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How Hedge Funds Will Fare in Next Big Crash

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Agecroft Partners is a hedge fund consulting and marketing firm, and as such has to keep its eye on the crystal ball.

With that in mind, Donald Steinbrugge, the firm’s founder and managing partner, has looked at how the industry would fare in the event of a market decline like that of 2008 sell-off.

He notes in a written statement that mainstream media were full of negative commentary about hedge funds when asset prices declined and volatility spiked from mid-September to mid-October.

Steinbrugge doesn’t expect a 2008-type sell-off in the near future. But what if?

The outcome for the hedge fund industry would be very different, he writes.

Changed Industry

The makeup of the hedge fund investor base changed dramatically since 2008 as pension funds — stable and long-term investors — have been significant allocators to the sector. According to Steinbrugge, “this trend could actually be enhanced by a market decline as pension funds strive to reduce their unfunded liability by enhancing returns and reducing downside volatility.”

In addition, endowments and foundations, major redeemers after the 2008 market correction, have repositioned their portfolios to better withstand liquidity events.

Steinbrugge explains that it was common practice for these investors to overallocate to private equity in order to maintain a targeted allocation. This became a big problem in 2008, when capital calls increased while return of capital stopped.

Now, he writes, most liquidity issues have been resolved, and endowments and foundations will be much more active allocators to hedge funds in the event of a similar selloff.

Finally, the fund-of-funds segment has become more stable. They are using less leverage, and their investors are better informed about the products they are buying.

Another big difference today is that hedge fund investors and managers are using significantly less leverage than in 2008 when highly leveraged funds of funds closed, suffered huge withdrawals or saw lenders reduce their leverage. This in turn led to significant redemptions from the underlying hedge funds.

Today, individual hedge funds use less leverage, which should help their performance in a down market and reduce the amount of withdrawals, Steinbrugge writes.

Further, hedge funds’ liquidity terms and underlying investments have become better aligned. In 2008, a mismatch in a fund’s liquidity terms  — often monthly or quarterly — and its underlying investments worked well as long as the fund experienced positive flows.

But with the large redemptions at the end of 2008, many funds raised gates and suspended redemptions. This hurt liquid strategies “by turning them into ATM machines for many investors who needed liquidity,” Steinbrugge says.

Since then, investors have been more willing to accept longer lock-up provisions for less liquid strategies, and have avoided funds with mismatches in liquidity terms, Steinbrugge says. “We should see significantly less use of gates and suspension of redemptions in the future.”

If Bernie Madoff’s fraud had any positive aspect, it was to bolster the due diligence process of many investors to reduce the probability of a future fraud. Today, according to Steinbrugge, investors focus intensively on transparency, operational due diligence and the quality of service providers.

What Are the Alternatives?

Investors are not redeeming out of hedge funds, despite the recent spike in volatility of the capital markets, Steinbrugge writes. This is because of a lack of investment as money market funds are yielding close to zero and generating a negative real return and the 10-year U.S. treasury is yielding approximately 2.5% and could sustain a large market value decline if interest rates rise.

Institutional investors view hedge funds as more attractive if they are concerned about a market sell-off, Steinbrugge says. In addition, once the market actually does sell off, investors’ emotional response is the market can always go lower, which again makes hedge funds look attractive. Steinbrugge expects any future market sell-off to create winner and loser hedge fund organizations. The industry net flow will hold up better in the event of a major sell-off, but each individual firm will fare differently.

Instead of assets leaving the industry, they will rotate within it. How each firm does will depend significantly on several factors.

One is investment strategy. Hedge fund strategies come in and out of favor, and large market sell-offs tend to be a catalyst for major changes in the relative demand for various strategies. This happened after the 2008 sell-off, and is likely to happen after any future one, Steinbrugge says.

Another factor is how the fund performed relative to its peers. Volatile markets cause significant deviations in performance across mangers in similar strategies.

Those managers that significantly underperform their peers will experience larger withdrawals than those that successfully navigate through the difficult markets by better protecting their investors’ capital.

Finally, a fund’s success will depend on the degree to which its performance meet investors’ expectations, according to Steinbrugge.

“Hedge fund managers that have been truthful with their investors, done a good job of educating their investors on their investment process, along with how it does in different market environments, and treated their investors fairly relative to gates and other restrictions of liquidity will have a much easier time holding on to their investors.”

— Check out 3 Reasons to Go From Hedge to Mutual Fund on ThinkAdvisor.