From the February 2017 issue of Investment Advisor • Subscribe!

Hedge Funds Have Grown Up, for Good and for Bad

After 10 years, hedge funds are still a mixed bag of opportunity and risk

Did you know? You can earn continuing education credits by answering questions about this article.

Start earning credits
Hedge funds have evolved, but they're still not for everyone. Hedge funds have evolved, but they're still not for everyone.

A decade ago, two business school graduates founded a hedge fund with a $15 million portfolio, with seed money from family and friends. A top Wall Street hedge fund manager investor gave them desks and back office support. The young managers invested in complex, under-the-radar opportunities over the next few years. The fund's good performance attracted savvy investors, culminating in an allocation from a university endowment.

Illustrative hedge fund start-up stories like this were thick on the ground 10 years ago. As 2017 opens, the hedge fund industry is radically changed, in good and bad ways. Here are four key changes that have benefited investors and four that have worked against them.

First, it's arguably easier to get basic information on most managers and their strategies in these once-elusive investment vehicles. Since 2012, most hedge fund managers with $150 million or more in assets under management have been required to register as investment advisors with the Securities and Exchange Commission. The agency's Investment Advisor Public Disclosure site provides access to considerable information, including the names of the managers, addresses, telephone numbers, investment strategies and assets under management — information that used to be largely the domain of consultants and funds of funds.

On the flipside, even more information might have been accessible if the Jumpstart Our Business Startups (JOBS) Act of 2012 had gained any meaningful traction with respect to hedge funds. The act relaxes a long-standing ban on general solicitation and advertising by various privately offered investment opportunities, including hedge funds (but only if certain conditions are met).

Although the JOBS Act allowed meaningful new pathways to asset raising in other sectors (e.g., crowdfunding), the conditions to be met to take advantage of the new opportunity present operational and compliance challenges within existing distribution networks. Few hedge funds to date have taken advantage of the new opportunity to publicly advertise their wares.

Second, I believe the compensation model has improved. A decade ago, hedge funds typically offered investors a Hobson's Choice; pay a 2% management fee and a 20% performance fee — or scat. Pressure from billion-dollar pension funds and other institutional investors has challenged the “heads I win, tails you lose” approach. Some hedge funds are offering lower fees offered for longer lock-ups and reducing management fees as fund assets rise.

Still working against investors is the relative rarity of “claw backs,” where a share of past performance fees get returned to investors during periods when the hedge fund loses money.

A third way would-be hedge fund investors may have benefited is from a lower cost of admission to hedge fund strategies in the form of liquid alternative mutual funds, or “liquid alts.” These hybrids give investors access to hedge fund strategies at a lower barrier to entry (e.g., without minimum net worth or income requirements), and with the increased transparency and daily liquidity of a mutual fund.

Liquid alts were an immediate hit with investors, with assets doubling between 2011 and 2014, and peaking at $416 billion at the end of 2015, as tallied by Brian Haskin, founder of Los Angeles-based DailyAlts, an information and news source for the industry. By the end of 2016, however, assets had drifted down to $407 billion, a victim of poor performance and funds closing. Haskin foresees more of the same until there's a market correction.

(Related: Liquid Alts End So-So Year Up 2.3%)

“It's hard to compete with the rally in equities, but I think 2017 will bring opportunities for more volatility,” Haskin told a colleague.

Finally, whether they know it or not, people from all walks of life have been exposed to the expanding universe of hedge funds through pension funds and endowments. The corresponding downside — and the biggest problem facing hedge funds overall — is finding lucrative and non-correlated opportunities in which to invest the nearly $3 trillion of assets entrusted to their management, as reported by BarclayHedge Research.

--- Read Is Active Investing Really a ‘Loser’s Game?’ on ThinkAdvisor.

Reprints Discuss this story
We welcome your thoughts. Please allow time for your contribution to be approved and posted. Thank you.

Related

Hedge Funds’ 2016 Performance Reverses 2015 Loss

Event-driven funds lead all major strategies with an annual return of 10.2%.

Most Recent Videos

Video Library ››