Is now the time for… hedge funds?

Hedge funds evoke a certain fascination. In the past, however, they have regularly fallen short of investors’ expectations. To this day, this asset class remains a black box to many people. The rise in the general interest-rate level has recently improved the return prospects for many hedge fund strategies, at least on paper. But in order to make sure that the added value of hedge funds actually finds its way into an investment portfolio, a purchase decision must not only be well thought out, but also implemented well.

Expensive investment products wrapped in black

Hedge funds have exerted a certain fascination over investors since time immemorial, but not without a proper dose of skepticism on top. That dubiety sometimes stems from the fact that it isn’t always clear, or is at least hard to understand, what exactly is inside the wrapper and how hedge fund managers (intend to) earn profits for their investors. In fact, hidden behind the blanket term “hedge fund” is a very diverse array of strategies with different risk profiles. Hedge fund managers, for example, try to spot and take advantage of macroeconomic disequilibriums (macro), to play good stocks against bad ones (equity long/short, market-neutral), to exploit mispricings between different assets (relative value, arbitrage), to profit from opportunities arising from corporate mergers and acquisitions and other events (event-driven), or to systematically follow existing price trends (CTAs), to name just some of the strategies. Besides this blatant complexity, periodically surfacing news about spectacular hedge fund failures or closures also isn’t necessarily conducive to a good reputation and makes this asset class appear to be one thing above all: risky – and at a high price to boot. The old “2 plus 20” formula (2% management fee plus 20% performance fee) admittedly is no longer a law of nature these days because downward pressure on total expense ratios has since spread to the hedge fund industry as well by now. Nevertheless, hedge funds still rank among the rather expensive investment products alongside private-market assets. Yet, an aura of fascination lingers. Hedge fund managers juggle billions and earn billions (in the best of cases). They bet against the world’s biggest companies and are masters of the universe. The hedge fund sector generates enough script material to turn into a streaming series, which of course hasn’t slipped the attention of Hollywood. In seven seasons thus far, the series “Billions” peers behind the scenes of the hedge fund industry. One can safely assume that the show deviates to some degree from the reality of hedge funds. The soap opera nevertheless does well at portraying how tough the business is – a business in which only the fittest survive. The quest for alpha, which by definition exists only in a limited quantity, is a grueling competition. It requires continual innovation and investment. The costly competition to recruit finance whizzes is also intense. In this environment, the big hedge funds grow ever larger while newcomers come and go. The overall number of hedge funds in existence has stagnated for years.

Survival of the fittest | No growth on balance

Total number of hedge funds

Sources: HFR Global Hedge Fund Industry Report Q2 2023, Kaiser Partner Privatbank

At the limit of capacity…| …or simply unattractive?

Annual hedge fund net inflows/outflows

Sources: HFR Global Hedge Fund Industry Report Q2 2023, Kaiser Partner Privatbank

(Un)realistic return expectations

It’s understandable that the average retail investor may have a distorted picture of hedge funds and the returns that can be achieved with them. But even many a professional investor is susceptible to misconceptions about hedge funds. According to a survey of investors conducted by Preqin, over 15% of the institutional investors queried expect this asset class to deliver a return of more than +12% per annum. That’s ambitious to say the least, and far removed from the reality of what hedge funds have actually delivered over the past years and decades. The average annual return on the Eurekahedge Hedge Fund Index since the year 2000, for instance, stands at a much lower +8.1% (and just +5.8% since the year 2010). And even those numbers likely misrepresent the true portfolio reality experienced by many investors, in part because some of the funds contained in the index are not investable (because they’re hard-closed), and in part because hedge fund indices’ performance figures are systematically skewed upward by a number of biases. Hedge fund managers, for example, report their performance voluntarily and only when it has been good up to that point in time (selection bias and backfill bias), and usually without verification by an independent auditor (self-reporting bias). Moreover, hedge fund index data do not get adjusted when funds are dissolved due to poor performance (survivorship bias). Fund-of-hedge-funds indices provide a better indication of what the hedge fund industry has earned for investors in the past. According to the Eurekahedge Fund of Funds Index, the industry’s performance, at +3.4% per annum since 2010, has tended to be disappointing. But that’s looking in the rearview mirror. What are realistic expectations today for the years ahead, in general and return-wise? As a general rule, hedge funds should have a low performance correlation with other assets in a portfolio, should diversify a portfolio, and should reduce its volatility. They should be a low-risk and low-volatility portfolio component that ideally delivers a high single-digit percent annual return (+8% to +9%) with mid-single-digit percent volatility (6%–7%).

