Let’s face it, we all saw this coming. Like a car crash in slow motion, where few of us watched and tried to stop it. This time, most people in the industry turned their heads before the crash; many hedge funds closed their eyes all together, simply hoping this wouldn’t happen at all.
Pulling recent AUM flow data from Pensions & Investments, 58% of hedge fund managers report a drop; 63% of funds-of-fund firms are also holding less.*
The headlines yesterday and last week include major closings, and layoffs at big firms.
Those are the results—let’s explore the drivers.
As our headline suggests, it’s common knowledge that high fees have been a sore spot for investors, and this fee compression and outflow of funds have been a long time coming, especially after a few years of underperformance. Ever since CALPERS started divesting its hedge fund portfolio all of this was inevitable—right?
We disagree with common wisdom, knowledge and the rumblings of the crowd. In fact, we think the indifference of the industry is the root cause of much of the outflows.
We believe there are two major forces driving this current trend and estimate that they will continue to hurt the broad industry until there is another shift.
Investors allocate to hedge funds for a variety of reasons: non-correlated returns, and the safer, less volatile, higher, risk-adjusted returns. This has not always been the case. Not that long ago, hedge funds made their mark through outsized returns. This was through the ability of managers to capture profits in any direction, asset class or at other times, including being fully hedged.
No more. The institutionalization of the industry has created a self-fulfilling prophecy of hedged, near-market neutral, low volatility, low risk and therefore, really low return streams. Frankly, two and twenty seemed cheap, if not reasonable when the performance was there; in those days, fees were not questioned. Today, we see the entire allocation to the asset class being questioned.
Gone are the days of outsized returns and swashbuckling managers who boasted that they couldn’t be reined in by the same ridiculous rules that their long-only counterparts have been stuck with. Top managers and analysts left long-only shops for the promise of freedom to invest how they saw fit, delivering outsized returns and reaping the rewards of 2% management fees and sharing in 20% of the returns. It sure beats active management long-only fees of 0.15% to 1.2%!
Institutionalization brought massive AUM to the industry, albeit to the top managers—the big brands. It also changed the way the money was managed forever.
I was once an emerging manager with an investment process aimed at beating markets and seeking opportunity everywhere. But to be taken seriously beyond high net worth individuals (where hedge funds started and earned their reputation), I too had to learn how to communicate risk management, fill an organizational chart with “all the right boxes” and compete with the big brands. Additionally, “skill” became the new buzzword and things like “low vol” and “pure Alpha” joined it.
Performance = no one bellyaching about fees
- A lack of modern marketing
At times we feel there may even be a disdain for real marketing. Let’s start with the entire sales team of hedge funds with the title “marketing” and not sales, business development or anything else more transparent.
Marketing is embraced as a title, less gauche than “sales” in a high-brow world. Marketing actually means fully explaining your investment process. This is reiterated frequently to explain the zigs and zags of the markets, the fund’s performance (relative and absolute), and how attribution analysis works to prove out the process.
Ultimately, the best clients are investing in your process, team, philosophy and the manifestation of the results those aspects deliver – performance. As market conditions are not always perfect for the process to optimally perform, staying the course, explaining how it should change and why the process has and will work again are critical.
There are funds that “adjust to market conditions” and still fail to deliver strong, risk-adjusted returns. Guess what? The world is overpopulated with hedge funds, so without any discipline and repeatable process, some of them should close. Innovation and instinct are real and worth paying for, not dramatic inconsistency.
For those that have performed as promised and have stuck with their process, will probably see similar markets again and perform. Yes, being an out of favor strategy sucks, but it is no reason for well-informed, professionally-handled investors to head to the exits.
Marketing works. Investor relations work. Consistent outreach works. Programmatic and systematic marketing that are available today and are championed by firms like ours are materially superior to the old call, meet, conference circuit, hire a new ‘marketer’ for another fresh contact list.
Let’s see a bifurcation among managers: institutional, low return, low vol, and (come on) lower fees. All those algos pay for themselves rather swiftly when at scale, and this is an inevitable outcome. The second set are the outperformers who return to their roots and beat the crap out of the markets. These managers usually pay little attention to the markets, treating them only as data points within their process of making money for their clients.
Lastly, we don’t need 10,000 firms. There is real talent—talent that delivers alpha consistently—that designs and manages solid risk adjusted returns across asset classes.
As many great managers have stated, we make money directionally and through uncertainty.
There is opportunity for modern marketing where AUM retention and raising new assets are equals; where investor outreach is a daily occurrence and where best practices and achieving alpha is in every department, not just investments.
After all, if there is no AUM, the business is just an expensive hobby.