by Mitchell D. Eichen, J.D., LL.M., and John M. Longo, Ph.D., CFA
Hedge funds have become a global phenomenon with over 8,000 funds managing $1 trillion in assets. Many, including Alan Greenspan, have called for a shakeout in the industry, while others, such as Warren Buffett, have said fees are too high. Yet few market analysts have offered any meaningful analysis or thoughtful insights as to how this important industry may evolve. This article lists five emerging trends in the hedge fund industry and discusses catalysts that may spur the realization of these trends.
The hedge fund market has grown rapidly for several reasons:
- Cachet of exclusivity
- Strong relative outperformance during the 2000–2002 bear market for U.S. stocks
- Low historical correlation with standard equity and fixed-income benchmarks
- High levels of fund manager compensation
- Fewer constraints on managers
While the hedge fund industry has grown rapidly over the past several years based on the above factors, in our view, this still-young industry is about to enter an evolutionary phase. We believe the following factors will act as catalysts to activate this evolution in the industry:
- The current difficult investing environment
- Increased competition
- New compliance regulations
- Increased institutional investor participation in the hedge fund asset class
The first point requires further expansion, while the others are more readily apparent and will be discussed in the rationale of our five emerging trends.
A Difficult Investing Environment
Historically, inflation, interest rates, and taxes act as drags on the economy. The lower these elements, the more investors will pay for earnings per share on stocks and the higher the market's price-to-earnings ratio will be. Since 1982, the start of the last great bull market that lasted until March of 2000, inflation is 35 percent lower, short-term interest rates are 72 percent lower, and capital gains tax rates are 25 percent lower. In contrast, the S&P 500 P/E multiple is 92 percent higher.
As Figure 1 illustrates, P/E multiple expansion has driven much of the stock market growth since 1983. If we assume no further multiple expansion, EPS growth consistent with its long-term historical average of 6 percent and a 2 percent return from dividends, over the long term the stock market would be hard pressed to return more than 8 percent annually. This anticipated return is a far cry from the routine, double-digit returns (up or down) we have experienced for much of the last decade. Combining this muted U.S. stock market environment with a flat bond-yield curve that is starting from very low nominal levels, and volatility (as measured by VIX) near a multi-year low, we have a recipe for muddled markets. Hedge funds rely on market volatility to generate returns, just as sailboats rely on gusts of wind to move swiftly across the water. Therefore, just as return expectations for the stock and bond markets must be lowered relative to their historical performance, so, too, must expected returns for hedge funds.
Figure 1
As such, we believe that the hedge fund industry must and will embark on an evolutionary path based on five major thematic trends.
Trend 1: Lower Fees
The standard hedge-fund fee structure consists of a 1–2 percent asset-based fee and at least a 20 percent profit participation fee. Many funds charge much higher rates, and hedge fund of funds charge an additional layer of fees. Hedge fund investors were glad to pay fees when returns were high, or even just modestly positive in the devastating 2000–2000 bear market. But in a muddled market environment with more middling returns and less overall volatility in the equity markets, these fees will simply become too large a percentage of the total fund returns, thus dragging down returns to investors to unattractive levels.
In addition, given the proliferation of new managers entering the space, and the intense competition that will ensue, it is inevitable that the average hedge fund fee will have to come down in order to attract investors. In addition, with much of the new money coming into hedge funds being contributed by institutional investors who have more buying leverage, and who are not accustomed to paying rack retail rates, it is hard to imagine they will not demand fee concessions from many hedge funds in return for large capital commitments. While established "star" managers may be immune from this fee pressure, it is all but certain that emerging managers will have to succumb to fee compression, thereby creating a trend toward a new and lower fee structure with which those who follow will have to comply. This was the trend in the institutional money management business that saw fees decline precipitously over the past 15 years as increased competition and consolidation created a more efficient market. This was also the trend in the mutual fund business where high loads and high internal fees were the norm a mere ten years ago. The hedge fund business will follow this trend as it matures. It is not a question of if, but when, and by how much.
Trend 2: Increased Liquidity
Most hedge funds have a one-year lockup provision and advance notice of 90 days before any capital withdrawal. Some private investment funds, such as those making venture capital investments in developmental-stage firms, have a clear and valid need for such long-term lockup arrangements. But the underlying instruments in most hedge funds are sufficient for 30-day-or-less liquidity. Other than the desire to earn fees for a longer period of time, it is hard for the average hedge fund to argue that it is absolutely necessary to hold client funds beyond 30 days. From the investor's perspective, all else being equal, one does not want to be a year away from accessing his or her money. Investors want to be able to withdraw their money in the event they see something with the fund they do not like, or simply if they need the liquidity. Since most hedge funds do not "need" to have these lockup provisions, as the industry matures, this will be one easy way for managers to distinguish themselves and accommodate client needs. Thus, we see increased liquidity becoming the norm of hedge fund investing, not the exception.
