The position of hedge funds in the financial industry is one which is coming under increased scrutiny. This has been a side effect of public dissatisfaction – indeed, outrage – at the banking sector following the financial crisis, and the progressively austere regulatory climate this has inspired. The logic goes that if banks, as major players in the markets, pose significant systemic risk to the financial system, so must other investment vehicles, which must accordingly be regulated also. This is nothing new. Indeed, following the demise of Long Term Capital Management in 1998, and the role this had in the failure of its counter parties, there has always been a building concern that it will all come to a catastrophic end. This unspoken worry has led to a mythos being constructed around hedge funds. They are seen as towering institutions, pulling unseen strings that result in miraculous profits and endow their employees with the cash to buy ostentatious trappings.
Indeed, this impression, and this concern, is not unfounded. Hedge funds do manage significant assets (housing $2.82 trillion amongst 10,000 firms according to latest reports), do pay extremely well, and do hold notable risk. However, to put hedge funds and banks in the same bracket is to wrongly succumb to the easy plausibility that they dominate finance and are the industry’s next poster child of disaster. Rather, they are but stocky trout in a sea replete with whales. Whilst, for example, $2.82 trillion may seem like an astronomical figure, it is important to remember that this is spread thinly across 10,000 firms. By comparison, UBS alone – as the world’s largest wealth manager – has $1.97 trillion under management. What’s more, this amount, similarly held by the likes of BAML and Morgan Stanley, is only likely to increase. Indeed, UBS increased its holdings by 15.4% on the previous year. All of this puts the role of hedge funds in sharp context and makes the adamant claim from within the industry that these funds do not hold systemic risk all the more credible.
Further backing this downtrodden view is formal analysis of hedge fund leverage before and during the 2008 financial crisis. Evidence suggests that hedge fund leverage is both fairly modest and counter cyclical to the market leverage of investment banks and the larger financial sector. Furthermore, hedge fund leverage, in the build up to the crisis, actually decreased. The leverage of other financial intermediaries, conversely, increased. Above all, however, perhaps most indicative of their relative insignificance is their propensity to fail. Hedge funds, is it safe to say, fail regularly. In 2008 – during the maelstrom of the crisis – nearly 700 liquidated. They, with grace and sombre acceptance, folded with no financial assistance, and so with no cost to the taxpayer. This was similarly the case with LTCM, and is what led Ben Bernanke, in 2009, to declare that he:
“would not think that any hedge fund or private equity fund would become a systemically critical firm individually”
Hedge funds, put simply, do not have the weight to demand intervention in their fate, and so lack the gravity of large banks and the impact their downfall has on the economy.
Accordingly, a refreshing Darwinism characterises the hedge fund sector: a dynamic not common in the financial industry and – critics argue – a cornerstone of its systemic risk. Indeed, the law of the jungle rules: the big get bigger, and the weak atrophy and die. The brutality of this is reflected is the resurgent trend of present for hedge funds to pack up and close their doors. Data compiled by Bloomberg shows, for example, that as of December 1st, 2014, returns have been a mere 2% – a figure that rivals the paltry performance of 2011. This measure, however, is revealing about how opaque the hedge fund industry truly is. Though returns may be poor, and though firms may be shutting shop, the sector continues to grow, with returns skewed aggressively. As Barry Ritholtz neatly put it:
“rather than the normal Gaussian distribution typically observed in smooth bell curves, it is feast or famine”
A handful of performers are capturing the vast majority of alpha, leaving but festering carcasses for their peers to loot for whatever remains. Accordingly, whilst a select few prosper, the vast majority stagnate, with some going so far as to collapse.
This, however, poses a problem. Namely, that hedge funds, by and large, are becoming too expensive and with results not strong enough to justify the costs. This, arguably, is what led the $298 billion behemoth that is CalPERS to slash its exposure to hedge funds to zero: it is simply impossible to select the emerging managers of the next decade, and this is risk investors would rather do without. This is a position further amplified by the imminent conclusion of the Fed’s quantitative easing programme. What the impact will be on everything from fixed income portfolios to emerging markets – particularly when rates rise – is massively uncertain. Consequently, for an industry founded on renown for spectacular returns, this is very much a defining period. Get it right, and we will see a return to the success enjoyed by Julian Robertson Jr and the like. Get it wrong, and the industry will be forever relegated to the leagues of niche investment. This may sound hyperbolic, but what with current liquidity shortages – a direct result of the imperious Dodd-Frank reforms – this is a very tangible reality.
What, then, for the future of hedge funds? They sit, after all, at a crossroads. They have enjoyed success and the positives and negatives distinction brings. On the one hand, they are increasing assets under management, and on the other, large institutional investors are slowly withdrawing. It is a complicated picture. Whilst most expect the industry to continue to grow, the flow of capital from institutions will not continue forever. Indeed, if the actions of CalPERS is any indication, pension plans and defined benefit investors will begin to take a long, hard look at the utility of hedge funds. A saving grace, then, may come from wealthy investors. As Dawn Fitzpatrick, CIO of O’Connor, contends, there’s “never [been] so much interest on the high net worth side” – an influence that will “change the complexion of the industry in profound ways”. As a result, though hedge funds may, at present, be in a quagmire, threatened by governments looking to impose ever more transparency, the future may not be as dark as it otherwise appears. Indeed, hedge funds may yet shed the awkward self consciousness of their adolescent years and mature into established fixtures of the financial world.