What investors want | A golden goose

Professional investors’ return expectations

Sources: Preqin Investor Survey Q2 2023, Kaiser Partner Privatbank

Better times in sight?

Returns of that kind from the better hedge fund managers are in fact likely to not be unrealistic looking ahead at least to the nearer-term future because the increased interest-rate level in the wake of the lengthy series of policy rate hikes by central banks automatically puts hedge funds in an improved starting position going forward. Many hedge funds use financial derivatives to implement their strategies and hold a cash allocation above 50%. Whereas this cash usually parked in the money market hardly yielded any interest over the past 10-plus years, today it is generating an annual income stream of 4% to 5% that ultimately accrues to investors in hedge funds. The tailwind produced by the new interest-rate regime also benefits managers that short sell stocks (in a bet on falling share prices). They now receive higher interest rates on the proceeds from short sales (pocketing a so-called “short rebate”). Taking a market-neutral equity strategy as an example (100% long/100% short), the interest-rate boost on US stocks (or in US dollars) can amount to up to 5% p.a. here as well. Besides this “base effect,” the return of interest rates to normal should also create greater potential for genuine alpha in the future because the end of the artificial ultralow interest-rate environment also means more volatility (and generally more opportunities) on financial markets, higher stock dispersion (more chances for stockpickers), and stronger price trends (greater potential for trend followers). A look back at the mid-2000s reinforces positive expectations. The US federal funds rate at that time was at the same level as today at around 5%, and hedge funds at that time were capable of generating an alpha of 5 percentage points.

Attractive (again) thanks to interest-rate turbocharger? | Risk-free interest rate plus 3 to 5 extra percentage points

Hedge funds vs. global equities, rolling 3-year return (annualized)

Sources: Bloomberg, Kaiser Partner Privatbank

The implementation challenge

The performance prospects for hedge funds have thus brightened lately. But even if an investor approves in principle of allocating money to this asset class, he or she still has the real challenge to contend with: implementing the allocation, which initially involves choosing the right managers. This is crucially important in the realm of hedge funds because compared to conventional equity funds, the dispersion between good and bad managers is much wider in the hedge fund space. According to calculations by Goldman Sachs, the performance differential between the 25th and the 75th percentile over the last 15 years amounted to more than 10 percentage points. Researching hedge funds requires a good deal of work, in part because the hedge fund universe constantly gets reshuffled – every year, around 10% of all hedge funds drop out of the market and an equal quantity of new managers join the fray. However, once a good manager has been found, there is no guarantee that one can invest in that specific hedge fund. Many of the top managers have closed their funds to new investors because they are already operating at the limit of their capacity. It is not unusual for those managers to regularly return capital to investors because they can no longer put it to work. Then comes the really challenging part of the implementation challenge, which is to put together a basket of hedge funds that’s as well-rounded as possible because hedge funds are a really good diversifying element only when as many sources of alpha as possible are captured and single-manager risk is minimized (an exception to this rule is multistrategy funds, which already implicitly provide a broad diversification of sources of return and risk).

Trial and error

Over the last 30 years, the financial industry has repeatedly tried to implant hedge-fund performance in investors’ portfolios in a variety of different wrappers. The outcome of those efforts in most cases, though, has been merely a high-priced, sluggishly performing, illiquid millstone in portfolios, albeit an uncorrelated one. The actual goal of creating a good risk/return profile while attending to the four dimensions of diversification (many substrategies and managers), access (low minimum investment requirements), liquidity (as high as possible), and fees (as low as possible) has regularly been missed with few exceptions. Funds of hedge funds, for example, have been around since back in the 1990s. They are widely diversified and correlate strongly with well-known hedge fund indices, but they make this already expensive asset class even more costly because they usually charge additional management and performance fees. In the past, this interweaving of hedge funds shaved up to 200 basis points off annual returns. In its early years, this product category also proved problematic due to the fact that some funds of funds offered monthly liquidity even though the underlying hedge funds had much longer redemption timelines. The development of investable hedge fund indices in the early 2000s aimed to counter this liquidity problem by making diversification and access to hedge-fund performance possible on a daily basis. However, many hedge fund managers at that time were unwilling to launch their strategies in parallel investment vehicles (managed accounts) for this new purpose. The consequence of this was a fatal adverse selection spiral (it was predominantly poorer managers that took part in this “innovative product”), which caused some investable indices to initially underperform “real” hedge fund indices by up to 500 basis points per annum. In later years, this underperformance diminished by roughly half, but this particular packaged product nonetheless never really caught on.

