Hedge funds have evolved from being the preserve of high net worth investors to being a diversification tool mainly used by institutional investors. This article charts this evolution. The path has not been smooth, with misconceptions creating problems for investors in hedge funds. However, the tough times of 2008 created a catalyst for a better understanding and a more beneficial approach to this area by investors.
The early days of hedge funds
Hedge funds started as a core of skilled and experienced traders and investors that successfully generated an enviable track record for this emerging investment area. As often quoted, the first hedge fund was equity long/short in strategy and run by Alfred W Jones in 1948. However, the basic long/short strategies used in managing such a hedge fund predate Jones significantly. There is even anecdotal evidence of hedge fund strategies such as merger arbitrage being traded well before that. Despite early beginnings it was not until the 1990s that hedge funds grew from being a cottage industry to become the widely recognised investment class it is today. The early days of hedge funds were the preserve of enthusiasts and eccentrics; for example, systematic trading strategies that rely today on millions of lines of coded algorithms were still around then but were driven by hand-drawn plots on charts and computers programmed by punch cards. Over time, this disparate collection of individuals and strategies gained traction and assets for one compelling reason: their returns. Returns were positive a majority of the time, running into double figures in terms of annual percentages, and when returns were negative, they generally had a downside that was small compared to equities. This return profile was and is very appealing to smart and rich individuals who provided much of the early funding for hedge funds. Furthermore, these wealthy individuals sat on the boards of endowments and charities that also had similar objectives: steady positive returns with a relatively controlled downside. Thus endowments and charities began investing in the area, lifting the assets in hedge funds noticeably. Before too long large pension schemes in the US and then Europe began to consider hedge funds as a useful addition to their portfolios and an ‘asset class’ was born. The only problem was that hedge funds are not an asset class and considering them as such can get you into big trouble.
The evolution of hedge funds
In the 2000s, more and more institutional and individual investors invested in hedge funds for both their desirable returns and also their diversification and downside control. Investors rarely specified which hedge funds they wanted and hedge funds started to be referred to as an asset class. An asset class is a group of securities that exhibit similar characteristics and behave similarly in the marketplace and have the same economic underpinnings, but hedge funds don’t; they are managed by a wide range of people with a wide range of strategies and thus there is no reason why hedge funds should behave similarly or that hedge funds today should look anything like hedge funds last year. Hedge funds can evolve quite radically, as we saw in the mid-2000s.
The demand for hedge funds was met with an increase of hedge fund managers as traditional investors from large investment management houses and proprietary traders from banks entered the space, drawn by the ability to make money with fewer constraints. Institutions that suffered departures eventually realised the money to be made out of hedge fund fee structures and either invested house money or offered opportunities to manage hedge funds in-house. Furthermore, banks realised how much money they could make from broking to and supporting hedge funds, given the high trading fees from portfolio turnover, the need for shorting and the sometimes exotic instruments used; banks were therefore instrumental in propagating hedge fund growth. Investment consultants to large pension plans also heavily bought into the investment rationale of adding hedge funds to portfolios given the attractive and uncorrelated return stream of the ‘hedge fund asset class’. Soon it was acceptable and commonplace for individuals and institutions to invest in hedge funds and assets invested in the space exploded.
Given the support that now existed to both set up a hedge fund, and raise assets for it, it was no longer difficult for newcomers with limited experience in traditional houses and banks to become hedge fund managers overnight. The problem was, the core of skilled investors and traders which originally formed the track record of the ‘hedge fund asset class’ were now outnumbered by those with less ability. Although the skill, independent thought, in-depth analysis, discipline and risk management that characterise a good hedge fund were still plentiful, there was also an abundance of hedge fund managers that traded the heavily brokered ideas by sell-side analysts rather than generated by their own analysis; ideas taking much more risk from market direction than their predecessors, with managers lacking the experience and discipline to manage the portfolio’s potential downside. Unfortunately, given the raging bull market in risk assets that characterised the middle of the last decade, these risk takers outperformed the old steady hands and became prominent in the portfolios of investors that had invested in hedge funds for their defensive and diversifying qualities. Then came 2008, an appalling year for hedge funds for a range of reasons. Those that had invested in the ‘hedge fund asset class’ for its defensive qualities were sorely disappointed. Although most hedge funds lost considerably less than equity markets and other risk assets, the loss was greater than historical analysis would have suggested. However, as mentioned above, the old steady hands that had generated the track records were still there but outnumbered by less skilled, less nimble and less risk-controlled newcomers, rendering the reliance on historical behaviour inadequate.
