Will L/S Hedge Funds Be Around In 10 Years?

More of an opinion-based question but curious to see what people think about the outlook for hedge funds long term.

I've just been thinking from an outsider's perspective, why would a pension fund or institutional investor ever give a L/S fund $$$ when they charge ridiculously higher fees relative to most MFs and all ETFs, especially when these funds have more or less underperformed broader indices?

I'm not experienced enough to talk more about it but I genuinely want to know if I'm missing something here. Will this style of L/S investing still be around a decade from now? What value does it add over most low-cost MFs and ETFs?

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Comments (33)

  • Research Analyst in HF - Other
Jul 12, 2021 - 12:09am

You are talking about platforms/market neutral shops? Lots of more directional L/S funds have pretty high corr vs SPX

Aug 3, 2021 - 4:49pm

Exactly. To be a little more precise (for those not in the industry yet), really it's market neutral specifically that is a fixed income alternative... something with a very low net bias. 

Even though AAA credit is close to guaranteed repayment, you'll still have forced sellers when you hit a real recession (I'm guessing its something few people on WSO have experienced!)... so even high grade credit isn't "safe" when things go south. 

I worked on a MN strategy when the S* hit the fan in 2008-09... we were closely paired MN w/ limited beta bias and were able to eke out +300-400bps of return when credit would've been giving negative returns. 

2008-09 was also the time frame that really hurt the L/S world... 2007 was probably peak HF?... A lot of funds that claimed to be L/S were really levered LO and when the tide went out you got to see who was "swimming naked."

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Most Helpful
Jul 12, 2021 - 9:54am

I'm assuming you're talking about the tiger cub, single manager style of fund.

A couple of points:

-Although MM platforms seem great for generating alpha, they are generally much worse from a junior career standpoint. This means SMs can pick and choose from the best talent on the street.

-MM platforms do have very impressive gross returns and sharpe ratios but a lot of these funds end up charging something like 4 and 40 fees to keep their system up and running (and pay PMs).

-SM funds are generally not designed to outperform indices (hence the name "hedge fund"). They may underperform in bull markets while reducing downside risk.

-Despite this, some funds do consistently outperform indices and have huge AUM as a result (Tiger, Viking, Lone Pine) although these funds are higher beta and definitely not factor neutral

-At some point, the pendulum swings too far in the direction of passive (ETFs). I know of funds that are focused almost entirely on arbitrage opportunities involving index funds. Once a company gets added to an index, there is forced buying and the price shoots up despite no fundamental changes to the underlying asset. This adds to the opportunity set that smart active managers can take advantage of (hence more alpha).

-Many of the other asset classes competing for LP money (PE, Private Credit, Infra, RE, VC, even ETFs) have ridden the coattails of a 30+ year bull market in rates and equities. If this ends due to inflation, fed policy reversal, etc, money could flow out of these asset classes and into rate agnostic L/S.

No I don't think single-manager style L/S will disappear as an investment strategy or even decrease in popularity over the next 10 years. In fact, I think more money will flow into the strategy, especially if the current macro dynamic changes. That being said, take my points with a grain of salt since I'm just a freshman in college so I don't really know what I'm talking about.

Jul 12, 2021 - 12:55pm

There are plenty of college freshman on this forum who dunno what they are talking about, you are NOT one of those. 

Instagram: @dickthesellsider | Substack: dicktoad.substack.com

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Jul 14, 2021 - 1:26pm

The passive ETF arbitrage is interesting, because traditionally any arbitrage-able difference should get whittled to zero (in a frictionless world) as people act on it, but here I don't see how that mechanism works. Regardless of price, when it enters the index you have a lot of forced buying (and to a smaller degree forced selling if it's leaving a smaller-cap index). This seems like it would violate any sort of EMH form for this particular situation, the arbitrage would always exist (one way I see out of it is if the large index buyers end up seeing this, too and speculatively purchase stock ahead of their inclusion to avoid this very issue, but that would require their fund rules to change). 

  • Research Analyst in HF - Other
Jul 21, 2021 - 6:55pm

I disagree with the last point but other than that spot on take and insightful for a college kid. I think the number of SM funds will decline and AUM will flow away from directional L/S as a whole, but the Tiger Global's, D1s, Vikings of the world will always be fed and may even grow. There's never not a place for funds that beat the index, have some level of uncorrelation, and especially in down years.

