1/4/17

Recently read a Bloomberg article about how the golden age of hedge funds is over. This is in large part due to the fact that hedge funds only beat a broad index of bonds by 175 basis points and hedge fund managers made most their income off of the 2% management fee they commanded.

Coupled with the lavish lifestyle hedge fund managers often lived, many public pension funds and private endowments are now pulling their wealth out of hedge funds as one New York City official remarked in the article:

Let them sell their summer homes and jets and return those fees to investors.

Do you think the golden years of hedge funds are over? Or, will the macroeconomic environment with low-interest rates around the world and a less regulatory government under a Trump presidency only indicate that the 782 hedge fund closures in past year was a blip on the radar.

Comments (28)

12/30/16

Been saying it for years

"Elections are a futures market for stolen property"

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12/30/16

Yeah, that was a good article. I definitely think we are still in a 'culling the herd' phase. The vast majority of HFs out there do not have anything resembling sufficient AUM to support meaningful research capabilities. Without that I'm not sure how they expect to outperform over the long-term. Generally there are way too many guys out there pursuing close to identical strategies...

That said, I don't think the large multi-strats are going anywhere. They may reallocate resources from one strategy to another, or from one set of pods to another, but as a whole those guys have the scale to do things on the research and technology side that other firms can only dream of. They also have the income to continue to attract top talent, which I think matters for sustainable competitive advantage in this business. There will certainly be a place for them, and in fact, I could see a bull case where more AUM gets allocated to these larger l/s managers as we shift further to passive as a whole. E.g. if I am an endowment manager and I'm pushing 80% of my equity AUM into passive strategies (which are obviously cheaper), then I may look to the major hedge funds to overlay some alpha with that last 20%. This is a net negative for the big long-only's and a net positive for the big long-shorts.

12/30/16

Easy to pull your money out off hedge funds in the midst of a very long bull market. When the market takes a bath we'll see how committed people are to passive investing, my thought is money will flood right back to active investing. Probably not to "golden age" levels but the flood to passive definitely seems to be overdone.

12/30/16

I made a post about new hedge fund methodologies incorporating data science. No one replied so I'm just going to casually sneak it into this discussion.
https://www.bloomberg.com/news/articles/2016-12-22...

12/30/16

Interesting read, how do you think it's going to affect the hedge fund industry?

12/30/16
imaginarynumber:

Interesting read, how do you think it's going to affect the hedge fund industry?

Im torn, because there's a lot of promise but so far machines have been known to royally fuck up investments. If someone has to watch the machine make every transaction it defeats the purpose of machine learning.

1/15/17

Thats a lot of money to cross the street.

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12/30/16

Didn't realize hedge funds were supposed to outperform in a massive bull market

12/31/16

How well did hedge funds do during the financial crisis?

"Elections are a futures market for stolen property"

12/31/16

Held up fairly well--about as well as would be expected, given their relatively low beta, plus some alpha (probably lower than the hedge fund index would indicate when survivorship bias is adjusted for). Through the financial crisis, stocks fell 49% and hedge funds fell 17% Here's a generally fair article on hedge fund performance that summarizes the issues with performance over time quite well:
https://www.aqr.com/cliffs-perspective/hedge-funds...

12/31/16
  1. There are too many hedge funds out there right now. The industry will eventually resize, and it is ok.
  2. People (media) tend to forget that it is all about risk adjusted returns, and not nominal returns.
  3. I second what was said by other people here on pulling your money out from HF right now. You do not need to have too much of common sense when it comes to investing in a bull market like we had in the past years. But let them panic when their pensions go down 50% along with a stock market.
Best Response
12/31/16

Let me add a few points to this topic:

