Global investors redeemed $33 billion from hedge funds during the first quarter, a loss of 1% of industry assets.
And according to a recent paper written by Donald Steinbrugge, chief executive of Agecroft Partners, withdrawals are likely to continue during the second quarter because of how hedge fund liquidity provisions are structured — typically either monthly or quarterly liquidity with a 30- or 90-day notice.
At the same time, Steinbrugge expects hedge fund net flows to hold up much better than they did during the 2008 financial crisis.
“As a percent of industry assets, this [1%] was a very small amount of redemptions considering the markets just experienced one of the worst sell-offs in the past century. In comparison, the third quarter of 2008 catalyzed a 12-month period in which 16% of industry assets were redeemed.”
Steinbrugge argues in the paper that the hedge fund sector has evolved and adapted since then, and is now much better positioned to withstand market turbulence. Here’s what he has observed.
Before 2009, many hedge fund and fund-of-funds managers pitched their strategies as generating absolute returns with a benchmark of T-bills plus 400 basis points. Investors thus expected hedge funds to generate positive returns regardless of market direction, and so were stunned when the average hedge fund lost some 18% in 2008. Massive withdrawals ensued.
Investors’ reaction was much different during the first quarter because managers had done a better job of educating them about their investment process and how their fund was likely to perform in various market environments. According to Steinbrugge, most investors today understand that a lot of strategies are positively correlated to capital markets, and so were satisfied with how their hedge fund portfolios performed.
Due Diligence and Transparency
Before 2009, investors’ operational due diligence on hedge funds tended to be cursory at best, and their hedge fund selections were often made quickly. For their part, many hedge fund managers offered little transparency about how their investment process worked or what positions were in the portfolio.
Trust was key; verification was not.
Two destabilizing events changed that. One, the Bernie Madoff fraud exposed the weakness of funds of funds’ due diligence process, a key reason investors hired them. Because of their poor due diligence on their managers and managers’ lack of transparency, investors wonder what other frauds the industry might be hiding. This in turn led to a temporary loss of confidence in the industry, resulting in more redemptions and reductions in allocations.
Two, hedge funds discovered that it mattered how their assets were custodied with prime brokerage firms following the Lehman failure. According to Steinbrugge, some hedge fund assets were held in the name of the prime brokers as hypothecated assets. Prime brokers used these hypothecated assets to lend to other funds for leveraged purchases, and to support the borrowing of stock for funds to short equities.
“Unfortunately, some of these funds were considered general obligations of the brokerage firm, and in the case of Lehman, assets custodied out of their London office had to get in line with other creditors in order to try to get their money back.”
Today, most investors have a greater focus on transparency, both of positions and investment process, operational due diligence (including a focus on how the assets are custodied at prime brokers) and the quality of service providers, according to Steinbrugge. This has given them greater confidence in their managers during periods of distress.
Use of Leverage
In 2008, numerous hedge fund investors — and especially big funds of funds — used leverage to enhance their returns, in part driven by positive performance expectations of a diversified hedge fund portfolio. The 2008 correction not only increased these funds of funds’ losses, but also led to their loans being called, which forced them to redeem from their underlying managers to repay the loans.
These redemptions of their underlying managers were then magnified when a majority of their investors also redeemed from their fund of funds. As a result, highly leveraged funds of funds either went out of business, suffered heavy withdrawals, or had their leverage reduced by their lenders.
Today, Steinbrugge says, funds of funds and other investors use much less leverage.
Evolved Investor Base
In 2008, high-net-worth individuals and families and funds of funds dominated the hedge fund investor base — and were considered “fast money.”
Today, pension funds are responsible for a significant percentage of positive net flows into the industry, and along with other institutional investors represent a majority of the industry’s assets. And the quality of each investor group has improved over the past 12 years.
Steinbrugge cites endowments and foundations, which were criticized for their redemptions after the 2008 market correction. Since then, these investors have repositioned their portfolios to better withstand “liquidity” events.
These liquidity issues were mainly driven by the private equity portion of their portfolios in that it was common practice to over-allocate to private equity in order to maintain a targeted allocation, which caused significant issues when capital calls increased while return of capital came to a halt.
Most of these liquidity issues have now been resolved, Steinbrugge says. Funds of funds have experienced the biggest transformation, having become much more stable by improving their due diligence processes on hedge fund investments, using less leverage and better educating for investors on what to expect during different market conditions.
Lack of Good Investment Alternatives
Steinbrugge writes that after the 2008 market selloff, the capital markets traded at significant discounts to intrinsic value, providing investors with sundry opportunities in traditional investments outside of hedge funds.
Today, he says, many markets have recovered a large percentage of first-quarter losses following massive, globally coordinated government stimulus, and are now viewed as potentially overvalued, leaving a lack of investment alternatives for investors.
Money market funds are yielding close to zero and generating a negative real return. The 10-year U.S. Treasury is yielding less than 1% and could sustain a large market value decline if interest rates rise. And many investors are fully allocated to equities and concerned there could be further selloffs.
Steinbrugge says this dynamic could increase asset allocation to the hedge fund industry. He notes, for example, that pension funds need to generate a return equal to their actuarial assumptions, typically in the 7% to 7.5% range. This is difficult to achieve when the fixed income portion of their portfolio is yielding around 1%.
Steinbrugge expects hedge fund industry net flows to hold up much better in 2020 than they did in 2008, but the effect on individual firms will vary considerably. “We expect a large rotation of asset flows within the industry as investors focus on repositioning their portfolios into those hedge fund strategies that are expected to outperform and redeeming from underperforming managers.”
The industry as a whole is well positioned going forward, he says, but only a few of the highest quality funds will benefit.