There was a ton of chatter about the hedge fund industry in the past week from both well-known hedge fund managers and the asset allocators who invest with them. A sampling:
- The CIO of the NY state pension says HF fees are unfair.
- Larry Robbins says that HFs have been hit by waves of fear, uncertainty and doubt.
- The CalSTRS CIO says the 2&20 model is dead.
- Steve Cohen is blown away by the lack of talent in the HF industry.
- Dan Loeb says industry performance has been catastrophic and that the industry is in the first inning of a washout.
- Bill Ackman says capital will flow to those funds that can justify the fees they charge.
These soundbites make it seem like an industry that’s in a state of flux. In some ways it is, but people are also jumping to conclusions. Here are my thoughts on the future of the hedge fund industry:
1. The big funds will continue to get bigger. A few years ago I contacted Ray Dalio’s Bridgewater Associates, the behemoth hedge fund that manages something like $150 billion. They told me they didn’t bring on any new investors with funds under $5 billion in AUM. Small funds need not apply.
There are ~10,000 hedge funds managing over $3 trillion in assets, but the top 10% or so manage around 90% of the assets. These large firms with long track records, huge back office support and all the bells and whistles institutional investors seek out will likely continue to attract the most investor capital. It’s the new “no one ever got fired for buying IBM.”
One of the reasons I feel so many big name hedge fund managers are sounding the alarm on the industry is because they’re trying to herd investors who are unhappy into their funds (it will probably work too).
2. But small funds will perform better. As the more established players continue to grow, their performance will suffer in most cases and many will look to diversify their product lines or go public to keep growing. Smaller hedge funds who have a harder time attracting capital will have to give investors better terms on their fees and liquidity provisions.
This is the space that will produce the best results, but there will obviously be a huge disparity in the returns because of the large number of funds. Seed investing in this space is a tough game, but that’s where the real alpha will lurk.
3. Assets will continue to grow. The media likes to predict the end of the hedge fund industry when pension fund managers make comments about leaving the industry for good (something CalPERS did in recent years). What most fail to realize is that most pensions have a very tiny allocation to hedge funds in relation to other institutional investors. For instance, CalSTRS has just a 1.7% target allocation to hedge funds in their portfolio. It’s still billions of dollars, but small in the grand scheme of things.
Pensions will act as something of a last-in, first-out player in hedge fund land. Most don’t have a large enough weighting for it to make a difference anyways. Foundations and endowments have been in the space much longer and have much larger allocations. The average foundation or endowment over $1 billion has 57% of their portfolio in alternatives. These funds don’t just make wholesale changes to their portfolios.
Contrary to popular belief, I actually see the use of hedge funds increasing in most cases, even from those investors who have seen subpar performance.
4. Investors will get interested in hedge funds again following a bear market. There will always be funds that perform well during bear markets. Investors will surely gravitate towards those funds after the fact. Never underestimate the power of a chase for performance.
5. Hedge fund replications will eventually gain a stronghold. I can’t believe more money managers haven’t followed in the footsteps of Cliff Asness to replicate hedge fund strategies using a lower cost, more liquid, quantitative approach. His firm AQR manages more than $150 billion in both hedge fund and mutual fund structures and they are one of the few that do it well. One would think pensions would particularly like this style of alternative investing.
Other firms will likely follow a similar path to gain assets. Many of these strategies are now well documented and it makes no sense to pay alpha-like fees for beta-like strategies that are now easier than ever to duplicate.
6. The reclusive hedge fund manager is a thing of the past. In the past hedge fund managers were reclusive. They didn’t want to be rock stars. They just wanted to put their heads down, go about their business and make a ton of money. And it wasn’t even about the money in most cases, it was about the game of beating the market and their competitors.
Now these guys are on CNBC and Bloomberg all the time. They do conferences talking about their best ideas. It’s easier than ever to gain access to their quarterly letters and investment ideas. Many hedge fund managers want to be celebrities now. My guess is this means more high profile flame outs.
This is all just one man’s opinion based on what I’ve seen and experienced. I don’t expect to see changes happen very quickly in this space because large investors never make decisions lightly and they always take a long time to move. And hedge funds will continue to charge premium fees for as long as investors are willing to pay them.
Many investors would like to see things change in a hurry but it can be tough to overcome the attitude of ‘this is how we’ve always done it.’ Maybe hedge funds should be at an inflection point, but my guess is it will take time for changes to occur in the industry.
Why People Invest in Hedge Funds
And now here’s the stuff I’ve been reading lately:
- Buffett’s lessons for systematic value investors (Alpha Architect)
- Financial gaslighting (Above the Market)
- Wonderful worlds that never existed (Motley Fool)
- Index investing makes markets & economies more efficient (Philosophical Economics)
- The worst bear market nobody ever talks about (Irrelevant Investor)
- Getting to know Mr. Market (Cordant)
- How to differentiate yourself to prospects (Kitces)
- When fringe sentiment dominates psychology (Big Picture)
- A victim of its own success (Reformed Broker)
- The high cost of high expected returns (The Thought Factory)
- Awesome graduation speech from Michael Bloomberg (Bloomberg)
- I was Prince’s personal chef (Food and Wine)