  1. Things are getting worse for the hedge fund industry right now. I don't want the various qualifications I'm going to make below to make it seem like this isn't the case. I expect things may continue to get worse for some time; the longer trend is likely toward the industry's economics getting softer. But those changes are not going to be immediate, or incredibly bad, Rather, we're seeing an industry at its all time peak success facing its maturity.
  2. The hedge fund industry is a victim of its own incredible success. The hedge fund industry's AUM has risen from about $240B (by the BarclayHedge calculation of hedge fund AUM) in the year 2000 to $2,980B as of 3Q16. That's roughly a 17% compound annual growth rate. But because AUM has grown so much, the space has become crowded, and some strategies have become less effective. And at the individual fund level, the big winners of the past 2 decades have become so huge that it becomes increasingly difficult for them to outperform, or to even continue to deploy at relevant scale the strategies that they were using in the past that made them such winners. But keep in mind that we're looking at an industry that has had absurd levels of success hitting its inevitable maturity. Hedge funds were never going to keep compounding asset growth at the same rate. It's frankly incredible that the industry has become as large as it has.
  3. Scary sounding news articles in the financial press focus on inflows and outflows into the hedge fund industry. For industry health, this number might be somewhat indicative, but it means less than you think. The 3Q16 Prequin report suggests that YTD outflows from the industry have been $67B on (by their definition) $3,240B of AUM (in 3Q16; didn't want to hunt for 4Q15, which would be more accurate). That is, roughly 2% of capital has been withdrawn. And that's considered a very large outflow. But the industry continued to grow! HFR reported that the industry hit its all time AUM peak in 3Q16 in spite of the outflows. How could this be? The reason is simple: for large pools of AUM, inflows and outflows generally matter less than the growth in the capital base from returns. In extreme cases, this can change, but generally inflows and outflows just aren't big enough to change the direction of AUM growth. This held true for traditional large asset managers as well for a very long time, which continued to maintain or even grow their asset bases even in the face of persistent outflows to passive alternatives, though this may not hold for them going forward as those outflows accelerate. Of course, all things being equal, inflows are better than outflows, and there are important second order effects from outflows on hedge fund economics, such as fee pressure related to those outflows, but the news articles on 2016's outflows are way overblown.
  4. Fee pressure isn't new. Here's what 2 minutes of Google search turned up:
    2016: http://www.cnbc.com/2016/07/14/investing-hedge-fun...
    2015: http://www.hedgefundinsight.org/fee-pressures-are-...
    2014: https://dailyalts.com/hedge-funds-continued-pressu...
    2013: http://www.agecroftpartners.com/papers-fee.html
    etc.
    The industry will always face some fee pressure, but note that the industry isn't really all that different from what it was a few years ago. These things change very slowly, and 2 & 20 was never the rate that large investors actually paid at most funds.
  5. A shake-out might help performance. There are a lot of highly duplicative funds out there, all chasing the same sorts of ideas. Seeing the weaker ones washed out might be a good thing for the survivors. Might be. I think this reasoning can be taken too far, though there is something to it.
  6. Keep in mind that journalists have a deep, deep hatred of the hedge fund industry, and a psychology particularly prone to catastrophizing any modest challenge to the industry. There are a few reasons for this; the first is that analysts who work in hedge funds have similar family and educational backgrounds to journalists, but make much, much more money. This, as you can imagine, is super annoying to journalists. The second is that journalists are working in an industry where the core business model has been imploding since the late 90s. They're psychologically primed to see a "fat" industry like hedge funds face the same disruptive challenges that their industry faces. This is why every year you will see news articles predicting the imminent demise of the hedge fund industry, and no reflection when a few months later it becomes clear that the industry has hit all-time record assets. And this is why financially illiterate journalists never compare hedge fund returns to the broader market on a beta-adjusted basis (where returns look basically ok over the long term, though somewhat softer in the past few years, as the industry AUM started to get huge). Beta-adjusting isn't a hard concept, but it goes against what journalists want to believe, so they never bother to educate themselves.
  7. So yeah, some serious qualifications to the "end of hedge funds" stories. All that being said, I want to reiterate that the hedge fund industry might well shrink for a while. Economics could get a bit softer. We'll probably see more fund closures than usual going forward. But from the perspective of an individual analyst, don't expect the world to look radically different in 5 years. These macro changes are subtle; the industry won't change dramatically. In a 3 trillion dollar industry, your, and your fund's, initiative and performance matters much, much more than whether the industry saw a 1% inflow or outflow over the course of the year.
1/4/17
Markov:

These things change very slowly, and 2 & 20 was never the rate that large investors actually paid at most funds.

agree

1/1/17

I guess you missed where Ray Dalio said that he thinks 2017 will be the year for stock pickers.. It's cool you can't catch everything. But seriously, click bait Bloomberg headliner as if there wasn't enough last year about the election. Who are you going to take seriously... Dalio or some "journalist"?

I think a better article would be The End of Journalists

Overwhelming grasp of the obvious.

1/1/17

Yep, missed that Dalio piece, thanks for making me aware of it.

1/9/17

Didn't he also set up a fund that was essentially a passive investment vehicle? What else should he say, this is going to be the year you should leave my other funds? It's hard to really draw a meaningful conclusion from anyone like him.

1/9/17

Perhaps, interesting point.. doubt we're anywhere near the "end of hedge funds". The golden era was in the 1980s and 1990s when everyone had to add one to their investment collection.

Overwhelming grasp of the obvious.

1/9/17
1/9/17

Lol that's not going to work as a hedge fund manager or investment banker replacement for several different reasons that with a little intuition I think you can figure out on your own.

If it makes you feel any better Haim Bodek told me so when I was in college. I just didn't understand why not at the time.

Overwhelming grasp of the obvious.

1/10/17

I'd think now is more of a golden era with AUM at an all time high.

1/10/17

By the same logic this would also be considered the golden era of flight..

Overwhelming grasp of the obvious.

1/7/17

It is not over. The answer depends on the style of the fund's investment. The hedge fund industry;'s investors are simply favoring different type of investment offerings. The falling ones are that focus on traditional long-short or imitate the index fund investing. The rising one are the traditional marco funds, activist-funds and special situations funds.

1/9/17

If I had to choose between being an analyst doing L/S at a large HF or doing long only at a large MF, I would take the mutual fund in a second. Comp is becoming relatively comparable and job security, lifestyle are much better at a MF.

1/9/17

You need some pretty great risk adjusted returns to make investing in an HF with their fee structure worthwhile. They've had mediocre returns as an industry for the past 10years. I'm sorry, I don't give a shit what your spiel is about performing poorly, but when your industry returns a fraction of what passive alternatives do and passive returns were more than enough to offset the losses from the last debacle and still outperform...you're going to lose business.

1/11/17

The more AUM that floods into passive Management Strategies the easier active management becomes since inefficiencies compound when people pile into indices rather than try to spot discrepancies based on fundamentals. Please continue taking your money to passive investment strategies and ETFs, tx!

1/11/17

This is not accurate. and M Mauboussin actually explains it pretty clearly. Highlights below:

The difference between the best and the average is less today than it was a generation or
two ago. We see this clearly when we examine the standard deviation of excess returns for mutual funds,
which has declined steadily for a half century.

Think of it this way: For you to have positive alpha, the industry's term for risk-adjusted excess return, someone has to have negative alpha of the same amount. By definition, alpha for the market must equal zero (before fees).

So you want to compete against less-skilled investors because they are your source of alpha. It is
disadvantageous for you if the weak players flee the market (selling their stocks and buying index funds), or if
the least capable professional investors lose assets to passive funds, because it means that only the smartest
investors remain in the active game. The truth is that weak players, whom the strong players require to
generate excess returns, are fleeing at a record pace.

1/13/17
1/17/17
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