The hedge fund industry, in general, has had a difficult few years since the financial crisis. Performance has been challenging, assets are harder to raise and retain, and the regulatory bar continues to rise. Additionally, investors are more sophisticated and, as a result, more demanding. While the expectation is not a fair one, hedge funds’ inability to outperform broad (equity) market indices has been a rallying cry for many investors, in particular as a way to demand larger and larger fee discounts. Many investors appear to have bet on 2014 as potentially the year of hedge fund revival, when equity markets would stabilise and hedge funds would be able to outperform the indices. Instead, the year ended with another double-digit rally for US equity markets that left the average hedge fund trailing far behind. All of this seems to have left many investors wondering whether the industry has entered a ‘new normal’ environment, far removed from the pre-2007 days, where stand-out performers are hard to find and it requires much more work to figure out what to do with hedge funds in their portfolios. Our choice of the title for this study, ‘What Lies Beneath’ is a nod to the challenges investors face in going beyond historical returns to assess the attractiveness of a hedge fund manager. With this in mind, the Strategic Consulting team analysed major developments in the hedge fund industry to assess the evolving value proposition of hedge funds, key investor themes, and the asset raising landscape for 2015.

The following are high-level takeaways from the study:

Hedge fund performance
• The size of the hedge fund industry seems     to have recovered from the financial crisis of 2008, having doubled since then.
• While the industry has faced some criticism about asset accumulation (to the detriment of performance), it is important to note that the vast majority (~90%) of the industry’s asset growth over the past six to seven years is attributable to performance rather than flows.
• Since 2010, hedge fund strategies have achieved varying levels of ‘excess returns’ when performance is adjusted for market exposure – credit/fixed income relative value (up 4%) and event driven (up 3%) versus macro (+1%) and equity hedge (-1%).
• Looking at equity hedge funds’ performance relative to other strategies, we found that:
   – ‘Conviction trades’ of equity hedge funds appear to significantly outperform their ‘consensus trades’, potentially providing a clue as to why some managers have done better than others. However, the level of ‘consensus trades’ in equity hedge funds’ portfolios has stayed relatively stable over time, suggesting that there has not been an increase in the number of ‘copycat’ hedge funds.
   – While recent underperformance relative to the S&P is not restricted to hedge funds alone, they may be more challenged by ‘crowdedness’ in their holdings (relative to the average daily volume of trading) on account of their rapid AUM growth.

Investors’ current hedge fund portfolios
• Overall, the investors in our sample appear to have held their percentage allocations to hedge funds relatively steady over the past year.
• Equity hedge funds and multi-strategy hedge fund managers saw their share of investors’ hedge fund portfolios grow the most over the last two years, whereas fixed income relative value (FIRV) and global macro appear to have lost the most ground.
• E&Fs and family offices in our sample had the highest proportion of investors that achieved annualised returns greater than 6% and a Sharpe ratio greater than 1 in 2014.
• Somewhat contrary to popular belief, most investors in our sample have a relatively high tolerance for beta in their hedge fund returns.

Hedge fund industry trends
• Large and mid-sized hedge funds (over $500 million in AUM) appear to have been better performers based on three-year annualised returns than small hedge funds.
• While the largest hedge funds continue to receive a majority of the flows into the industry, in recent years the proportion of flows they receive has been declining. One reason for this trend may be that more of them are now hard/soft-closed. This potentially reduces investor choice, but could be positive for performance in the long run.
• The average headline hedge fund fee levels in the industry are ~1.5% and ~17%. Large and mid-sized hedge funds, surprisingly, appear to have lower fees than small hedge funds. This may be because, on average, small hedge funds (<$1 billion) have limited ability to reduce fees below the 2/20 structure.
• Hurdle rate adoption in the industry has remained low at ~15%; one explanation is that many hedge funds and investors have preferred up-front discounts on management fees over negotiating a hurdle.

Investor allocation preferences and outlook
• The investors in our sample indicated they are 2.5x more likely to increase their hedge fund allocations than to reduce them in 2015 – a reduction from the significantly more bullish ~6.5x ratio in late 2013.
• Additionally, based on investors’ feedback, certain hedge fund strategies are more likely to be in favour in 2015, such as event driven, macro, and equity market neutral.
• We expect the hedge fund industry to receive ~$40 billion in new flows in 2015,with a range of $20-$60 billion, the majority of which is expected to come from pensions and private banks/HNW.

HEDGE FUND PERFORMANCE
Hedge fund AUM growth
We begin by examining the evolution of hedge fund industry assets since the financial crisis. According to HFR, hedge fund AUM has more than doubled during this period, from $1.4 trillion at the end of 2008 to $2.85 trillion at the end of 2014. Our analysis (see Fig.1) shows that despite concerns about asset gathering, ~90% of this growth ($1.2 trillion) was attributable to performance, and only ~10% (~$170 billion) was attributable to net flows into the industry.

