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The Economics Of Hedge Funds

The Death Of The Hedge Fund?    12 minute read

The Economics Of Hedge Funds

 

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Hedge funds have been synonymous with supernormal returns, but also with catastrophic failures. Some have critiqued their expensive fee models while others have complimented the ‘genius’ level of skill required to consistently outperform the market. Either way, public perception of hedge funds has always appeared mixed and divided. They can generate wealth and provide a much-needed liquidity for the market, but they have also been known to be driven by greed and so neglecting a wider social responsibility. Hedge funds have certainly made their mark on the financial landscape. However, are they here to stay?

What Do Hedge Funds Do?

Hedge funds are investment partnerships between a fund manager and a general partner. Hedge funds are pooled assets that are only open to “sophisticated investors” using strategic instruments defined by a given structure. Their initial aim was to generate a positive and absolute return on investment by either going short on all markets, which requires betting that equities, for instance, will fall in price or going long, which involves betting on rising prices.

An example of this is buying shares in Apple, and then shorting the market as a whole. The hedge allows the investor to place a bet on a specific company while cushioning the loss and insulating the fund by ensuring the decline of the entire market. A common strategy is to exploit small mispricings in the market – this can reap large financial rewards if it is highly leveraged. Hedge funds will simultaneously seek to magnify their gains by using borrowed money, whether this be from equities, bonds, M&A transactions or currencies.

The History Of The Hedge Fund

The 1920s were a period of global economic boom, as trade restarted following the devastation of World War I. There came an unprecedented demand for goods upon which a particular few benefited. The wealth of the merchant traders was pooled into funds with the goal of raising capital. As millions of dollars flooded the markets, an investment bubble began to form, and the overheating capital markets led to the 1929 Wall Street Crash and the Great Depression. During this era, investors experimented with the strategy of hedging. However, it was not until the 1940s that an investment vehicle was produced and put into action.

The hedge fund concept was created by Alfred Jones, a Harvard Business School Graduate turned Editor at Fortune Magazine. When writing an article on the current investment trends, Jones attempted to manage some funds of his own. He sought to minimise the risk in holding long-term stock positions by short selling other stocks and in order to further enhance his returns he employed leverage. This is now referred to as the long/short equities strategy. Before Jones, investment strategies only consisted of long positions.

In 1952, Jones converted his investment machine from a general partnership to a limited partnership, to which he added a 20% incentive fee. Incentive fees were designed to pay the fund managers based on their performance over a given period in relation to the benchmark S&P 500 index. Jones was henceforth the first money manager to combine long/short selling with leverage and a shared partnership with other investors. Alfred Jones has henceforth been dubbed as the founding father of the hedge fund.

Fortune magazine listed Alfred Jones’ unique investment fund in 1966 declaring that it had outperformed every other mutual fund by double-digit returns over the previous five years. Following the publicising of his strategy, some 140 hedge funds were born in two years. By 1986, there was an increasing array of different pursuits to hedge for lucrative returns: currency trading, derivatives, futures and options.

How Do You Build A Hedge Fund?

To start a hedge fund, most portfolio managers have a successful track record of investing under their belt. This is how they convince their first clients to trust them and how they build out their funds. There are many legal requirements that go into starting a hedge fund, and therefore it is essential to hire a law firm to write your corporate bylaws and decide on your entity – most are a limited partnership. The next stage is to simply choose your type and strategy of hedge fund and gather an investment team of trusted advisors. It is then required that you register as an investment advisor with the Securities Exchange Commission.

Almost all hedge fund managers will go to an investment bank to hire a prime broker. Often from Morgan Stanley, Goldman Sachs or Bank of America, these prime brokers will provide the burgeoning hedge fund with the financial services that it requires, from lending money, executing trades and providing it with the capital to short stocks. Brokers will also help to capitalise on the success of the hedge fund by attracting potential investors, such as pension funds and insurance companies. Most hedge fund managers require between $15,000-$50,000 to initiate their hedge fund due to the high startup costs. The recent regulations and lower operating margins have drastically increased the starting costs and therefore the barriers to entry are extremely high.

