New York, NY – 2012 was a bust for most hedge funds as the average fund posted a meager 5.5% return, compared to a 13% return for the S&P 500, marking the fourth consecutive year where hedge funds underperformed the overall equity markets. However, could this continued underperformance by hedge funds spell good news for purveyors of independent research? We think this is a strong possibility.
Most Hedge Funds Struggling
According to data provided by Hedge Fund Research, the S&P 500 has now outperformed the average hedge fund in four of the past five years, with the exception being in 2008 when both hedge fund performance and the overall market fell sharply.
An analysis conducted by the Financial Times, reveals that a simple diversified portfolio comprised of 60% in equities and 40% in sovereign bonds, has delivered returns of more than 90% over the past decade, compared with a modest return of only 17% after fees for hedge funds over the same time frame.
Of course, a few hedge fund managers have performed exceedingly well during this period. Hedge Fund Research reports that the top decile of hedge fund managers posted gains in excess of 30% in 2012. Unfortunately, a third of all hedge funds actually lost money for investors last years.
Research Providers Also Suffer
Maybe not so coincidentally, over the past five years independent research providers have also suffered as equity commissions have plunged and a rash of insider trading convictions have prompted asset managers, including hedge funds to dramatically slash their use of independent research.
According to Greenwich Associates, overall equity commissions has fallen 26% in the US since 2008, while the portion of these commissions allocated to pay for research has dropped 18% during the same period. The team at Integrity Research estimates that spending on independent research has fallen 34% since 2008.
A Rebound for Indies Possible?
So why are we modestly optimistic about the outlook for independent research in 2013? We think it comes down to competition. The lackluster performance seen in the hedge fund industry over the past five years is creating considerable pressure for hedge funds to differentiate themselves by trying something different. One such strategy would be to reverse their pattern of the past five years by starting to invest again in building up their internal and external research capabilities.
Paradoxically, the independent research business has fared best when asset managers have hired more internal analysts. These analysts have historically consumed nontraditional sources of research and data provided by a diverse group of independent research firms. Interestingly, we have recently spoken to a few asset managers who are starting to bring on new third-party research providers in an effort to boost their investment performance.
Ultimately, we believe the poor performance generated by hedge funds over the past five years could spell good news for the independent research industry in 2013 as some funds try to differentiate themselves from their peers.
Of course, we do not expect this buy-side pickup in the use of indie research will boost everyone’s bottom line as investors are likely to continue to look for proprietary data and non-consensus insights rather than more traditional fundamental research sources.