For the past few years we have listened to many in the hedge fund industry bemoan the difficulties of achieving gains in a bull market. Others argued that the lack of volatility was a significant obstacle to traditional hedge fund strategies.
While no official end to the bull market has been declared, the upward trajectory of stock prices has flattened or declined. At the same time, we have seen some of the greatest market volatility in 2018 than has been witnessed at any time since the financial crisis, yet the HFR hedge fund weighted composite index has only mustered year-to-date gains of 0.81 percent. This, after suffering a 0.46 decline in June…arguably a month that saw high levels of volatility and pullback, both of which should have engendered favorable hedge fund returns, based upon the industry’s previous arguments.
Why Invest in Hedge Funds?
One might reasonably ask why hedge funds continue to enjoy favor among investors? The answer to this question is complex but rational. First, one must look beyond the current state of affairs. For example, the HFR fund weighted composite index reveals net gains of 5,7 percent over the past I year and 11.33 percent over the past 3 years. Investors in hedge funds are not day traders.
Second, large investors, such as pensions and endowments, do not utilize hedge funds as their sole investment, but rather as a portion of an overall investment strategy. Third, the HFR fund weighted composite index reflects the industry as a whole and ignores individual funds that are achieving out sized gains relative to their peers. In short, many investors are experiencing outstanding results.
Finally, large investors are often more concerned with capital preservation than they are with out sized gains. Consequently, they are willing to accept smaller gains as a trade-off for higher risks of loss. For many such investors, the aftermath of the financial crisis looms large in their collective consciousness.
Many argue that the high management fees, averaging 1.56 percent according to Prequin, may be acting as a disincentive, because the largest funds can do quite well on management fees alone, regardless of performance. This is not a plausible rationale, as only the most short-sighted of hedge fund managers would employ such a strategy. Nonetheless, this argument holds sway with many investors and has certainly created pressure on the two and twenty model.
On the Horizon
There is a significant initiative on the horizon that holds the promise of injecting new blood into the hedge fund industry and that is the Federal Reserve’s proposed rewrite of the Volcker Rule.
If the changes survive public comment and move forward, hedge funds will benefit from a relaxation in the rules which prevent banks from investing in hedge and other private funds.
This has tremendous potential to increase hedge fund assets under management. However, the current aggregate level of hedge fund performance must be increased to make the most of this rule change. Consequently, the hedge fund industry as a whole, needs to up its game and posture itself to attract such investment. If hedge funds need an incentive beyond management and performance fees…this is it.