The Types Of Hedge Funds

There are several hedge fund strategies that tend to fall into the following categories as either equity or fixed-income based.

  • Long-Short Funds: This includes hedge funds that take both long and short positions in securities with the aim of using superior stock picking strategies to outperform the market
  • Market-Neutral Funds: This is a sub-category of the aforementioned fund where managers attempt to hedge against market movements
  • Event Driven Funds: Making gains from market events (mergers and acquisitions, political turmoil or natural disasters)
  • Macro Funds: These funds take bets on the market performance and long-term economic trends based on the fund’s investment philosophy and their research.

The following are the general investment strategies that are commonly pursued by hedge funds.

  • Neutral: purchasing investments that are expected to go up, then offsetting the investment dollar-for-dollar by selling them on the overall market (e.g. one of the S&P 500 ETFs)
  • Equity: similar to the neutral strategy but instead you are shorting a portion of the portfolio
  • Global Macro: makes money from large economic trends (shorting interest rates, currencies, etc.)
  • Reduction In Volatility: buying low-volatility stocks while shorting high-volatility security

The Key Players In The Industry

Judging hedge funds by their total quantity of assets under management and the following are ranked as of January 2015.

  1. Bridgewater Associates
  2. J.P. Morgan Asset Management
  3. Och-Ziff Capital Management
  4. Brevan Howard Asset Management
  5. BlueCrest Capital Management
  6. BlackRock

Enter The High Rollers

One of the most infamous hedge funds of the 1980s was the Tiger Fund, headed by Julian Robertson, who started managing $8m of funds. By the time the Tiger Fund was at its peak performance, its net worth was $22bn. Robertson’s underlying hedge fund philosophy was:

“Our mandate is to find the the 200 best companies in the world and invest in them, and find the 200 worst companies in the world and go short on them. If the 200 best don’t do better than the 200 worst, you should probably be in another business.”

Despite the fame and fortunes associated with the management of hedge funds, the industry has seen repeated turmoil between the years of 1969-1970, 1973-1974, the late 1990s and the early 2000s. The sector was thrown into the media spotlight in the 1990s when “the man who broke the Bank of England” George Soros famously speculated against the pound joining the European Exchange Rate Mechanism.

Several high-profile hedge funds, such as the Tiger Fund, Long Term Capital Management and George Soros’ Quantum Fund collapsed in spectacular fashion. Hedge funds are once again coming under fire today, following thousands of closures and their microscopic success rate.

The Hedge Funds Of Today

After the financial crisis of ’08, regulators have clamped down on the activities of the dominant players in the hedge fund market. The US Securities and Exchange Commission (SEC) required that hedge fund managers register as investment advisors under the Investment Advisors Act of 1940. This requires them to hire compliance officers, keeping real-time performance records and a code of ethics.

Despite this, hedge funds have beaten the odds. The development of the “funds of funds” – which is simply a collection of mutual funds that invest in multiple hedge funds – provided greater diversification for investment portfolios and lowered the minimum investment threshold to $25,000. When the father of the hedge fund created his first investment machine, the industry was just managing a mere $100,000. By 2013, the industry recorded a record high of $2.4trn in assets under management.

 

Assets_Managed_By_Hedge_Funds_Worldwide_data_TMMChart.png

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The above chart highlights the increasing amount of assets under management since the dawn of hedge funds. However, it is the number of hedge funds that has increased, and hence the amount under management, but not the amount that each hedge fund itself has in its portfolio.

From Boom To Bust?

In 2006, hedge funds were known for their ‘2:20’ fee model, whereby portfolio managers were paid an annual fee of 2% of the investment and a 20% cut of any of the profits that were generated. This paid handsomely for portfolio managers during the periods of economic boom: George Soros is reportedly worth an estimated $24bn.

But hedge funds have suffered in a world of low interest rates since the financial crisis, with the Bank of England lowering the rate to 0.5% in 2009.