The returns over this time frame were supported by two broad market rallies: the credit rally in 2009 and 2010, and the equity rally in 2012 and 2013, during which the industry garnered ~$590 billion and ~$520 billion in performance gains, respectively. In contrast, net flows have been growing at 3-4% per year, a relatively sedate pace of growth, which seems to go against the grain of the thesis of ‘asset gathering’ at the industry level.

Fig.1 also shows that 2014 saw more flows than any other year since 2008 ($76.4 billion in total). This appears to support one of our key hypotheses: 2014 has potentially been a ‘bet on hedge funds’ year for many hedge fund investors, and the industry’s performance in 2014 is likely to strongly influence how investors perceive the value added by hedge fund managers to their portfolios.

Alpha generation by hedge fund strategy
As mentioned before, the performance-led AUM growth of the industry was supported by broad market rallies. Since hedge fund investors often look to hedge funds to deliver returns unrelated to market exposure, we decomposed hedge fund returns into (1) returns attributable to market exposure, or beta, and (2) excess returns, or ‘alpha’, using a relatively simplistic analysis.[1] Overall, our analysis suggests that some strategies appear to have generated more ‘excess return’, when adjusted for market exposure, than others. Key takeaways by strategy:

Equity hedge
• Consistent beta (~0.4-0.5) to equity markets.[2]
• Zero or negative excess return in the past four years. Across the past five years, annual ‘excess return’ averaged -100bps.
• Appears to be the most challenged among all major hedge fund strategies, based on this analysis.

Event driven
• Consistent but lower beta to equity benchmark relative to equity hedge (~0.2-0.4).
• Positive excess returns in four out of five years, though the level appears to have decreased a bit in 2014.
• Average annual excess return averaged ~300bps over the past five years.

Macro
• Low correlation with most benchmark indices. Additionally, correlation and beta against most indices vary significantly from year to year. This is in line with expectations because being tactical in managing exposure to different asset classes/risk factors is a key value proposition of the strategy.
• Average excess annual return of 100bps, though 2014 appears to be a potential ‘comeback’ year (500bps excess return YTD in 2014, on average).

Credit/FIRV
• Relatively consistent beta to high-yield (HY) index (~0.3-0.4).
• Highest average annual level of excess return (~400bps) across strategies.

Onceagain, our analysis suggests that it has been harder for equity hedge funds to differentiate themselves, both relative to other strategies as well as to their own historical performance:

• In the past five years, on average, ~30% of equity hedge funds have produced returns in excess of what could be explained by market exposure, while ~50% of funds across all other strategies have done so.
• In 2010, about half of all equity hedge funds produced positive excess returns compared to only about a fifth that have been able to do so in the past two years.

A popular axiom in the industry today is that security selection, which is potentially the main driver of the performance of equity hedge funds, is harder to do well in today’s environment. In the next section, we highlight some of the key challenges equity hedge fund managers face today and attributes that may be helping some managers outperform others.

Factors impacting equity hedge funds’ performance
We started by examining managers’ investment patterns that potentially affect performance. In order to do this, we used position and return data/analysis across a large number of equity hedge funds from Novus, a business (unaffiliated with Barclays) that provides industry intelligence to institutional investors and asset managers. The Novus Hedge Fund Universe (HFU) contains 11,000+ securities and 100,000+ positions across 800+ equity hedge fund managers. Novus also constructs custom, non-investable strategy indices based on select trade characteristics.[3] We compared the seven-year performance of two such indices:

1. Conviction index – list of 20 stocks (recalculated quarterly) that the highest number of managers in the HFU have more than 5% of their portfolio invested in.
2. Consensus index – list of 20 stocks (recalculated quarterly) that are held by the most number of hedge fund managers in the HFU.

Conviction trades of equity hedge funds have significantly outperformed their consensus trades over the past seven years – conviction trades have outperformed S&P by 300bps while consensus trades underperformed by 300bps. One explanation for consensus trades’ underperformance is that they are more likely to be sold at the wrong time (too early); managers are more likely to sell securities they have less conviction in when the market turns against them, thus potentially missing any subsequent recovery in prices.

Another reason why investors should avoid consensus trades is that it is not worth paying 2/20 fees for exposures that can typically be obtained more cheaply.[4] Managers with high levels of consensus trades are potentially less distinctive (i.e., more correlated with other equity hedge funds), and less valuable to investors’ portfolios. Assuming this is true, investors may want to consider relying more on position-level analysis to assess manager skill and avoid relying solely on historical returns and returns-based analysis. The next question we investigated is whether the aggregate levels of consensus trades in hedge funds’ portfolios have changed significantly over time – based on our investor interviews, there appears to be a view that more equity hedge funds have been piling into consensus trades recently, and this may be driving recent underperformance. Our analysis shows that most equity hedge funds in the sample are fairly unique in their holdings and that the level of consensus trades in managers’ portfolios has remained relatively steady over time, implying that the percentage of so-called copycat hedge funds in the industry has not increased. Specifically:

• Nearly two-thirds of equity hedge funds have less than a 30% overlap with the top 100 frequently traded names.
• A little over a quarter of equity hedge funds (28%) have truly differentiated portfolios (i.e., <10% of their portfolio overlaps with the 100 most frequently traded stocks among equity hedge funds).

