The loss of liquidity and its impact on hedge fund performance.
Redemption issues and their impact on future practice.
Management challenges and sector performance.
The threat from alternatives to hedge funds.
How the crash changed the rules of the game.
The dilemma of a global regulator.
Victim Rather than Villain
The hedge fund sector has been vilified by some politicians, both in Europe and in the US, as if it were a significant contributor to the banking collapse and subsequent global recession. In reality, the hedge fund industry was very much a victim of the banks during the latter half of 2008, and there are some significant litigation actions pending, in which hedge funds are suing investment banks for alleged misdealings in their collateralized debt obligation (CDO) products and credit default swap (CDS) transactions.
However, potential misdealings aside, it is clear that the dreadful performance turned in by many hedge funds in 2008 was precipitated not just by stock market and property price collapses, but also by the total loss of liquidity in all risky markets, a direct consequence of the massive deleveraging by banks. At the same time as they were reducing the size of their balance sheets, numerous banks closed or drastically slimmed down their proprietary trading desks, leaving hedge funds with no bidders for any instrument that had any degree of complexity about it.
Adding insult to injury, many banks forcibly withdrew previously agreed lines of credit to hedge funds, forcing any hedge fund manager running a leveraged strategy to liquidate their positions as fast as possible. Finally, their clients, disappointed by the lack of “absolute returns” that they were implicitly promised by the hedge funds, became extremely nervous, and many decided to turn their investments back into cash, even though they often had nowhere to put the cash (as banks themselves posed a risk for any significant cash holding), and had no clear alternative investment strategy in sight.
The Impact of Redemptions
Faced with the perfect storm of poor performance and severe redemption pressure, hedge fund managers were forced to close funds or suspend redemptions, in order to protect values for those investors remaining with the fund. What the sector experienced during 2008, in other words, was less a performance issue, with strategies failing to work, than a bank run caused by their liquidity mismatch. Money that fund managers thought was “sticky money” (i.e., money that would stay with the fund for the medium term, and so give the fund’s investment strategy a chance to work) turned out to be “on demand” money that investors urgently wanted returned to them.
It did not appear to matter, in these circumstances, whether the hedge fund was invested in assets that the investors could expect to be highly liquid, such as equities or government bonds, or whether the fund had a very illiquid strategy, such as asset-based lending, where there was effectively no liquidity or secondary market for those loans. In the latter situation, if a significant proportion of the investors run for the exit at the same time, the fund management has very few options. They can either halt redemptions or run the risk of paying out all of the remaining liquidity at the expense of those opting to stay. Or they can simply liquidate the fund.
Management Challenges and Sector Performance
In reality, the way the hedge fund sector as a whole managed the difficult circumstances that characterized the second half of 2008 and the opening months of 2009 was highly commendable. As a generalization, portfolios were managed in a way that protected the interests of as many investors as possible. As a fund-of-funds manager, we were often on the phone to our hedge fund managers saying that, on behalf of our investors, we did not want the fund attempting to pay out all redemptions by liquidating the portfolio at fire-sale prices, as that hurts everyone. We wanted to see redemptions frozen and value preserved.
What the hedge fund sector has learned from this whole experience is that there is a definite price to pay for liquidity, or the lack of it. Investors clearly value the ability to convert their investment back into “cash at hand” in a reasonably short time frame. That ability has a significant value, so in future we will see that option priced into the contract between investor and fund. Moreover, for investment strategies that are largely liquid, the dealing terms will be forced to become more liquid to match the underlying instruments. As a consequence, we will see more monthly dealing hedge funds, with perhaps only a month’s notice or even less for withdrawals. We will also witness the continued development of many more daily dealing UCITS III type funds, trading in long-only and long-short strategies, in response to this new-found desire on the part of the investor community for highly liquid products. (The caveat to this, as we shall see in a moment, is that in the current investing environment, it is not clear that hedge fund managers have that much more added value to offer, even in this new format, versus passive investments such as an exchange-traded fund or ETF, where the units can be traded at any time, and where the unit charges are vastly lower than hedge fund fees.)
While the near-liquid funds move to highly liquid redemption terms, strategies that legitimately need a longer investment period to realize their returns, such as distressed debt and structured credit, will move their terms to something more akin to a private equity structure, with anywhere from a two-to-five-year lock-up, and no option for investors to get their money out early. The “middle ground,” which used to be comprised of hedge funds with 90-day exit clauses, but where the strategy was, in reality, rather more liquid that this conveys, will come under huge pressure to improve its liquidity terms. It will not be possible for managers to seek to hold assets just to control them; rather, they will have to match the liquidity terms of the clients to the liquidity terms of the assets. That will be a very significant change for the industry.
The Threat from Alternatives to Hedge Funds
The resolution of the liquidity mismatch is only one of a number of changes that the sector is going to have to deal with. Another challenge, which ironically arises naturally from the current dislocation of the markets, is that a large number of investment opportunities today do not require a hedge fund strategy to generate very acceptable levels of return. This is a point that is hard to overemphasize in terms of its potential impact on the sector—at its moment of maximum client distrust, the hedge fund industry must contend with the fact that many of the best returns available today may lie outside of their hedged strategies.
As an example, take the present dislocation in convertible bonds. An investor today can buy long-only convertible bonds, and be satisfied to simply earn the market beta (which is to say, the performance delivered by the market itself, rather than any outperformance, or alpha, delivered by the skill of the hedge fund manager). That beta has a very good chance of delivering a return on a mixed portfolio of investment-grade and high-yield bonds, in excess of 10–12%. Faced with those levels of expected return, there is little incentive for an investor to seek to gain another 3% by investing with a hedge fund manager promising 15% returns with the traditional hedge fund fee structure of 2/20 (2% management fee and 20% performance fee), but which also comes with all the liquidity, regulatory, and potential fraud risks that hedge fund investing entails. What this means is that it has become much more difficult for hedge fund managers to justify their alpha fee than it was in an era where market beta was delivering very low single-digit returns.