Jul 28, 2021 - 8:27pm

Curious to hear your thoughts on the last point specifically as it relates to why AUM will flow away from L/S. I don't disagree that number of SM funds will decline but I did think to a certain degree that a potential paradigm shift with the current macro environment could make a more nimble strategy like L/S more favorable. I do think there won't be ton of inflow to L/S since too much AUM can potentially break the strategy as short side of the equation becomes too crowded and the L/S strategy really becomes long alpha and factor exposure management game while also having to manage increasing tail risks inherent in short with crowded market. Ultimately though, in light of the current environment where we could be coming up against a paradigm shift that could negatively affect other strategies (I think there's too much allocation to fixed income that could be redistributed in coming years and potential headwinds for other asset classes like PE, etc.), I thought L/S is in a pretty good spot to at least maintain or even slightly grow AUM. I do think there will be a consolidation in the industry where big gets bigger though.

Interested in hearing what you think some of the drivers that would lead to AUM outflow from L/S. 

Array
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  • Analyst 1 in IB - Gen
Aug 3, 2021 - 8:33pm

Why do you think money from PE/VC/Infra would move to L/S if rates go higher? I dont quite understand that logic

Aug 3, 2021 - 11:41pm

As interest rates increase, the value of assets decrease. You can think about it in the context of a DCF: if the cost of capital (or required rate of return) increases, then everything gets discounted by more, so the intrinsic value of the asset is less.

In PE, Infra and VC, you are long an asset so you benefit from rates going lower. In L/S you have the flexibility to be net short assets if you want so you can control your indirect rate exposure.

Jul 12, 2021 - 8:00pm

FIG Newton is pretty much on the money. I'd dissent slightly and say that the number of Funds in operations will probably shrink somewhat, but there will always be demand for L/S Funds that consistently generate alpha at scale and preserve capital on the downside.

Jul 21, 2021 - 3:27pm

Hard to think of a scenario where l/s is completely gone. There will always be value in bottom up research picking winners over losers etc. You can always add market/beta exposure, the magic is the l/s component of the fund no matter what you call it. LS is dead when investing is dead.

Aug 3, 2021 - 5:06pm

forget about the fees for a minute... let's say you work for a major sovereign wealth fund or a huge endowment... you see there's very few LO managers who can consistently outperform, particularly in large cap. Instead of trying to pick one that does, you can go to a MM and after-fees they can consistently give you +200-400bps of pure alpha... then you go to your other huge institutional relationship manager and they'll give you pure beta (S&P 500 index fund) basically for free. You can overlay that alpha on to the beta and be consistently outperforming the market, doing better than if you had allocated to a LO who didn't outperform. 

I guess one of the questions is if they really deliver +200-400bps of alpha consistently? If there are any threats to that? 

I would argue that w/ passive growing so quickly the inefficiencies in the markets are growing and I believe focused industry analysts are kind of becoming the arbiters of short-term re-pricing more so than LO's... but maybe LO's can play more of a role in long-term re-pricing... if they can survive. 

For reference I'm on the LO side. I think the only competitive advantage for LO's is time arbitrage. 

Aug 3, 2021 - 10:16pm

People ask if active equity is going away every two weeks… passive funds probably own 20-35% of most equities at this point. Where does that go in this scenario…60-65%?

Equity markets would basically cease functioning properly if passive became more than 50% of the market.

Aug 5, 2021 - 9:05am

I guess it depends on how you define passive, but I think it already happened in US domestic equities. I don't know how Bloomberg is defining it in the below article. I'm guessing they're including ETF's, which is kind of a gray area. Historically they were purely passive, but the last few years you've had huge growth in "active ETF's"... a la ARKK, etc. I don't know how they're classifying those. But I think US (particularly large cap) is over 50% now. 

I saw an interview w/ Jack Bogle years ago where he estimated that passive could continue to work even if the passive mix got to as high as 80%. It's impossible to prove, and I don't necessarily believe it, but just adding that to the conversation. 

Passive likely overtakes active by 2026, earlier if bear market | Bloomberg Professional Services

Passive mix of US domestic equity ~54%

Aug 4, 2021 - 10:57am

I believe they will be around forever. They are a good business model. The only thing that would affect this would be if the Bernie Sanders, AOC and Elizabeth Warren types find someone worse than them to become President with a majority house and senate. We are talking 60 senators and 60% house plus 6-7 justices. 

Aug 8, 2021 - 10:35am

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Aug 10, 2021 - 11:26pm

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