High fees… | …erode alpha

Hedge funds vs. funds of hedge funds and UCITS hedge funds

Sources: Bloomberg, Kaiser Partner Privatbank

The next product wave began in 2012 to 2014. Cloaked in the legal structure of conventional mutual funds, hedge funds were now being marketed explicitly to retail clients in a diversified and liquid form with low minimum investment requirements and relatively low total expense ratios (2% to 3%). This time, though, also credible hedge fund managers were willing to give retail investors access to their strategies. The problem now, however, was a different one: a systematic brake on performance that had multiple causes. Regulated investment funds, for example, are far less flexible than hedge funds with regard to the employment of borrowed capital and derivatives, short selling stocks, holding illiquid assets, concentrated risks, and other criteria. They are also subject to higher regulatory and compliance costs. And finally, there were still too few incentives for participating hedge fund managers to make their best trades available for the new investment vehicles, which ultimately posed competition to hedge funds. The new product wrapper gave the general public better access to hedge fund strategies, but since the brake on performance amounted to as much as 300 to 400 basis points annually and often left only low single-digit percent returns in the end, three-quarters of the funds of this type have already been liquidated by now. Products that attempted to capture “alternative risk premia” likewise failed to catch on in the mid-2010s. They were premised on the hypothesis that hedge funds’ alpha stems from permanent market inefficiencies that can be exploited just as well by means of simple trading strategies. The hypothetical backtests looked fantastic, as they so often do, but in reality, these products turned out to be just another failed experiment.

Backtests always look good | Live performance rarely does

SG Multi Alternative Risk Premia Index

Sources: Bloomberg, Kaiser Partner Privatbank

A good copy suffices

This brief historical account shows that there has been plenty of trial and error during the past decades. But it did produce one successful experiment: factor-based hedge fund replication. In layperson’s terms, factor-based hedge fund replication utilizes statistical risk models in an attempt to find out how a large number of (hedge fund) managers are invested in stocks, bonds, currencies, and commodities (factors) and then seeks to copy (replicate) those positions cheaply and efficiently. This approach can be implemented in the form of an investor-friendly UCITS structure with a low minimum investment requirement, daily liquidity, and at an acceptable total expense ratio. Although only 80% to 90% of the performance of good hedge funds can be replicated this way, the much lower costs leave a very competitive performance left over for investors on the bottom line. Even more than ten years after their invention, hedge fund products of this kind are not yet particularly widely disseminated or well-known, perhaps in part because they undermine the myth of hedge funds being inaccessible premium products and are primarily viewed by the hedge fund industry as black sheep that not only hurt its reputation, but also harm its business model. (Why should someone invest in illiquid hedge funds with a total expense ratio of 5% when he or she can get a liquid version for a fifth of the price that is tradable daily?). Their obscurity, in any case, certainly doesn’t owe to a disappointing performance. Two of the best-known factor replication products (the SEI Liquid Alternative fund and the NN Alternative Beta fund) have achieved a quite handsome annual return of +4% to +6% since 2016 with a high correlation of 0.8–0.9 to well-known hedge fund indices. The performance of these strategies could even head in the direction of the +10% mark in the future because factor-based replication, like so many other hedge fund strategies, is implemented with the use of financial derivatives. Cash that doesn’t have to be deposited as margin collateral can thus be invested in the money market or in short-term government debt securities. The return formula therefore comes out to be 4%–5% (risk-free interest rate) + 5% alpha at the moment.

Solid (hedge fund) performance… | …implemented cheaply

Factor-based hedge fund replication

Sources: Bloomberg, Kaiser Partner Privatbank

Conclusion: Time for hedge funds, but selectively

So, is now the time to invest in hedge funds? The answer depends on the individual investor. In any case, the hedge fund asset class has gained attractiveness relative to equity markets, some of which have become expensively valued again. At the same time, the fixed-income sector (government, high-yield, and cat bonds) is offering more alternatives these days in an environment of high market interest rates. Whoever has a big enough budget for alternative assets can reap added value from an allocation to hedge funds. If implemented properly and if all pitfalls are avoided, hedge funds really can improve a portfolio’s volatility and enhance its risk/return profile. Interested investors, though, no longer have to forgo liquidity in exchange these days. The illiquid part of a portfolio should remain reserved for those types of assets that are still available at most in a semi-liquid format (private equity, private credit, infrastructure, and real estate). After years of evolving, hedge fund strategies have become a feasible option for retail investors today, but this asset category is still not yet suitable for do-it-yourself investors. Interested investors should therefore put their trust in a private bank’s investment expertise.