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.