Trend 3: Increased Transparency
Investing on faith was once accepted as part of the "price of admission" into the hedge fund industry. Indeed, the cachet of an exclusive or closely guarded strategy may have been a positive. Then came Long-Term Capital Management (LTCM)—the most spectacular of all hedge fund blowups. Clearly there has been a movement toward increased "factor transparency" in the post-LTCM era, which calls for the disclosure of the macro characteristics of a fund at month's end such as the percentages of long and short exposure. In our view, factor transparency does not meet the due-diligence requirements of most sophisticated retail or institutional investors. Investors have a right to know exactly what they own and how returns were generated. More investors will make these demands on their hedge fund managers in the face of misleading, and in some cases fraudulent, activity, news of which finds its way into the popular press on a regular basis. As such, many funds, especially newer emerging funds, will be forced to deliver full transparency if they wish to raise substantial assets. Indeed, institutional investors often demand that their hedge fund investments be located in a managed-account vehicle (that by definition offers complete transparency) run pari passu with the hedge fund company's traditional partnership structure. To preserve strategy confidentiality, non-disclosure agreements with "teeth" may have to be signed and enforced in return for transparency. Furthermore, mandated hedge fund registration for advisors with more than $25 million under management will ensure increased operational transparency.
Trend 4: Focus on Emerging Managers
Size may be a disadvantage to certain hedge fund strategies at high levels of assets. In their later years, some of the top performing hedge funds, such as those run by George Soros and Julian Roberston, had difficulty in replicating the spectacular performance of their earlier years. Part of the reason for diminished performance may be due to the difficulty in putting large sums of capital to work profitably. Other reasons are some managers' inability to build a scalable business, either due to limitations on their strategy or the simple fact that some hedge fund managers are great investors, but poor businesspeople who function more efficiently in smaller environments devoid of bureaucracy.
In other cases, successful funds attract competition and suffer from key staff defections, as star analysts who have been major contributors to performance leave to create their own funds—often running a similar strategy. A certain amount of size is necessary to ensure critical mass and organizational viability. But there is no free lunch, as smaller fund management firms require extra due diligence and monitoring. Hence, hedge fund investors in the future will have to carefully weigh the balance between confidence in delivering alpha relative to operational risk. In our view, the mandated Securities and Exchange Commission's registration requirements will provide many investors with a fair amount of comfort (akin to investing in a non-household "name" mutual fund) and tip the balance in favor of those firms that are able to deliver investment performance in highly competitive markets.
Trend 5: Focus on Niche Strategies
Although this trend is clearly related to the prior trend, there are some subtle differences. For example, the bulk of the 8,000 hedge funds are following traditional strategies such as long/short fundamental equity, event-driven, statistical arbitrage, global macro, merger arbitrage, and so forth. But how many funds use esoteric forms of technical analysis and combine them with option overwrites to earn extra income and reduce risk? Probably not too many. The key take-away is that as more managers flock to the hedge fund space, investors should seek out those funds with a definable niche and run a strategy that is not easy to replicate, as this superior performance will be more likely to persist.
Summary
Hedge funds play a useful role in portfolios due to diversification and lack of correlation with traditional stock and bond portfolios. The industry is still evolving, and as it matures there will be a fallout of managers, compression in fees, increased liquidity, and improved transparency. Competition, a difficult market environment, increased institutional participation, and added regulatory scrutiny will promote the evolution of emerging managers with niche strategies who are best positioned to provide superior investment performance. Emerging managers with niche strategies are hard to find and require extra due diligence and monitoring. Many of these trends have already begun to manifest themselves. They will become part of the normal evolutionary process as the hedge fund industry, not yet in its adolescence, continues to mature.
Mitchell D. Eichen, J.D., LL.M., is the founder and CEO of The MDE Group Inc., and a member of the Financial Advisory Board to the Rutgers Graduate School of Business. He can be contacted at meichen@mdegroup.com or (973) 887-4900.
John M. Longo, Ph.D., CFA, is responsible for developing MDE's investment due diligence policies, practices, and procedures, and is a professor of finance at the Rutgers University Graduate School of Management. He can be contacted at jlongo@mdegroup.com or (973) 887-4900.
