Hedge Fund sector insight Q2 2016
Investors need diversification in portfolios, however in recent years there has been clear evidence that various asset classes are becoming ever more closely correlated with each other. This is a problem. One asset class that is supposed to boost overall portfolio diversification is hedge funds. Managers have become hugely wealthy by charging high management fees and adding to this by additional performance fees. With an estimated over 10,000 global hedge funds and funds of hedge funds according to Hedge Fund Research Inc (HFR) – near the record high in 2014 – investors and analysts say that many managers are chasing the same ideas, driving spreads downward and lowering potential returns. This is at a time when the fund industry is being driven more and more by falling fees and passive strategies.
The name “hedge fund” originated from the paired long and short positions that the first of these funds used to hedge market risk. Over time, the types and nature of the hedging concepts expanded, as did the different types of investment vehicles. Today, hedge funds engage in a diverse range of markets and strategies and employ a wide variety of financial instruments and risk management techniques. The traditional measure of risk is volatility, or the annualized standard deviation of returns. Surprisingly, most academic studies demonstrate that hedge funds, on average, are less volatile than the market. For example, over the period from 1994 to 2009, volatility (annualized standard deviation) of the S&P 500 was about 15.5% while volatility of the aggregated hedge funds was only about 8%.
They would typically charge 2% annual management fee with a 20% performance fee over a stated performance target. This has made the industry leaders very wealthy. For instance, the world’s 25 highest-paid hedge fund managers earned a combined $11.62bn in 2014 and $21.5bn in 2013. Consider that many tracker funds now only charge 0.1% and you can see the issues facing the industry. The hedge fund industry also remains concentrated with the 20 largest funds controlling 57% of the total hedge fund Net Asset Value. Many of the newer funds launched in the last ten years have struggled to gain traction with assets and many have closed.
In the boom years the leveraging within hedge funds produced stellar returns, however the most recent history is far from compelling. In the first quarter of 2016 the average fund declined by 0.8%. That follows a loss of 1.1% for the average fund in 2015, and a gain of just 3% in 2014. In other words, the average investor has earned a cumulative 1% since the start of 2014. Market conditions have been difficult for the hedge-fund community. Sudden shifts between “risk-off” and “risk-on” markets, such as the dramatic market turnaround in February, are very hard to time. Official intervention in the markets, either through central banks or regulatory action, can also provide significant headwinds.
Interestingly, London remains a hedge fund powerhouse with £275 billion ofAssets under management (AUM). This is second only to New York globally in terms of the size of the hedge funds industry with £700 billion AUM. Hedge fund asset growth in the UK and Europe is outpacing that of the US. In the first half of 2015 investment of some £9 billion was placed into European-based institutional hedge funds, compared to net outflows of capital in US-based funds over the same period. The three biggest companies in the UK include Man Group, Brevan Howard and Winton Capital.
Man Group is one of the world’s largest independent alternative investment managers and a leader in liquid, high-alpha investment strategies. Trading since 1783 (originally as a sugar brokerage) and has 25 years of experience in alternative investments with $78.6 billion assets under management (as at 31 March 2016). The company has several operations but two of the main brands are AHL which has a track record spanning around two decades. Trend following strategies use sophisticated computer algorithms to identify trends, which allow them to trade hundreds of diverse markets simultaneously, and avoid biases introduced by human emotions. It invests in 400 liquid markets. The other company is Man GLG, founded in 1995, which has built up a widely respected group of investment professionals who cover equity, macro, emerging markets, credit, fixed income, convertible bond and thematic strategies. It employs 141 investment professionals operate in a collaborative environment, unconstrained by a house view.
Brevan Howard was founded in 2002 and is often seen as the largest macro hedge fund in the world. Global macro is a hedge fund strategy that aims to profit from large economic and political changes in various countries by specialising in bets on interest rates, sovereign bonds and currencies. The managers tend to use both quantitative analysis and qualitative evaluations to understand global relative price movements, liquidity, volatility, business cycles and other macro-economic conditions, so as to profit from them. Assets have fallen sharply at the company in recent years, now down to $20 billion. There are signs that the company are increasingly turning to retail investors for funds, rather than just the large institutional accounts.
Founded in 1997, Winton Capital is a systematic investment manager that uses the scientific method to develop advanced investment systems. The firm has $30 billion in assets with The WDP, being the flagship programme. It invests long and short, using leverage, across global futures, forwards, and cash equities. It is the least constrained application of the Winton Investment System. Consistent, risk adjusted returns are the key desired outcome.