Two further areas of competition for hedge funds, apart from the fact that investors can build their own long-only portfolios with relative ease, come from ETFs, and from the synthetic hedge fund replicators now being offered by the likes of Goldman Sachs, State Street, and Merrill Lynch.
There is now a substantial body of research on hedge fund performance that suggests that about 80% of a hedge fund manager’s income stream can be attributed to “alternative beta” factors rather than to management skill. Alternative beta factors refers to market risk characteristics such as equity risk, term structure, credit risk, small cap equity, and emerging markets equity, as well as nonlinear returns such as trend-following strategies. It is now possible to replicate a significant part of hedge fund returns through investing in an appropriately designed futures, ETF and/or options strategy. As they are using liquid instruments as their building blocks, these replicators have no hedge fund fee structure associated with it, and provide complete liquidity, full transparency, no fraud risk, and the opportunity for investors to trade in and out as they require.
Of course, it is true that there are limits to how much of a good hedge fund manager’s strategy can be replicated in such structures, and the remaining 20% of manager alpha cannot be captured through these products. However, just as ETFs are taking market share from the actively managed long-only fund industry, I believe the hedge fund replicators now being developed by the former investment banks, among others, will attract sizeable flows of pension fund money that would, in the past, have gone directly into hedge funds.
How the Crash Changed the Rules
What all this amounts to is that, quite apart from the coming wave of regulation that hedge funds are going to have to deal with, the rules of the game have already changed as a result of the crash. While they were evolving anyway, as they do whenever an industry matures, the market meltdown of 2008 has definitely speeded up this process.
One such change we were seeing just before the crash was a convergence between the active managers in the long-only space, now that the UCITS III rules allow them to take short positions in some circumstances, and hedge funds. This has put a further strain on hedge fund fees, as investors are only willing to pay above-average fees if it gives them access to real investment skill that they cannot tap into at a lower fee structure. Asset allocators (funds of funds, pensions, endowments, etc.) are becoming much more skilled at separating their beta market exposure from their alpha (the value added brought through skill), putting real pressure on hedge fund managers to prove that what they are providing is not simply a leveraged market return. Sophisticated investors are quite capable of leveraging their own positions; they do not need a hedge fund manager to do that for them. So, if on careful analysis a hedge fund’s perceived outperformance over the relevant benchmark turns out to be simply a return due to leverage, then that is no longer going to be accepted as the creation of genuine alpha through investment skill.
It is now becoming quite widely recognized just how much the performance of some hedge fund strategies owed simply to leverage. However, ETFs have been created that are leveraged two to five times, which investors can access directly if they want leveraged plays, so that game by the hedge funds has gone. One must also recognize that leverage was a strategy for a buoyant market where liquidity and credit was cheap. Similarly, if the hedge fund strategy was based largely on short-selling, there are short-leveraged ETFs that investors can now use. Again, this is yet more pressure on hedge fund managers to demonstrate to investors just where their alpha performance comes from. Much has been said about the scalability or otherwise of hedge fund strategies. As successful hedge funds attract a flood of investor money, it inevitably pushes them towards a multi-strategy approach to be able to deploy a large amount of capital effectively. With real skill this can continue to be effective, so another dynamic in the market is that we see the larger, more established and institution-like hedge funds becoming multi-strategy funds, while at the same time the smaller, more niche funds, with assets under management of £100–250 million, are seeking to limit their growth. As managers are paid based on the amount of assets under management, remaining small takes real discipline, but the penalty for not doing so is poorer performance if you grow larger than the opportunity set in which you are investing.
As an added dynamic, there is tremendous pressure on politicians and regulators to “do something,” so more regulation now looks certain. However, the irony of this is that the market itself has forced hedge funds to become much more transparent and open, anyway. Following the Madoff fraud, no hedge fund manager can expect to operate an opaque structure on a “trust me” basis.
An International College of Regulators?
There are real dangers, however, lying in wait for regulators as they seek to move into the hedge fund space. What would the shape of such regulation look like? One view seems to be favoring the formation of an international college of regulators who would somehow have oversight across the highly complex investment strategies and positions of some 3,000–7,000 hedge funds around the world. The data requirements necessary to enable such oversight are absolutely huge. If one remembers that the individual investment banks themselves did not know or understand what was on their own balance sheets, and it took some of them many weeks with an army of staff to begin to put some numbers to their exposures, it is well-nigh impossible to see how a single regulatory body could have meaningful oversight of the risk exposures of the entire financial industry. And if it saw what it deemed to be too much risk, how would it address this? By sending a mass email to everyone saying “cut all X exposures by Y percent?” Or would they focus on just the largest funds, thereby giving smaller funds a competitive advantage in the market?
Any intervention by a global regulator would be likely to have a tremendous distorting effect in the market. As hedge fund managers live and breathe market distortions, gaming the regulator to produce distortions would become a very viable strategy in its own right. Political rhetoric is easy. Implementing meaningful regulation for a sector that has already become vastly more transparent to investors is much harder. Is the additional gain in transparency and stability that is being sought really worth the huge effort and expense that would be entailed, remembering that the current crisis was precipitated by loose credit standards and the bursting of an asset bubble, events in which hedge funds were only a minor player? These are questions regulators will have to ponder as they look to extend their sway over the hedge fund sector.