“Hedge funds, private equity and venture capital funds have played an important role in providing liquidity to our financial system and improving the efficiency of capital markets. But as their role has grown, so have the risks they pose.” Jack Reed
During the past few decades, hedge funds have evolved from obscure investment vehicles to highly popular investments in the global market. Institutional investors including pension funds, endowments, insurance companies, private banks, and high-net-worth individuals and families are attracted to hedge funds. Not surprisingly, hedge funds have drawn considerable attention from investors, practitioners, and academics. The period after the financial crisis of 2007-2008, also called the Global Financial Crisis (GFC), was tumultuous for hedge funds and resulted in startling headlines. Today, hedge funds have become, and are likely to remain, an essential part of the financial landscape. After taking a brief historical look at hedge funds, we discuss current hedge fund debates and controversies, and take a glimpse into their future prospects.
A hedge fund is a pooled investment vehicle that uses various strategies to invest in different asset classes. Professional investment managers administer these privately offered funds. Hedge funds attempt to produce above-average investment returns using many strategies and tools ranging from traditional stock-picking to complex derivative and arbitrage plays.
Characteristics of Hedge Funds
Several key characteristics differentiate hedge funds from other types of pooled investments such as mutual funds as well as other alternative investments including private equity. First, not all investors have access to hedge funds. In the United States, for example, hedge funds are only open to “accredited” or qualified investors. Until recently, being qualified as an accredited investor simply involved having or making a sufficient amount of money. As of February 1, 2016, the US requirements changed. The Financial Services Committee and the US House of Representatives passed HR 2187, known as the Fair Investment Opportunities for Professional Experts Act. Now individuals can qualify as accredited investors based on measures of sophistication such as having a minimum amount of investments, certain professional credentials, and experience investing in exempt offerings, being knowledgeable employees of private funds, or by passing a qualifying accredited investor examination. The expanded definition of an accredited investor still continues to exclude many, if not most, investors.
Second, hedge funds have wider investment latitude than many other types of pooled investments. For example, hedge funds are highly flexible in their investment options because they can use financial instruments generally beyond the reach of mutual funds. Hence, they can engage in more aggressive strategies and positions, such as short selling, trading in derivative instruments including options, and using leverage (borrowing) to enhance the risk/reward profile of their bets. However, a hedge fund does not necessarily use hedging techniques given that the classification scheme for hedge funds has broadened considerably over time. The only limitation to a hedge fund’s investment universe is its mandate. Thus, some hedge funds can invest in anything including stocks, derivatives, land, real estate, and currencies. By contrast, most mutual funds follow the traditional “long only” model of investing in that they mainly stick to investing in stocks or bonds. Few mutual funds short-sell stocks because they face some restrictions and the higher costs of operating a long-short portfolio.
Third, hedge funds often use leverage. That is, they can borrow funds to potentially increase their returns. However, leverage can destroy hedge fund returns as seen during the GFC.
Fourth, the compensation or fee structure differs for hedge funds. Besides charging various fees, which are associated with more traditional pooled investments such as mutual funds, hedge funds also have a performance or incentive fee. For example, a once common fee structure called “2 and 20” enabled hedge fund managers to charge a flat 2 percent of total asset value as a management fee and an additional 20 percent of any profits earned. However, these fees have trended lower in recent years.
Finally, hedge funds are lightly regulated. Yet, as a result of the GFC, hedge funds have come under increased regulatory scrutiny. For example, as of July 2010, the Dodd-Frank Wall Street Reform Act requires hedge funds with more than $150 million in assets to register with the Securities and Exchange Commission (SEC). Further, under the “Volcker Rule”, banks are now restricted in their ability to sponsor hedge funds and are prohibited from proprietary trading of them.
Benefits and Risks
Hedge funds offer some notable benefits over traditional investment funds. For example, the investment strategies used by hedge funds can potentially generate positive returns in both rising and falling markets. Given that hedge funds may have low correlations with a traditional portfolio of stocks and bonds, including hedge funds in a portfolio offers potential diversification benefits. That is, adding hedge funds to a balanced portfolio might reduce overall portfolio risk and volatility and increase returns. The large number of strategies available to hedge fund managers can help them meet their investment objectives. Hedge funds offer a long-term investment solution that eliminates or at least reduces the need to correctly time entry to and exit from markets. Finally, hedge funds have some of the most talented investment managers. Not surprisingly, hedge fund investors have high expectations about the potential risk/return contributions that hedge funds can provide relative to more traditional portfolios.
Despite these potential benefits, hedge funds have structural disadvantages that subject investors to certain risks. For example, hedge funds are not only subject to less regulation than many other structures but also offer limited transparency. For example, hedge funds are not required to detail redemptions publicly. Consequently, managers often closely guard those numbers to avoid any trace of loss of confidence. The lack of investment constraints poses a greater risk of strategy and style drift. Some funds use investment strategies that expose investors to potentially large losses, such as using leverage. Hedge funds typically require investors to lock up money for a period of years resulting in a lack of liquidity. They often have a gate provision that gives managers the right to limit the amount of withdrawals on any withdrawal date to not more than a stated percentage of a fund’s net assets. Finally, hedge funds are subject to high fees and complex incentive structures, which can induce excessive risk-taking to exceed previous fund high water marks or attempt to generate greater performance fees. A high-water mark refers to the highest peak in value that an investment fund/account has reached. Typically, managers are eligible for performance fees if the value of their funds exceeds their previous high-water marks. Thus, hedge funds are not for everyone but they can meet the specific investment goals and needs of some investors.