These findings lead us to believe that recent challenges faced by equity hedge funds may have to do with other factors, some of which are not limited to hedge funds. For example, active management, in general, has been less rewarding in recent years. Only 12% of equity mutual funds have outperformed the S&P 500 in 2014, while 56% did so in 2010.

One particular challenge relevant to equity hedge funds is the impact of ‘crowding’ among equity hedge funds in recent years, i.e., increase in hedge fund holdings relative to the underlying liquidity of the holdings:

• The total long market value held by hedge funds has grown 2.5x over six years.[5]
• The estimated 30-day liquidity, estimated as the percentage of their portfolio equity hedge funds in the Novus database can liquidate over 30 days (assuming they do not account for more than 20% of the trailing 90-day average daily volume of each security), has decreased from ~50% in 2008 to ~20% in 2014.

As we know, liquidity dries up in stressed market conditions, resulting in prices ‘gapping’ when a lot of market participants try and liquidate their positions (‘bolt for the exits’) at the same time – thus accentuating the liquidity challenge even more. We believe this development puts an even heavier emphasis on manager ‘conviction’ going forward, since managers are more likely to sell those positions they have less conviction in when the market turns against them, oftentimes liquidating positions at distressed prices and/or missing a rebound in prices. A perfect illustration of this trend was seen in October 2014: during the sell-off in the first half of the month, many hedge funds with low conviction in their trades sold their positions, and were not able to capture the market rebound in the later part of the month.

HEDGE FUND INDUSTRY TRENDS
In this section, we explore two questions that are ‘evergreen’ in relevance for participants in the hedge fund industry, regardless of market conditions. These relate to the impact of hedge fund size on performance and flows, and hedge fund fees.

Size as a factor for HF performance and flows
There is an ongoing debate about the relationship between hedge fund size and performance. To try and address this question, we categorised all the funds in the HFR database with at least three years’ returns into performance quartiles. Fig.2 shows this distribution of funds across performance quartiles by fund size. Overall, in the past three years, large and mid-sized hedge funds (over $500 million) have produced higher annualised returns than small hedge funds.

Select highlights from the analysis:

• Mid-sized funds ($1-$5 billion) had the highest representation in the top performance quartile (nearly ~40%).
• The largest funds (over $5 billion) had the ‘safest hands’, with 72% delivering above-average returns, but not as many of them made it to the top quartile as mid-sized funds ($1-$5 billion hedge funds, and to a lesser extent $500 million to $1 billion hedge funds).
• The smallest funds had the greatest representation in the bottom quartile (27% versus ~10% for larger hedge funds). It is important to note, however, that this is not necessarily a knock against small funds, given the large number of funds in this size category, and certain biases in the analysis that disproportionally hurt smaller hedge funds.[6]

The next question we addressed was about the hedge fund size categories that are attracting flows from investors recently. Fig.3 shows that, while the largest hedge funds continue to receive a majority of the flows into the industry, in recent years the proportion of flows they have been receiving has been declining. Hedge funds with over $5 billion AUM captured a little over half of the total flows into the industry YTD Q3 2014, compared to over 80% in 2010. Mid-sized hedge funds, those with $1-$5 billion in AUM, on the other hand, received one-third of total flows YTD Q3 2014 versus only 10% in 2010. These conclusions hold good even when looking at flows into different hedge fund size categories when normalised for their AUM base, as shown on the chart on the right in Fig.3. At the end of Q3 2014, $5 billion+ hedge funds accounted for 67% of industry assets but received only 53% of YTD Q3 2014 flows; hedge funds with $1-$5 billion, on the other hand, accounted for only ~20% of industry assets but received 33% of flows. This trend is consistent with our finding that mid-sized hedge funds are outperforming other hedge fund size categories given that, generally speaking, performance and flows tend to be positively correlated in the long term. Another factor that has contributed to the declining share of net flows to large hedge funds may be that more of them are now hard/soft-closed. We tested this hypothesis by surveying a number of managers across strategies and firm size categories. Some interesting takeaways:

• A large majority of the $10 billion+ hedge funds (86%) that we surveyed had at least one of their products hard or soft-closed.
• 40%+ of mid-sized hedge funds ($500 million to $5 billion) also had at least one closed fund.
• This is especially true for event driven, FIRV and equity L/S strategies.
• A majority (two-thirds) of these managers had closed these funds in the past one to two years.

