The hedge fund industry has experienced an incessant yet rocky growth in size since the turn of the century, having increased the proportion of assets under management from hundreds of billions in the early 2000s to over $3.5trn as of 2017. Nevertheless, the standard Alpha centred investment structures no longer seem to be able to satisfy investors’ demands. Are they truly worth it?
MiFID II Versus AIMFD
Since the inception of MiFID II in early January 2018, some fund managers looked to part from the expensive licence in favour of the easier to comply AIMFD to shield against a number of expensive obligations entailed by the former. The panorama, especially for hedge funds operating in Europe, has indeed changed as of late and the need to offer conspicuous returns is put to the test. For instance, major hedge funds favoured speculative subordinate debt transactions on Italian mid-tier banks, driven by motives of the country’s credit recovery policy as well as eurozone interest rates rises in 2019. The question to be asked however is simple: if equity indexes such as the S&P 500 and Nasdaq produced annual returns of 19% and 28% respectively in 2017, why should high-net-worth individuals and institutional investors place capital in riskier and less transparent vehicles?
The latter choice is aggravated by the conditions concerning the lower 8.5% yield which the hedge fund industry offered in the same year, despite it being its best performing one since 2013.
A Toronto based investment consultancy firm, conducted a study which compared the returns from a selected pool of hedge funds against simple benchmarks, combining both equity and debt indexes. Interestingly, it was found that the open-ended vehicles revealed an average underperformance of 127 basis point over the last 16 years.
Some Advantages of Hedge Funds
“Beware of little expenses, a small leak will sink a great ship”
The traditional ‘2 and 20’ fee structure appears to be the factor to blame for the missed basis points as investors end up with Beta style and closer to market average returns rather than the desired abnormal Alpha rates. Adding fuel to the fire, it was found that investors firmly believe their premium payments are justified by the fund managers’ superior market capability of exploiting ‘active’ strategies, while in some cases their interests revolve around building the volume of assets within the fund itself.
It is common knowledge that hedge funds are effectively able to borrow both cash for ‘long’ positions and securities to ‘short-sell’ in the process of trade execution. However, the latter strategy seems to be the ultimate incentive which attracts investors. Using leverage, hedge funds promise enhanced returns, yet by definition the former strategy is also a double-edged sword capable of magnifying losses and wiping out accounts. In the UK, the FCA uncovered in 2015 that hedge funds on average have an astonishing 27x ‘synthetic leverage’, often obtained from prime brokers through margin financing. Conversely, the latter group of service providers, according to recently obtained data, seems to be performing at its highest, with revenues from bulge bracket investment banks soaring a 20% rise in the first quarter of 2018 due to their prime brokerage divisions.
There is no clear bottom line on such complex facets characterising the industry. However, events seem to be one-sided at times, whereas finance providers benefit from healthy returns and the investors’ opportunity cost may be forgone.
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