally, these funds (while more expensive than traditional mutual funds) are generally cheaper than a hedge fund.
The mutual fund’s liquid structure may not be appropriate for all asset classes.
While retail liquid alternatives answer some of the objections to hedge funds, the liquid structure raises its own set of concerns. Daily liquidity is often a strong selling point, but there are many asset classes and investment styles that are not appropriate for daily liquidity. The stocks of micro and small companies, frontier and emerging market equities, privately traded stocks and bonds, and smaller high yield bonds/bank loans are examples of securities that would be difficult to trade as frequently as needed to match a mutual fund’s daily investor flows.
In the event investors were buying or selling heavily, this “asset/liability mismatch” between the fund’s underlying investments and its investors’ demands would result in liquidity pressure that could push down the prices of the portfolio’s investments. For example, if investors were buying heavily into the fund, the manager might have a hard time putting the money to work in these less liquid securities. The result could be an opportunity loss. Worse yet, if investors were selling heavily out of the fund, the manager could be forced to sell these less liquid securities quickly or at inopportune prices, resulting in heavy losses.
Whether launched as a single-manager fund or multi-manager fund, the evaluation
of the manager(s) and their motives for launching the product is important. An argument can be made that these funds inherently have a “negative selection” effect – the potential for the “best and brightest” hedge fund managers to continue managing hedge funds, while less-proven managers end up managing these daily liquid strategies.
Why would an established hedge fund manager…with a strong performance record…who is currently getting paid a 1.5 to 2 percent management fee on assets and an additional 15 to 20 percent fee on the performance generated by the hedge fund…now be willing to offer a mutual fund for a much lesser fee? In our experience, the answer is often that the liquid fund manager is young and emerging with a track record too short and assets under management too small to attract an institutional following.
Are these new alternative funds here to stay? Here’s what you should expect moving forward.
When examining these new alternative funds, our additional diligence items include the assessment of whether the presence of the new daily liquid vehicle will alienate the hedge fund’s existing investors, driving them to the lower-fee, more liquid mutual fund. Is historical performance of the traditional hedge fund representative of what to expect going forward in the new mutual fund? Will this proliferation of products be a distraction from the investment manager’s focus? Which fund(s) gets trading allocation priority when there is a new stock to buy or short or when selling a stock they both share?
Through our ongoing due diligence, we have found managers where a daily liquid strategy can work and others where it cannot. There are some very high-quality, well-established managers who can offer their time-tested hedge funds strategies (or a similar variant) in a daily liquid fund format and have legitimate reasons for the product expansion.
Many established hedge fund managers have concentrated client bases comprised of large foundations, endowments and pensions and are looking to diversify their assets to appeal to high-net-worth individuals or retail investors. Many of them see the daily liquid opportunity as the next direction for the industry and want to be involved early as a way to grow assets and make their firms more resilient from any negative impacts on the traditional hedge fund industry.
Last but not least, here are few things to remember when it comes to investment opportunities.
Daily liquid alternatives have appealing characteristics, and we will continue to evaluate each new opportunity. As the daily liquid alternatives industry has grown, we have started to see a few high-quality investment managers who are capable of managing hedge fund-like mutual funds and who understand the potential conflicts and liquidity issues often associated with this business decision.
However, thus far, we have seen very few. The proliferation of these funds is concerning because many retail investors do not have the resources of an investment advisor skilled in hedge fund evaluation. Meanwhile, over the last five years, many managers of traditional hedge funds—facing pressure from investors—have become much more transparent. They are offering more attractive and better-balanced liquidity, and they have started to reduce fees thereby taking away some of the objections that have made the hedge-like mutual funds such an appealing alternative.
Investing in the best portfolio managers who will deliver the best risk-adjusted net return after fees, in a fund structure that most closely matches an investor’s access with the duration of the underlying assets, requires expertise. The key is finding the right manager and structure—whether a private partnership or a mutual fund—a challenge that demands ongoing research and evaluation, and the discipline to not simply jump on the latest investment bandwagon.
As lead analyst in the alternative investments arena for Boston-based Federal Street Advisors, E. Douglas Huber is responsible for identifying, evaluating and monitoring Hedge Fund and Private Equity managers. For more information, visit www.federalstreet.com.