When looking at the challenges and opportunities facing hedge funds, I’d like to start by going right back to basics and looking at the question: What is a hedge fund? By doing this, I hope to be able to show more clearly what went wrong last year and determine the outlook for the industry going forward.
The website www.investopedia.com comes close to describing what the market had come to expect from the asset class. It defines a hedge fund as “an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns”. I think this is a deeply misguided definition that clearly aligns itself with what the industry had become – a fee structure looking for a strategy. That’s not what the industry used to be, and certainly not what I believe it should be, namely an investment strategy that clearly balances capital preservation with capital appreciation. Perhaps a better definition, certainly in the equity long/short context, should be an investment strategy that clearly balances capital preservation and capital appreciation with the goal of achieving absolute returns with low correlation and low volatility.
The very first hedge fund, created by Alfred Winslow Jones in 1949, had the clear goal of disaggregating individual share price performance from the movements of the general market by shorting shares – in short to try and isolate the alpha. The industry seemed to forget what hedging is really about as a ferocious appetite for ever increasing performance led to an almost total disregard for risk. This is not a unique situation by any means. History is littered with examples of the times when greed has eclipsed fear in an ‘investfest’ of epic proportions. Most like the current financial crisis, of which the hedge fund industry is a part, is the South Sea bubble of the early 1700s. In this mania, the creation of the joint stock company allowed external investors to own shares in newly developed private ventures. Such was the appetite for these ‘new issues’ that companies sprang up like weeds with an ever increasing number of investors looking for greater and greater returns. In the culmination of the mania, new companies advertised their purposes with incredible promises like the company that set itself up to carry on an undertaking of great advantage, but no-one to know what it was. It is important to note that in manias and bubbles, expectations often become unreal, something worth remembering when considering expected returns from hedge funds in the future.
The hype cycle
Bubbles are not all bad – they can bring about positive as well as negative outcomes. I would like to show you a chart pioneered by Gartner, the technology consultancy (see Fig. 1). They have developed the concept of a “hype cycle” and consider it a critical part of the successful adoption of any new technology. Their theory dictates that the mass market adoption of any product starts with a technology trigger that drives a period of adoption. That in turn leads to a peak of inflated expectations that drives a sharp retraction back down to the trough of disillusionment from which a healthy industry growth slope emerges called the slope of enlightenment. I have chosen to illustrate this by using the internet bubble (see Fig. 2). We have collated data for the number of internet IPOs in the period 1998 to 2000 and then tracked the lifetime of those companies. We have also included the Nasdaq as a proxy for the internet hype cycle. As you can see the development fits the Gartner hype cycle chart well.
I use this example because it is still fresh in everyone’s mind and it highlights the ease with which greed can so easily overtake common sense. There is one key factor missing from the Gartner analysis that I think is critical to this type of curve and pertinent to the current financial bubble and that is capital. The surge to the peak of inflated expectations can only occur if capital is freely available and cheap: it acts as an accelerant. Only in this environment does capital search out higher and higher returns with less and less regard for the risks involved.
I was running a technology hedge fund in the Internet bubble and I had literally hundreds of Internet start-ups coming through my offices asking for capital. The normal blueprint was that a couple of ‘entrepreneurs’ would set up a company, decide on something they could sell or trade over the internet and demand US$10 million for a 10% stake in their venture. I would always ask what they were contributing for the other 90%. In the most outrageous cases of the internet incubators, companies sought out capital based on this model to then invest in start-ups on the same basis thus multiplying the dilution of the investment such that US$100 of invested capital only had a tangible cash value of US$1 in the ultimate target investment. As an investor I needed my investment to increase in value by 100 times just to break even. There were some great short opportunities thrown up by this total excess.
I use this example to illustrate what often happens when a new, and exciting, and seemingly irresistible investment opportunity presents itself. If something sounds too good to be true, it probably is. Well in the internet world it certainly was. The internet is now pervasive, the wave of available capital has massively accelerated the adoption of the technology and driven the industry well up the slope of enlightenment. Most importantly we would not be where we are today in terms of internet adoption without the bubble.
