In the past five years, hedge funds have suffered a lot of unfair criticism and even open hostility. Mainly, hedge funds went from occupying a happy space in which managers employed niche trading strategies in sub-$500 million funds where liquidity wasn’t a problem, to $5 billion funds in which managers can’t trade a lot of small cap stocks or assets that aren’t already in deep liquid markets. In addition, managers used to be able to charge much lower management fees because operating costs were small, but operational costs have ballooned exponentially while management fees have gone down, making it nearly impossible for new players to enter, or for innovation to occur.
Investors want investment strategies to look like they did ten years ago (extremely liquid, with high returns and low fees) while simultaneously wanting todays funds to be uncorrelated and to look different from the funds invested in the commoditized strategies. Unfortunately, you can’t have both. The main problem with hedge funds is that the industry itself has changed significantly since the early 2000s, while investor expectations have remained the same: namely, static and therefore unrealistic.
How it Used to Be
I began my career in the early 2000’s investing in and later managing alternative assets. Around this time, a fund was considered large when it held around $500 million in AUM. These larger funds were primarily macro-strategy funds focused on trading in deep, liquid markets such as futures, government bonds, currencies, and equities. The primary investors in hedge funds were ultra-high net worth individuals and endowments, with large endowments beginning in the $10 billion range.
At that time, fees for hedge funds were typically a 2% management fee with a 20% incentive fee. Most of the 2% went to keeping the lights on and paying staff. Given the smaller size of these funds, not much was left over through management fees alone to pay for the new backyard pool. Therefore, profits were primarily made through performance fees. Regulatory and reporting burdens weren’t as grueling as they are now, which kept overall operating costs much lower. A launch of a $10 million fund was common, and operational break-even was achievable in just a couple of years.
Funds outperformed relative to today as they ran with a higher degree of risk (as measured by volatility) and had a high risk-free rate, keeping the wind at their backs and providing a wide range of dislocated sectors and mispriced assets. In addition, much lighter regulations on banks allowed easy leverage from prime brokers and further facilitated the low cost of running a fund.
Over the years, the number of assets under management (AUM) and the number of investing strategies have exploded. Now, investment strategies are developed around bonds, asset-backed securities (bonds backed by mortgages, and people’s credit card payments). Most trades are made by appointment or by brokers, so that markets have become semi-opaque. Settling a loan can take weeks, instead of minutes or a day. It’s become a completely different animal to simply trading stocks; a kitten that’s grown into a lion.
Today, people are investing in $35 billion funds, and endowments average $20-40 billion—it’s a completely different order of magnitude. Understandably, it’s now much more difficult for individuals to comprehend what’s going on underneath the hood in the investment world. While high-worth individuals and regional family wealth management offices are still involved, they’re outweighed by pensions like CalPers; sovereign wealth funds with $100 billion in assets.
When I was working at an endowment at the beginning of the millennium, our desired minimum check size was $30-50 million. By the time I left, that metric had grown to $70-100 million. Today, that institution manages almost three times the assets it had when I started there. I can only imagine that the minimum ticket size has grown to $100-150 million at the very least, and realistic allocations are more likely in the $250-350 million dollar range. Considering that this was the whole amount of a decent sized fund almost twenty years ago, it’s no wonder that expectations from hedge funds have not had time to catch up.
In addition, these amounts are dwarfed by the pension money that has come into the hedge fund arena over the last decade. Today, every fund manager is fighting for an allocation from larger institutions. These institutions often have gatekeepers whose job, rightly, is to protect them from taking unnecessary risks. Unfortunately, this often manifests itself in an extreme propensity to play it safe, and hyper-focusing on backward-looking data. With larger dollar amounts chasing the same anomalies, dislocations are smaller and get arbitraged away more quickly. Spreads that used to go from 2-10-2; might now go from 2-5-2, which has created distortions in investment methods and returns data.
All this has led to a dampening of returns, while increasing the breakeven operational costs of running a successful hedge fund. As mentioned above, startup costs twenty years ago used to be relatively low but the sharply rising costs of office space and utilities including employee salaries, research, a CFO, administrators, lawyers, and employee incentives have made the hedge funds of yesteryear a complete impossibility. Previously, the aggregate dollar amount of the 2% management fee managers charged covered operating expenses. Now, today’s compliance and reporting requirements as well as reduced management fees 1.5% make the price of entry prohibitive to emerging managers with smaller assets under management who don’t have large savings to fund operations while assets under management grow. In an environment in which investors are seeing lower returns and therefore demanding lower fees, it’s easy to see why the “model” feels broken to both investors and managers.
