Published On

June 7, 2017

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In the first quarter of 2017, TIGER 21 Members’ asset allocation to hedge funds reached a new low of 5 percent, less than half the 12 percent allocation back in 2007.

So what is going on here? Are TIGER 21 Members simply finding more attractive opportunities elsewhere, or are there systemic problems with hedge funds? A look at the industry shows there are good reasons TIGER 21 Members are walking away from hedge funds, and our Members are not alone.

Part of a Wider Trend

The decline in TIGER 21 Member allocations to hedge funds is part of a wider trend that has seen this once fashionable investment vehicle fall out of favor in recent years.

According to CNBC, hedge fund clients withdrew over $100 billion from hedge funds in 2016, the worst year for redemptions since 2009. The pace of those redemptions accelerated later in the year, with $43 billion in the fourth quarter alone.

These outflows are taking a toll on the industry. According to industry research specialists HFR, a total of 1,057 hedge funds liquidated in 2016, the highest total since 2008.

8 Problems with Hedge Funds

What is driving hedge fund attrition back to financial-crisis levels? Well, here are eight legitimate beefs investors may have with hedge funds:

  1. High fees. The traditional fee construct in the hedge fund industry was known as “2 and 20.” This referred to a 2 percent annual management fee plus 20 percent of any positive returns earned by the fund. It’s tough for an investor to come out ahead while paying such a steep price without extra-ordinary performance. For example, in order to net investors a 10 percent return, a hedge fund would have to earn gross returns of about 14.5 percent. To put it differently, in that scenario a hedge fund would have to do about 45 percent better than a low-cost investment alternative.
  2. Onerous lock-up periods. Hedge funds often require capital to be kept in the fund for a specified period of time, and/or have limited liquidity windows. The reality is that changing investment and business conditions are too fluid for some investors to tolerate having their money held captive in this way. Also, it is one thing if the fund’s lack of liquidity matches the underlying assets illiquidity, but often these funds have freely tradable public equities or other liquid assets, where liquidating assets to meet capital redemptions would not destroy value or force a strategy to be unwound prematurely. In such cases, it is more likely to feel abusive or egregious to the limited partners if the fund still locks up their capital.
  3. Returns have disappointed. The good news is that last year eVestment’s database of hedge funds showed the best average return since 2013. The bad news is that this return was just 5.34 percent, or roughly half of what the S&P 500 earned. That kind of performance is not attractive enough on an absolute or relative basis to justify the high fees or lockup periods.
  4. Active investing is out of favor. Passive investment strategies like index funds have drawn more net flows than active strategies in each of the past five years, and during the last two of those years active funds experienced net outflows. Clearly, active management is out of favor with investors, and since hedge funds are like active funds on steroids, it is not surprising that they have lost popularity.
  5. Investment styles can be opaque. Hedge fund managers often prize the flexibility to take advantage of whatever types of opportunities present themselves. That’s all well and good, but for investors who want to know what to expect from their managers and to be able to continually monitor whether a manager is following the agreed-upon investment style, the “just trust me” attitude of many hedge funds can be frustrating. In periods of high returns, it is easier to cast one’s lot with a fund that has a great track record and checks out in every other way, but in a period of low returns, this approach doesn’t cut the mustard.
  6. Hedge funds are miscast as an asset class. In the search for higher returns, some institutional investment consultants began recommending allocations to hedge funds, based on their historical risk/reward characteristic as an asset class. The problem is, the actual component holdings could be long or short, leveraged or not, domestic or international, stocks, bonds, or commodities – you get the picture. A hedge fund is a structure (or many structures) but not an asset class.
  7. Confusion between hedging and speculating. Some disillusion about hedge funds may stem from the fact that the name itself is often a misnomer. Hedging suggests a reduction of risk, whereas many hedge funds are geared towards ramping up risk through the use of leverage and options.
  8. Scalability can be limited. For some particularly elaborate or obscure investment strategies, success can be its own worst enemy. A strategy that works beautifully with $100 million under management could prove impractical for $1 billion or $10 billion in assets. Hedge funds that attract clients because they achieve success in their early years often find they are unable to repeat those successes with more assets under management to lug around. In fact, throughout the industry there are examples of hedge funds that made money for several years and then were able to ramp up their assets dramatically based on that track record. They then lost more investor money in one or two years than they had made in the prior 10 or 20, simply because they now have so much more invested. Such a fund could have a very positive IRR on a dollar invested from the beginning of the fund, yet, in total, may have lost far more money than it made for investors because of when the most money was invested.

What could turn hedge funds around?

Despite the problems, don’t shed any tears for the hedge fund industry. It still commands some $3 trillion in assets, according to HFR. And, there are reasons to believe the industry could turn things around.

Slowly but surely, the industry is trimming its fat fee schedules. HFR reports that average hedge fund fees are now 1.48 percent for annual management, plus an average return participation incentive of 17.4 percent. Those are still hefty fee levels, but they do represent a significant reduction from the traditional 2 and 20 construct. If hedge fund fees can continue moving in the right direction, more investors may start to see them as worthwhile again.

Obviously, better returns would also help attract investors. One factor that might help is that the relative performance of active and passive strategies tends to run in cycles. A return to a phase more favorable to active managers – featuring, say, more emphasis on valuation and less on return correlation among stocks – could create more opportunity to add value.

More importantly, hedge funds, in the aggregate (understanding hedge funds are a structure and not a single class of assets) have had a correlation to a spread off the risk-free government interest rate. Hence, low interest rates suggest low hedge fund returns. If higher interest rates return, look for a material increase in hedge fund performance and activity, regardless of fee structures.

Interestingly, the attrition of hedge funds may itself be a positive for future performance. Given the lucrative fees, a boom for the industry naturally attracts a lot of players, many of whom are not up to the task of consistently adding value as investors. A weeding-out of the weaker players may improve the industry’s overall average performance.

Meanwhile, it seems, TIGER 21 investors are not so much keeping their powder dry but constructively investing in other types of assets, particularly real estate and direct private equity. That may carry the most important lesson for the hedge fund industry – there are always alternatives for investors to choose if a particular class of investment fails to present competitive opportunities, particularly if they are charging to much for the pleasure of participating.