Hedge funds raise the alarm bells, but should we listen?

By Tom Wickers, Hottinger Investment Management

Hedge fund managers have featured heavily in financial news in recent weeks, highlighting their short positions and foretelling another stock market slump[i]. Valuations continue to look stretched to a significant number of analysts across the investment sector, but when stimulus is implemented on this scale, stock markets become flush with cash and economic recoveries become even harder to predict. Hedge funds, which are considered to consist of some of the sharpest minds in finance, find themselves placed at the extreme end of market pessimism, which bodes the question, should other investors be taking heed?

Hedge funds were created as early as 1949 but made their names in the dot-com bubble at the turn of the millennium. The industry led the market in driving prices in technology stocks but timed its exit well as the market peaked[ii]. The result was that the HFRX Global Hedge Fund Index made annual returns of 16.1% between 1998-2003 in stark contrast to the S&P 500 returns of 4.5%[iii]. Financial rock stars were born such as Neil Woodford and Steve Cohen and since then, bright talent and investors’ cash have been attracted to the industry like bees to honey. In 2003, there were 3,000 hedge funds managing $500B of asset. At the end of last year, despite years of poor performance, there were 11,000 hedge funds managing $3.5T[iv].

It is no secret; the hedge fund sector is not currently held in such high esteem. Investment managers, that are able to short securities and otherwise create unconventional investment strategies using derivatives, used to be the pride of Wall Street. Not only did hedge funds make exceptional returns through arbitrage strategies but their reading of the market was also thought to be second to none.

However, after an extended period of dismal returns, asset managers are beginning to think twice about their allocation to alternative strategies. Figure 1 shows the returns of the Hedge Fund industry since the S&P 500 and the HFRX index recovered from the 2008 Global Financial Crisis (GFC). Over this time, the hedge fund industry has returned an average of just 0.57% per year and the Sharpe ratios do not look much prettier. There are some winners among hedge funds, the Renaissance’s Medallion fund being a reputed one, however they are few and far between.

Figure 1: The cumulative total returns of standard hedge fund Indices in relation to the S&P 500 and the Barclays 10-year Treasury index for the period of March 2011 – December 2019.

The pressure has mounted on hedge fund managers’ returns as arbitrage opportunities have become relatively scarce while fees have remained steep. The standard hedge fund fee of two and twenty, when added to muted gross returns, makes investor frustration with net returns even more understandable. In some ways the industry has fallen victim to its own success; as the number of hedge funds has risen dramatically and competition has increased, making opportunities hard to come by. Furthermore, returns from arbitrage strategies aimed at exploiting differences in global economic policies are being hampered by historically low interest rates experienced globally since the 2008 Financial Crisis.

Fund performance is not the only selling point for hedge funds as many investors have also traditionally invested to gain access to the sector’s ‘best ideas’. Idea conferences are held where hedge fund managers disseminate their favourite stock picks to eager ears. However, Epsilon Asset Management has recently analysed the historic returns of these stock picks and found that the ‘best ideas’ performed no better than hedge funds’ regular ideas[v]. The result is that the image of pristine predictive power that these fund managers used to embody has been tainted; investors have begun to lose faith in hedge funds and over recent years the industry has been experiencing net outflows[vi].

The hedge fund industry’s recent performance and predictions during the longest recorded equity bull market have not been noteworthy, yet some might argue that predicting recessions and downturns are a different kettle of fish. Good market timing is a skill that every investor wishes they had but few seem to exhibit. Hedge funds do appear to perform better than their peers in this regard. A study in 2017 found evidence that hedge funds that are more active in positioning around economic cycles outperform their less active counterparts[vii]. However, the study also found that the active funds were hit hardest during the 2008 Financial Crisis, which questions the industry’s more recent positioning in severe recessions[viii].

Predicting market movements is extremely difficult at the best of times. When the world is dealing with an unprecedented pandemic shock, the job becomes even harder as hugely influential factors such as new virus cases and the potential for further stimulus shift daily. The hedge fund industry has demonstrated some market timing ability and navigated the dot-com bubble expertly, but has also lacked market-beating predictions in recent times and failed to position well for the GFC. Short positions in the hedge fund industry probably shouldn’t be seen as a red flag any more than warnings from investment managers in other sectors. It is clear that the average investor is of similar mind as demonstrated by the market’s continued upward trend in the face of hedge fund warnings. It may be that a second market dip does occur, and we continue to be positioned defensively out of concern for this possibility, but our main causes for concern will continue to come from economic figures and statistics rather than the positioning of others in this crisis.

[i] https://www.ft.com/content/0ddb5f58-7989-4ec1-b531-bd76e0a8822a

https://www.ft.com/content/e1e1c3ef-1849-46bc-a472-2af8c0aabe5b

https://www.ft.com/content/9cc21492-099a-4639-8d7c-c5a9b3f465ce

[ii] M. Brunnermeier et al., ‘Arbitrage at its Limits: Hedge Funds and the Technology Bubble’, May 2002 http://www.econ.yale.edu/~shiller/behfin/2002-04-11/brunnermeier-nagel.pdf

[iii] https://blogs.cfainstitute.org/investor/2017/03/06/the-golden-age-of-hedge-funds/

[iv] https://www.bloomberg.com/opinion/articles/2019-11-25/the-hedge-fund-war-for-talent

[v] Epsilon Asset Management, ‘Hedge Fund Alpha and their Best Ideas’, April 2020 https://www.epsilonmgmt.com/research/hedge-fund-best-ideas

[vi] https://www.evestment.com/news/covid-19-crisis-shifts-hedge-fund-flows-negative-in-march/

[vii] M. Brandt et al., ‘Can Hedge Funds Time the Market?’, June 2017 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2988484

[viii] https://www.institutionalinvestor.com/article/b1505qrv393rd2/even-the-most-skilled-hedge-funds-are-bad-at-predicting-crises