From the August 2016 issue of Investment Advisor • Subscribe!

The Death of Hedge Funds?

Hedge funds have struggled over the last few years as fee compression puts pressure on managers

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Hedge funds will have their day again, Altegris chief Rivkin says. Hedge funds will have their day again, Altegris chief Rivkin says.

We have seem claims of “the death of hedge funds” on a few blog posts and comments from some well-known participants acknowledging performance and structural issues. However, don't hang the black crepe for hedge funds yet.

Yes, it's been a tough time for the industry. The average hedge fund performance has been disappointing during this bull market, compared to the S&P 500. The HFRI Fund Weighted Composite Index has generated an annualized gain of just 1.7% over the past five years. The S&P 500's average annualized return for the same period was 11%. Investors are pulling more money out of hedge funds than they’re putting in — something that hasn't happened since 2009, according to Hedge Fund Research, which found more hedge funds are closing shop than opening up. However, Preqin reported in April that hedge fund assets topped $3 trillion in the first quarter, with outflows representing less than 2% of the total.

The big issue for observers is defining a real hedge fund as opposed to a highly correlated leveraged fund, or funds that run large net long positions versus true hedging. More significantly, there continues to be pressure on fees. Many liquid alternative hedge funds have flat fees without a performance carry. Technology is allowing a replication of some hedge fund strategies with even lower fees.

Furthermore, institutions are pushing back on the traditional 2-and-20 fee structure with some success. Performance that beats similar low fee structures will be able to push for higher fee structures. However, those funds are few and far between.

Those in the hedge fund industry (and to some extent, the private equity industry) have Alfred Winslow Jones to thank for the 20% incentive fee structure (he didn't believe in management fees, according to a 2004 profile of his firm in Barron's). Founded in 1949, A.W. Jones & Co. is considered the first modern hedge fund. Using what today might be called a factor-based model, combining elements of leverage and shorting, and running a “neutral” portfolio with as many stocks short as long, Jones created a structure of receiving 20% of the profits. He borrowed this structure from the old-time merchant sea captains who took 20% of a successful trip's profits. Somehow, the 20% performance fee became the norm, with the asset-based “management fee” coming into play later.

As a new analyst, I had the opportunity to call on A.W. Jones in the late ’60s. That was a requirement of young analysts at Mitchell Hutchins, where the idea was to test one's self with the best money managers. This was a time when true analytical work could make a difference. Regulation and technology have changed much of that. As a result, investment strategies today must use a different approach and a different cost structure to meet investors’ needs for risk control and uncorrelated strategies.

The less liquid the strategies used to incorporate direct involvement in investment structuring and continued engagement with corporate management, the more likely a performance fee structure makes sense. However, for most hedge fund strategies, fee compression is the big risk. One has to do real work to determine the value add from a hedge fund manager and the risk control and investment process that is being implemented. Real monitoring of the process is required.

I believe we will continue to have a big hedge fund industry, particularly as we move through the remainder of this decade and maybe beyond with low global growth and likely low interest rates. When we get into slow growth periods, room for accidents and spikes in volatility remains high. This calls for running a diversified portfolio incorporating less-correlated strategies, determining the true amount of illiquidity that one can accept in order to take advantage of time arbitrage and avoid the liquidity trap that I wrote about in my previous column, and picking up the premium from true active management of assets.

The current period of central banks pulling growth forward through excess liquidity will come to an end. When it does, hedge funds, private equity firms and active managers will potentially have their day. They will make use of many of the old tools, but some new Moore's Law-driven tools as well. The world is changing, but there will be a slow death of the structure and economics of various investment tools we currently have at our disposal. Fresh looks at how one is investing continues to be a major requirement of investment advisors.

--- Read Bob Doll Judges His 10 Predictions for 2016 on ThinkAdvisor.

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