May 19, 2016
Over its long history, the financial services industry significantly grew in complexity and sophistication. Players of all kinds constitute the large international ecosystem with strong cross-border ties. While one sort of players may see a rapid growth, others will experience historical, seasonal or a different type of decline. Hedge funds, in particular, seem to be attracting attention recently due to growing concerns over their operations and sustainability.
Hedge funds represent partnerships of accredited investors uniting their assets into a common pool to create a complex investment portfolio and generate extraordinary returns for partners. As explained by SEC, many hedge funds seek to profit in all kinds of markets by using leverage (borrowing to increase investment exposure as well as risk), short-selling and other speculative investment practices.
When we refer to hedge funds, the count always goes in billions – that’s how massive the business is. According to The Guardian, 25 best-paid hedge fund managers put $13 billion into their pockets in 2015, a sum that exceeds the GDP of many nations, as the source notices.
Although hedge funds are not subject to some of the regulations that are designed to protect investors, they are subject to the same prohibitions against fraud as are other market participants, and their managers owe a fiduciary duty to the funds that they manage.
To balance high risks taken by hedge funds in their aggressive quest to generate returns, the government has restricted the opportunity to join an investment partnership to the wealthy part of the population.
As Richard Marston, Wharton Finance Professor, Director of the George Weiss Center for International Financial Research, commented, Congress originally was wise to limit the investor pool to those wealthy enough to be able to make judgments on their own, without the help of SEC regulations. According to Mr. Marston, those individuals and institutions can perform the necessary due diligence themselves and can take on large risks.
In the US, hedge funds have been quite successful in making rich even richer – hedge funds managers are reported to be making billions in fees. The rule for fees is usually 2% flat fee + 20% from profits earned. Although previously hedge funds managers haven’t been complaining about taking home too much money, the situation is reaching its tipping point.
As Jim Chanos, billionaire hedge-fund manager, said at The SkyBridge Alternatives (SALT) Conference, "The fees are ridiculous. I'm shocked they stayed this high for this long."
However, as stated by CNN, the party is over. The $3-trillion-dollar hedge fund industry isn’t generating as many returns anymore. In fact, CNN reports that the HFRI Fund Weighted Composite Index (a barometer of hedge fund performance), has generated an annualized gain of just 1.7% over the past five years. For comparison, S&P 500's average annualized return is reported to hit 11% for the same period. Bloomberg also reports a decline in hedge funds managers’ bonuses in 2016. The figures suggest that hedge fund firms may cut bonus compensation by as much as 15%.
Even the notorious Warren Buffett has commented on the ridiculousness of managers’ compensation, saying, Our two managers at Berkshire (Todd Combs and Ted Weschler) each manage $9 billion. They would get $100 million each at a hedge fund just for breathing. The compensation scheme at hedge funds is unbelievable.
As HFR suggests, hedge fund capital declined in Q1 2016 as volatile markets and early quarter performance resulted in falling investor risk tolerance and led to redemptions from underperforming strategies.
Moreover, the latest report from HFR indicates that the total global hedge fund capital declined to $2.86 trillion, including investor outflows of $15.1 billion. Not only it marks the largest quarterly outflow since Q2 2009, but also the first consecutive quarters of outflows since 2009.
With shrinking returns partially eaten by eye-popping, but also declining, fees, professionals believe that it is likely that the number of hedge funds will be declining further and investors will be pulling their assets out of managers’ hands. Bloomberg reported that over the last five years, the number of new hedge funds started in Europe and the US has slowed. Meanwhile, fund closures in Europe and the US have accelerated.
While the trend may be seen as negative at first sight, some see it as a generally positive impact on the industry overall. Given the scale of hedge funds operations, there could be just too many sharks in the pond already. The global market is not infinitely expandable and the growing number of hedge funds with billions of private assets can’t just squeeze more from the same market and provide the same value as the limited number would be able to.
As Daniel Loeb, Founder and Chief Executive of Third Point and one of the most successful and powerful US hedge fund managers stated in the Q1 2016 Third Point investor letter, There is no doubt that we are in the first innings of a washout in hedge funds and certain strategies.
However, Mr. Loeb emphasizes the positive side of the chaos, saying, As most investors have been caught offsides at some or multiple points over the past eight months, the impulse to do little is understandable. We are well-positioned to seize the opportunities borne out of this chaos and are pleased to have preserved capital through a period of vicious swings in treacherous markets.
In addition to leveraging technology for survival and successful investment decisions, professionals need to be looking for the best market to apply their talent. And some believe that Asia is an actively emerging hedge fund heaven.
Given that hedge funds feed off of extremely wealthy part of nations, the Asian market has a huge promise for the industry. According to some estimations, there were 4.7 million high-net-worth individuals in Asia holding almost $16 trillion in 2014. India and China, in particular, were the number one and two fastest-growing pools of money. Moreover, the amount held by rich people in both countries surged by 12.4% annually between 2006 and 2014.
In addition to the growing wealth of Asian nations, the index indicating hedge funds performance in the region looks quite promising. The most recent report indicates that HFRI China Index surged 6.1% in March while the HFRX Japan Index gained 3.1% the same month. HFRI India Index is reported to gain 11.8% in March, the strongest monthly performance since January 2012 and third-highest since Index inception.
However, even the positive trend in HFRI in Asia doesn’t brighten the fact that total Asian hedge fund capital has still declined in two of the last three quarters since peaking at $126.3 billion in Q2 2015. The Q1 2016 decline included investor outflows of $2.3 billion, the largest net outflow since Q1 2009.
Along with the right choice of the market, technology could become a life jacket for hedge funds. With the rapid development of sophisticated machines and application of AI across industries, hedge funds can become another part of the ecosystem heavily reliant on data and sophisticated algorithms.
In fact, according to the Greenwich Time, in recent years, many hedge funds have become reliant on algorithms when it comes to investment strategies. Quantitative hedge fund managers either depend exclusively on these computer models or use them extensively to guide decision-making.
Experienced mammoths of the industry will soon clash with computer-reliant scientists. As David Siegel, Co-founder of Two Sigma Investments and a computer scientist, declared, Eventually, the time will come that no human investment manager will be able to beat the computer.