New Performance Benchmarks
Most would agree that smaller emerging managers tend to outperform larger more established ones, mainly because of their agility in exploiting opportunities that larger funds cannot. However, in order for a small manager to capture large family office or institutional investment dollars, the operational staff that needs to be in place on Day One is almost guaranteed to be prohibitively expensive. As a result, it forces funds to compromise on investment talent, and by forcing funds to take in large AUM growth right away, the higher yielding returns are pushed aside, and funds enter self-enforced doom spirals to satisfy investor demands for subscriptions and liquidity. You’ve lost before the race has even begun.
Due to competition from “liquid Alts” products and ETFs and mutual funds, hedge funds are forced to provide ever more frequent redemption periods, and due to the month-to-month timeframe under which most funds are operating, the time required for an investment thesis to yield its maximum return is no longer given any runway. As an investor, a high return year was lumpy, in a sense—one could see a month with little or negative returns, only to have a +20% month when an investment thesis was proven correct. Managers are no longer afforded enough time to develop a medium- or longer-term investment thesis and are not incentivized to have a large outperformance. Rather, they’re pushed to outperform some arbitrary benchmark with consistent month-over-month returns.
In order for hedge funds to be considered alternative investments, they cannot be lumped into the same product category as mutual funds. With mutual funds beginning to launch long/short strategies and including private debt and equity, this will only lead to further fee compression and reduced returns. In addition, investors who want investments that are liquid enough for everyone to pour their money into while still remaining uncorrelated to everything else when the market goes down? You can’t have your cake and eat it too.
I’ve ascertained five points of interest from watching things unfold from the sidelines:
There are a lot more opportunities and inefficiencies to exploit at smaller dollar values.
As more money is invested in a strategy; spreads (and therefore returns) compress. Incidentally, convertible arbitrage, which was one of the most popular strategies used when I began my career in the early 2000s, is now almost non-existent as a standalone strategy/fund.
Market volatility leads to opportunities. Given the agility of funds to recognize a mispricing and enter and exit an investment, capturing a fluctuation in spreads or the normalization of pricing should be encouraged rather than the opposite.
A dampening of market volatility has had a detrimental effect on returns and has created a market with large fat tail risks, or idiosyncratic ones that are difficult to hedge or are prohibitively expensive. As a result, the decline in return in spread trades has led to the need for funds to add more strategies with directional risk to their portfolios.
Operational costs have gone up exponentially. Funds are facing rising regulatory, compliance, and legal requirements. Large institutional clients require far more diligence and therefore the cost of obtaining a large check continues to increase.
Investors are like babies: they want everything. But instead of stymying or vilifying methods or funds that don’t live up to their demands, they need to revise their expectations in order to enter into true partnership with their managers; setting more reasonable forecasts and gaining a more thorough understanding of the investment strategies managers are using.
It’s important not to forget that hedge funds are businesses that have to hire staff and invest in infrastructure to be good stewards of their investors’ capital. It generally takes three years to get a hedge fund up, running, and stable. If investors want high returns, they have to be willing to accept down months and a little more volatility, in order to make money on the upside. This has always been a marathon, not a sprint.
Advice for Investors
As long as rates stay in the low single digits, the era of uncorrelated +20% returns seems to be coming to an end for the industry as a whole (between low trading volumes and low interest rates, you’re highly unlikely to make 20% returns). There will always be a few small outliers and quantitative funds that produce large returns, but with so many fund managers chasing the same ideas, the returns will continue to dampen in favor of more mutual fund/index-like returns. Instead, I would argue that ultra-high net worth individuals, family offices, and smaller endowments should invest in smaller managers, away from the mainstream hedge fund strategies, and lock up capacity for undifferentiated lower liquidity strategies to generate higher returns.
LEGAL INFORMATION AND DISCLOSURES
This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Terra Incognita has no duty or obligation to update the information contained herein. Further, Terra Incognita makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Terra incognita Capital, LLC (“Terra Incognita”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Terra Incognita Capital LLC.
©2022 Terra Incognita Capital LLC