This is important in understanding the hedge fund bubble and the future of the industry. To cover what went wrong in 2008, I would like to show you the correlation of equity long/short hedge funds with the market. I will focus on equity long/short as this is my area of expertise although I am sure it can be applied to other strategies. The correlation of funds to the market reached 0.9 as early as 2001 – at this point and with the benefit of hindsight, it is clear that the concept of hedge funds as protectors of capital as a part of their mandate had gone out of the window. As more and more hedge fund entrepreneurs flooded the market, the product set as a whole became little more than a leveraged long only offering. The benefit of an upward trending market for five years linked with the ever increasing wave of abundant capital drove the industry from 4,000 funds and US$700 billion invested to almost 8,000 funds and US$2 trillion. A clear hype cycle if ever there was one (see Fig.3). What made the situation worse was that the nominal sharp increase in assets under management (AUM) was being magnified through the use of leverage such that there was a multiple of the US$2 trillion AUM in actual investments and, of course, the vast majority of them were on the long side. Another problem was that, in common with so many bubbles, expectations of returns became over inflated. Investors wanted higher and higher returns and in a seemingly ‘no lose’ environment, managers happily obliged by taking more and more risk. It was an accident waiting to happen.
Revisiting the roots
While I know that last year was a very painful one for investors, I don’t think the industry is about to disappear. Indeed, I think that the effects of the past 12 months will ensure that the industry revisits its roots and emerges from the trough of disillusionment – where we are firmly placed at the moment – to emerge far stronger.
One of the problems that occurred in equity long/short in 2002–2007 was that managers were finding it hard to make the returns that the market expected without resorting to leverage or direction. I am a passionate believer in the importance of balancing risk with reward in a fund, and elementary analysis shows that it simply isn’t necessary to employ these techniques to generate an attractive return profile.
We have looked at the Morgan Stanley world developed market index of companies with a market cap of more than US$500 million. This gives us a universe of 750 names and we have analysed the performance of these companies year by year for the last 20 years. If we look at the performance of a fund that had been long of the top quintile of performers and short of the bottom quintile with 50% of NAV invested in each (i.e. 100% gross exposure and market neutral) you may be surprised to discover that the return profile of the fund would have been huge. A 58% compound growth rate over the period would have turned US$1 million into US$3.6 billion. To be more realistic, we looked at the second quintile against the fourth and the return profile would still have been 18.8% compound. Digging deeper into the numbers, there is a strong dispersion of returns between winners and losers, a critical element in any long/short stock specific portfolio. This is a relatively simplistic exercise but it does go to show that excellent returns can be made by utilising single stock positions on both the long and short side of the balance sheet. This is in clear contradiction to the perceived view prevalent in the bull market run of 2002–2007, that significant amounts of leverage, direction, concentration or a combination of these were required.
Time to mature
So, in conclusion, I want to say that I strongly believe that the hedge fund industry will emerge far stronger than it has ever been, but it will offer investors what I think they should expect of the industry. The huge wave of capital linked with cheap credit and the expectation of easy returns acted as an accelerant for the industry that will bring it to maturity more quickly. That maturity will mean a clearer balance of capital preservation with capital appreciation. Absolute return will be achieved with low correlation and low volatility. I believe this requires a balance of long and short single stock positioning and in equity long/short at least this is the critical factor. Anecdotal evidence suggests that only about one in 10 equity long/short managers are effective or comfortable in shorting individual stocks and this is a vital part of successfully risk-managed returns. This will drive a reduction in the number of funds in the industry where many managers will not have the skills or the stomach for risk management and single stock shorting. In addition, I believe that the problems of liquidity and transparency in the past twelve months will ensure that these two factors appear high on the list of investors ‘must haves’ going forward.
The result will be a smaller industry of highly skilled managers who will deliver on both sides of the equation – preservation as well as appreciation of capital.
ABOUT THE AUTHOR
Mark Hawtin joined GAM in 2008. He manages GAM Delphic, a global long/short equity fund, balancing fundamental analysis and active trading according to market conditions. He was formerly a partner and portfolio manager of the Eureka Interactive Fund of Marshall Wace.