As of September 2016, US based Caxton Associates, Och-Ziff Capital Management and Tudor Investment have cut fees and charges. This year, hedge fund returns are weak. The average return was 2.6%, a long way from the 13% witnessed in 2006. As such, management has been forced to cut investors fees as they struggle to attract clients.

The average annual management fee now falls at around 1.39% of a client’s assets from 1.68% in 2006. Many hedge funds have drastically decreased their management under holding: Eurkeahedge has added $14.7bn in assets this year compared to the previous $108.7bn. Hedge funds are now underperforming in a direct comparison to their peers – 60% to the traditional mix of equities, and 40% to that of Treasury bonds.

Leading_Hedge_Funds_Worldwide_As_Of_2015_Net_Gains_In_US$bn_TMMChart

As of 2015, the largest gains in the industry were made during the 20th century. Furthermore, hedge funds have been susceptible to flash crashes in the markets. In 2010, the US Stock Market crashed, which saw the S&P 500, the Dow Jones Industrial Average and the Nasdaq composite lose $1trn. Flash crashes can also occur on an individual level: in 2012 Knight Capital Group lost $440m in 30 minutes during what has been described as “the mother of all computer crashes.”

This was four times its net income from 2011. One of the trading algorithms allegedly started pushing through rogue transactions on up to 150 stocks from Nokia to Berkshire Hathaway whereby they were being sold low and bought high.

Flash-Crash-Chart

The Debate On Hedge Fund Performance

Research from Barclays Strategic Consulting revealed the critical drivers of poor performance in hedge funds in recent years. They asked hedge fund managers what they felt were the key downfalls of the industry. 74% cited that the hedge fund industry had too many players relative to the opportunities and rewards available. The issue is not the size of the industry but the number of assets available. 5% believed that fees were too high, with others highlighting the changes in the macro climate (low-interest and growth rates) and changes in market behaviour.

There is a debate that if fund managers are paid in relation to how their assets perform, there is a tendency to gather as many assets as possible and hold onto them indefinitely. This results in a market that is crowded by mega funds devoted to collecting money and tracking the indexes. When hedge funds underperform, they have been known to take huge risks in order to make up for the loss in returns, but this can lead to their quick demise.

The Monkey Test

In 2013, academic research conducted by Cass Business School released the results of ten million portfolio stocks picked at random 40 years ago, as if by monkeys, and these performed better than those picked by money managers themselves.

The tracker fund was weighted against their share of the market. The research concluded that an index could be based on the size of the dividends instead paid by the companies, i.e. the value of a companies assets if they were sold or declared bankrupt. These measures are not inflated by the market, unlike market capitalisation values.

Are We Witnessing The Death Of Hedge Funds?

Hedge funds are actively managed. While actively managed funds saw a $147m withdrawal in 2015 passively managed funds saw a huge deposit of $365bn in net inflows. Passive investing is a strategy by which funds aim to maximise returns over a long period by keeping the buying and selling to a minimum. They achieve the same returns as a particular index e.g. the S&P index.

There are two types of passive investing: passive ETFs track index funds and passive income. These funds charge a smaller fee which removes the conflict of interest that portfolio managers face between high fees and returns. For instance, Vanguard’s S&P 500 index charges five basis points or $50 on every $10,000 under management. Bank of America analysts predict that this trend will continue in the foreseeable future, which therefore presents a considerable threat to hedge fund assets under management.

As of the beginning of 2016, passive funds represent one-third of the investment industry. But there is a way for the active managers to consolidate their superior market share – hedge funds must outperform on their benchmarks which differ from the passive investors. This requires outperforming on growth stocks, and lesser quality stocks on the S&P common stocks ranking.

The industry is facing severe macro challenges and industry disruption from Fintech. Robo-advisors are simply technology-backed advisors who replicate activities performed by the Registered Investment Advisors. It will need to remake its fee model and generate increased returns in order to survive the changing climate. But 2016 has been the year to short political changes, and 2017 could present some new opportunities within this type of active management.

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