The deflating effects of underperformance and overregulation
Warren Buffet’s wager with Protégé Partners epitomizes the gloom hovering over the hedge fund industry. In 2008, the Oracle of Omaha bet the New York-based fund-of-funds $1 million that index funds would outperform hedge funds over the next 10 years. Six years in and 313 basis points up1, Buffet now looks unbeatable.
For the sixth year in a row, hedge funds have underperformed the stock market by a wide margin (3% versus 12.3% to date). While there are always some funds that knock the cover off the ball like the good old days, the star managers are not the same from year to year and most hedge funds fall well short of their benchmarks.
Presumably, institutional allocators prefer to play it safe with the tried and true, but, in doing so, may be bringing down overall industry averages.
Making matters even worse for hedge funds generally is that most of the new capital flowing into the industry is coming from institutions rather than wealthy individuals and is going mostly to the marquee names2 rather than the newer and nimbler funds that have historically posted more impressive gains. Presumably, institutional allocators prefer to play it safe with the tried and true, but, in doing so, may be bringing down overall industry averages.
Punctuating the industry’s disappointing performance was CalPERS’ recent decision to completely liquidate its $4 billion hedge fund portfolio. Even though CalPERS’ announcement did not immediately trigger a run on hedge funds by public pension plans, it undoubtedly jolted the industry into realizing that its elevated fees and complex investment strategies could alienate other major investors if its overall performance does not pick up.
When hedge funds were generating momentous double-digit returns — and before the Bernie Madoff and Stevie Cohen scandals — investors accepted their 2&20 fee structure, investment opacity and illiquidity. But underperformance and loose controls have driven big institutional investors to pressure hedge fund managers on management fees, infrastructure and compliance. Some large investors are even calling on managers to precondition their performance fees on meeting market benchmarks (just like in private equity) and to strengthen their boards of directors. Neither of those reforms was in the air just a few years ago.
That rebalancing of internal priorities cannot help but have a depressing effect on investment creativity and staff morale. In hedge funds’ heyday, front offices reigned supreme.
Since Dodd-Frank required their registration with the SEC in 2012, hedge funds have had to report voluminous amounts of information about themselves to both the agency and the public on an ongoing basis.3 Collecting and aggregating all that data requires robust back offices (whether in-house or outsourced) which now compete with hedge fund front offices for the attention of management. That rebalancing of internal priorities cannot help but have a depressing effect on investment creativity and staff morale. In hedge funds’ heyday, front offices reigned supreme. That’s how we got SAC Capital.
The most telling indication of the depression into which the hedge fund industry has fallen is its own reaction to underperforming the bull market. The industry now meekly promotes itself as a source of uncorrelated returns and downside protection in bear markets. Whatever happened to outsize returns, superior risk-adjusted returns or even absolute returns? They’re gone (at least for now), along with the industry’s erstwhile cachet.
What prompted this post is a pitch I heard the other day from Northern Trust Company. NTC is offering shadow administrative services for hedge funds. Not so long ago, hedge funds administered their own data because they didn’t want anyone else to know what they were doing. Post-Madoff, however, they lost their autonomy with regard to their control of data, custody of assets and execution of trades. Big investors demanded that hedge funds engage independent third-parties to verify and evaluate their positions and returns. According to NTC, many of those same investors have now decided that one level of independent oversight of hedge funds is not enough and someone trustworthy should be looking over the shoulders of their third-party administrators. In other words, fourth-party administrators!
No wonder hedge funds are now shutting down at a rate not seen since the financial crisis.4 It simply costs too much for new funds to build the infrastructure needed to attract institutional money, and even those funds capable of doing so may still not get the new capital anyway if their performance is less than stellar or turns out to be a flash in the pan.
1 The S&P 500 is up 43.8% over the six-year period and the HFR index is up just 12.5% (net of fees).
2 In the first half of 2014, 10 elite firms (such as Citadel and Millennium) accounted for about a third of the $57 billion that came into the industry.
3 Funds that market in the EU now also have extensive reporting obligations under the AIFMD.
4 According to HFR, 461 hedge funds closed during the first half of this year putting 2014 on pace to become the worst year for hedge fund liquidations since 2009 when 1,023 hedge funds bit the dust.