Hedge funds, which historically have been the brightest stars on Wall Street generating outsized returns and earning astronomical paychecks, have finally had their comeuppance. Now a prolonged period of high fees, anemic returns, and significant fund redemptions have prompted numerous fund closings, and have led many managers to struggle to figure out how to recapture their past success given the new normal.
Low Returns and High Fees Plague Funds
Over the past three years, hedge funds have posted meager annual returns of 2% — well below the returns of most index funds and ETFs according to data compiled by Bloomberg.
This factor, combined with high fees associated with the traditional 2-20 hedge fund compensation model have discouraged investors from allocating new money to funds and have prompted existing investors to try to renegotiate their existing fee arrangements.
According to Hedge Fund Research, the average management fees for the hedge fund industry stood at 1.5% in the second quarter, with the average incentive fee at 17.6%. This compares to the average expense ratio for a U.S. stock index ETF of 0.345%, according to Morningstar.
In a survey released by Preqin in September, about 49% of investors cited high fees as a key issue facing the global hedge-fund industry in the second half of this year. Around 58% of investors said their interests were not aligned with managers’, a number that climbed from 49% in June 2015.
Withdrawals and Closings Ramp Up
Due to these trends, investors have ramped up their withdrawals from hedge funds. According to Hedge Fund Research (HFR), investors withdrew $28.2 billion from the hedge fund industry in the 3rd Qtr of 2016, the most since the second quarter of 2009. During the first nine months of the year, investors redeemed $51.5 billion, despite the fact that overall industry assets rose to a record $2.97 trillion.
It was the fourth consecutive quarter of redemptions, the longest since 2008 and 2009, HFR said. Redemptions were concentrated in the biggest funds, with almost $22 billion withdrawn from firms with more than $5 billion in assets. Firms managing between $1 billion and $5 billion saw net outflows of $7.4 billion.
Besides redemptions, a large number of hedge funds shut their doors altogether. According to HFR, there were 239 hedge-fund closings in the second quarter of 2016, compared with 200 in the second quarter of 2015. The number of new funds opened also slowed, with 200 launched in the quarter, compared with 252 in the year-ago period. The 2nd Qtr 2016 was the third straight quarter where the number of liquidations exceeded the number of launches.
One of the biggest closings was Perry Capital, which announced in September that it would be closing up shop after 30 years in existence. Founder Richard Perry explained this move, writing that “market headwinds against us have been strong, and the timing for success in our positions too unpredictable.”
Other well-known hedge funds, including Chesapeake Partners Management, and London-based hedge fund Nevsky Capital, both closed in the first half of this year citing that changing market conditions had made their investment approaches unlikely to succeed going forward.
A Changed Market Environment
The reason for this prolonged underperformance has stumped many hedge fund managers. Some have blamed low interest rates and political and economic uncertainty for their weak performance. Others have pointed the finger at high frequency and algorithmic trading and increased government regulations for depressing their returns.
Many believe that one of the key problems with the current hedge fund industry is the fact that too many funds are investing in the same ideas leading to overcrowded trades. This has led some fund managers to conclude that a sharp reduction in the number of hedge funds is needed before hedge funds can again produce consistent Alpha. Others believe that to improve their performance they need to look for more diverse investment strategies and non-consensus ideas.
However, a number of managers admit that the old rules of hedge fund investing don’t seem to work in the new market environment. Unfortunately, most managers have yet to figure out how to consistently outperform going forward.
Given these bearish trends, we would not be surprised to see continued underperformance, withdrawals, and consolidation in the hedge fund industry in the coming quarters. In our view, this is likely to lead to lower fees and shrinking margins for the bulk of hedge fund managers.
Unfortunately, this would be bad news for many sell-side and independent research providers as hedge funds have traditionally been their most profitable customers. We suspect that many hedge funds will particularly not be very patient with research providers producing traditional research coverage and consensus ideas.
However, the good news for research providers is that hedge funds will be hungry for unique and value-added sources of non-consensus investment ideas. Consequently, we suspect that hedge funds will continue to pay significant fees for a range of unique research and data services, including high quality short ideas, alternative data sources, and non-traditional research and data analysis services. In our view innovation, exclusivity, and uniqueness are likely to be rewarded the most by hedge funds in the coming few years.