Pretty much everything that could have gone wrong for hedge funds in 2008 did. The market had a big down move, the counterparties that hedge funds used were in trouble and fighting for their lives, the complex instruments traded by some hedge funds were heavily misvalued due to panic, markets were probably the least liquid they had ever been and, mainly because of their own liquidity issues, investors were pulling their money en masse. Although it didn’t seem like it at the time, arguably the best thing that could happen to the hedge fund world was happening – a proper stress test. The hedge fund managers with true ability were outperforming the less skilled and a Darwinian evolutionary leap forward was happening. And, just as importantly, the seeds of a new understanding of the hedge fund world by investors were growing which would eventually benefit both hedge fund managers and their investors.
A new way of thinking?
Following the stress test of 2008, nobody was selling hedge funds as a ‘free lunch’ any more. This was the best thing that could have happened to the area as it facilitated more logical discussion and signalled a maturing of the way hedge funds presented themselves and the way they were viewed by investors. To their great benefit, hedge funds stopped being magical black boxes and started being seen as just another usefully different area to invest.
There have been big changes in investors’ perception of hedge funds as a result of 2008. Most visible is that investors no longer believe the wishful thinking that hedge funds give bond-like risk with equity-like upside. This has been an important change as it allows for a framework for sensible discussion over the benefits and downsides of investment in this area. Although this may seem somewhat counter-intuitive, anecdotal evidence points to those that saw hedge funds as ‘risky, unknown and unknowable’ being much more receptive to considering investment now the downside has been demonstrated by example and is more transparent.
We have also seen the gradual erosion of the ‘hedge funds as an asset class’ myth. A growing number of investors now realise they have to look below the surface both at strategy and manager levels: hedge fund strategies vary widely in terms of risk and return and within any given strategy, the variations can be vast. In line with this, transparency has improved to the point where investors, with the right resource, cannot just rely on history but also get a better understanding of what the fund does and so estimate how risky a hedge fund may be going forward.
Today, assets in hedge funds are back to previous highs but the way in which people invest is quite different. First of all, there is much less “blind” investing in funds of hedge funds. This doesn’t mean that this class of investment is obsolete – there are plenty of funds of hedge funds that are thriving and doing an excellent job. However, in 2008 investors recognised that what was seen as a layer of risk reduction can turn into a layer of risk if not fully understood. As such, funds of hedge funds are used much more as advisors, partners or outsourcers and much less as a ‘black box’ investment in their own right. Growing in place of those funds of hedge funds that have failed to evolve are either specialist consultants or consultants with provable specialism in the area, although some are evolving into pseudo-funds of hedge funds – a concerning step backwards. Next, investors in hedge fund are much more particular about the types of hedge fund they invest with, seeking certain strategies and approaches that best complement their existing portfolio rather than just a stand-alone investment.
Furthermore, such investors are careful to make sure they are getting true alpha and returns that can’t be accessed elsewhere for the high fees they pay – there is less tolerance of beta both traditional and exotic. However, investors are not averse to paying a fair fee for alpha and increasingly we are seeing equity long/short strategies finding their way into the equity bucket of an institutional portfolio rather than the hedge fund bucket, for example. The natural conclusion of this is that we will see a growing trend for hedge fund managers to run unconstrained long-only portfolios.
Finally, investors are demanding more from the hedge funds themselves and in turn, the hedge funds are responding pleasingly. Hedge fund managers themselves find direct investment from logically acting longer-term money such as pension plans more preferable than assets consolidated by an intermediary such as a fund of hedge funds and so there are great benefits in terms of transparency, access and fees for pension plans that invest directly.
Chris Jones recently joined bfinance as Head of Alternatives. He has 18 years’ experience of investing in alternatives.