Based on the responses of participants in our survey, there are two main drivers for this trend toward closing funds. Firstly, as hedge funds have grown in size, more have reached some type of natural capacity limit – a ceiling on how big they can grow in the short term. Secondly, more large hedge funds are responding to investors’ concerns regarding performance by actively limiting net new flows into their funds. Our view is that, while this could reduce investor choice in the short term, this is likely a positive development for the industry as it can potentially lead to a greater focus on investment performance.

Hedge fund fees
It would be remiss to talk about hedge fund trends without discussing fees. In Fig.4, using data from the HFR database, we show average headline fees by fund size, with management fees plotted on the x-axis and performance fees on the y-axis.

Two key highlights:

• The current average fee structure for the industry is: 1.53% management fee and 17% performance fee.
• Surprisingly, on average, the smallest hedge funds have the highest fees (1.53%/18%), while the largest have the lowest (1.37%/16%).

Finding this to be curious, we plotted the distribution of management fee by fund size, as shown in the chart on the right side in Fig.4. Interestingly, we found that nearly half of the $5 billion+ hedge funds charge 1.5% in management fee, while only a third (37%) of small hedge funds do (more of the small hedge funds charge a 2% management fee than do large hedge funds). There are two potential explanations as to why mid-sized and large hedge funds have lower headline fees than small hedge funds which, at first glance, may seem counterintuitive:

1. Investor profile – large funds have proactively reduced headline fees to address the concerns of their larger, more sophisticated investors who have considerable negotiating leverage.
2. Financial – large hedge funds have more flexibility to reduce headline fees because they do not have pressures on their operating margins, i.e., facing business risk, to the same extent as small hedge funds.

According to our analysis, assuming a gross return of 5%, large and mid-sized hedge funds have an operating margin of 25-50% in each of the four fee scenarios analysed. These margins are very healthy, and comparable to large asset management firms that have historically had operating margins between 25-35%. Small hedge funds, on the other hand, can break even only when they charge at least a 1.5% management fee or more. Mid-sized/large hedge funds, therefore, have more flexibility to offer fee discounts without significantly increasing business risk; consequently, the pressure (from investors) on them to reduce fees is much greater than for small hedge funds.

Another fee-related topic we explored was the incorporation of hurdle rates in hedge funds’ terms for the calculation of performance fees. As shown in the chart on the left in Fig.5, despite the fact that hurdles have been one of the most often heard requests from investors, the adoption rate of these has remained low (15% across the industry). Additional colour on hurdle rates in the industry is as follows:

• Among the managers that include a hurdle rate, 62% use a variable benchmark (e.g., 3M Libor) and 38% use a fixed cash rate (e.g., 6%).
• The two most commonly used structures are a floating borrow rate (46% adoption) and a fixed rate of 4-8% (24% adoption).

To better understand why managers have not embraced hurdle rates, we analysed the economic impact of a hurdle in the chart on the far right in Fig.5 by plotting the different hurdle rates on the vertical axis and the gross performance scenarios on the horizontal axis. Each cell in the grid, therefore, represents the change in fee revenue attributable to a certain gross return number and a specific hurdle rate versus a 2/20 flat fee structure. Select highlights:

• The negative impact on fee revenue of having a hurdle at <0.5% (most borrow rates today) is minimal (less than 3% of total revenue).
• However, a fixed hurdle of 4-8% (the second most commonly adopted structure) can be significant – assuming a return scenario of 5-10%, the impact is the same as a 20-40% haircut to a manager’s overall fee revenue.

Given that the average management fee in the industry is ~1.5%, we can hypothesise that many managers/investors have chosen to settle upon an up-front discount on management fee rather than incorporating a hurdle, which may be more costly for managers and represent more complexity (and a less obvious victory relative to a flat fee discount negotiated up front) to some investors.

Footnotes

1. Methodology: calculated annual beta for each strategy and multiplied the estimated beta by benchmark returns to determine the return attributable to benchmark beta. Subtract this from annual HF returns to arrive at excess returns.
2. Using S&P 500 as benchmark
3. Four key indices Novus has constructed include Consensus Index, Conviction Index, Size Index, and Concentration Index
4. Many names in the Consensus Index are mega cap stocks such as Google, Apple, etc.
5. The market capitalisation of the S&P 500 has increased by 2.2x over the same period; Bloomberg, Strategic Consulting analysis Source: Novus
6. There are a number of biases in this analysis (e.g., survivorship and backfill bias, reporting bias). One we want to highlight in particular is that high performing funds are the most likely to move up to the next AUM size category. This phenomenon has an especially adverse impact on the performance characteristics of the smallest HF size category, where most of the poor performing funds that cannot grow into the next category are likely to aggregate.