Brief History of Hedge Funds
Although the origins of hedge funds can be traced to the 1920s, Alfred W. Jones introduced the term “hedged fund” and subsequently created the first hedge fund in 1949. Jones inspired a new investment model by incorporating technical analysis methods into forecasting to create the first long/short strategy. Long/short strategies incorporate both long positions in securities that are deemed to be underpriced and short positions on securities that are considered overpriced. Jones is also credited for the incentive fee structure used by hedge funds today. The incentive fee structure was initially established at 20 percent of realised profit.
By 2008, the hedge fund industry claimed almost $1.93 trillion in assets under management (AUM). Overall investments decreased in the aftermath of the GFC, but increased to a record $3.02 trillion during the fourth quarter of 2016, excluding $360.4 billion in funds of funds. According to data from Hedge Fund Research (HFR), which tracks performance and flows at global hedge funds, hedge fund liquidations in 2016 hit the highest number since the GFC. For 2016, liquidations totalled 1,057, surpassing the 1,023 liquidations from 2009, though falling well short of the record of 1,471 liquidations from 2008. The number of new launches totalled 729 in 2016, which represents a steep decline from the 968 launches in 2015 (HFR 2017). As a result of more liquidations and fewer launches, the number of hedge funds globally fell below 10,000 for the first time since 2014.
Current Issues, Debates, and Controversies
Several major debates and concerns surround hedge funds. According to a recent survey by Preqin (2017), performance (73 percent) and fees (64 percent) are the two key issues facing the industry. This debate tends to resurface especially when hedge fund performance is weak relative to other investment alternatives. Investors pay two types of fees: a management fee and an incentive or performance-based fee. Evidence suggests a slight trend for declining fees. According to HFR, at the end of 2016, average management fees had slipped to 1.48 percent, while the average performance fee dropped to 17.4 percent. For new launches in 2016, the average management fee for funds fell to 1.33 percent, declining from 1.6 percent for 2015 launches, while the average incentive fee for funds declined to 17.71 percent, down 4 basis points from 2015 fund launches. As Kenneth J. Heinz, President of HFR, notes, “The hedge fund industry fee structure continues the process of evolving to meet increased investor demands, as well as persistently low, albeit increasing, level of interest rate” (HFR 2017). Despite declining fees, hedge fund fees still remain high. Moreover, no regulatory limits exist on the fees hedge funds can charge.
After the GFC, high fees have not necessarily resulted in high returns. Beginning with the early 2009 bull market, hedge fund returns, on average, have lagged traditional asset returns (Martin and Copeland 2016). For example, the Barclay Hedge Fund Index shows returns of 2.88 percent, 0.04 percent, and 6.10 percent in 2014, 2015, and 2016, respectively. This index measures the average return of all hedge funds, excepting funds of funds, in the Barclay database (Barclay Hedge 2017).
Not surprisingly, performance results differ between different indexes because hedge funds are not required to report returns. For example, the HFRI Fund Weighted Composite Index® gained 5.5 percent in 2016 versus 6.10 using the Barclay Hedge Fund Index. Performance differs dramatically among hedge funds. For 2016, the top HFRI decile averaged a 32.7 percent return, while the bottom decile fell an average of – 15.5 percent. Dispersion between the top and bottom HFRI deciles was 48.2 percent in 2016 (HFR 2017). By comparison, the annual total return on the S&P 500 Index during 2014, 2015, and 2016 were 13.69 percent, 1.38 percent, and 11.96 percent, respectively (YCharts 2017).
Given high fees coupled with poor returns, frustrated hedge fund investors in 2016 continued to withdraw capital. In fact, investor dissatisfaction with hedge funds has not been this high since the GFC when they withdrew $154 billion in assets in 2008 and $131 billion in assets in 2009, according to HFR. In 2016, hedge fund liquidations increased, bringing the number of closed funds to the highest level since 2008. Nonetheless, the AUM of hedge funds increased each year since 2008.
Besides fees and performance, Preece (2017) notes other debates and controversies surround hedge funds. For example, one issue is whether reported hedge fund returns are overstated due to biases inherent in their reporting. Several factors, including serial correlation of returns, smoothed returns, survivorship bias, selection bias, and infrequent sampling, can affect reported returns. Other issues focus on the relative lack of regulatory oversight and transparency for hedge funds as well as the use of leverage and hedge fund malfeasance including accusations of fraud ranging from misstating results, engaging in bribery, and failing to disclose conflicts of interest. Finally, some question the role of hedge funds in society.
The Future of Hedge Funds
According to a survey by Ernst & Young (EY) (2016), the primary objective for the hedge fund industry going forward is the ability for it to adapt to evolving demands. EY’s analysis reveals four key metrics necessary for hedge funds to thrive going forward: (1) the need for continued asset growth (56 percent), (2) the ability to effectively manage talent (23 percent), (3) successful cost management and operational efficiency (11 percent), and (4) successful technological transformation (4 percent). To remain competitive, hedge funds must offer greater diversity in nontraditional hedge fund products as investors continue the trend of shifting assets toward investment strategies not easily replicated in the traditional space. Additionally, the average management fee rates continue to decline requiring hedge funds to seek new ways to reduce costs. Growth remains as the top strategic priority in achieving economies of scale, which are predicated on the ability to recruit and retain successful managers.
In its annual survey, Preqin (2017) notes that 84 percent of investors had avoided hedge fund investments due to terms and conditions of hedge funds with two-thirds of investors indicating that hedge funds had not met their performance expectations. Yet investors plan to increase their hedge fund exposure to those using relative value, macro, event driven, and equity strategies. In total, Preqin reports that 51 percent of institutional investors allocate at least a portion of their portfolio to hedge funds and about 90 percent of these investors have a hedge fund target allocation of 5 percent or more.
Despite challenges, some experts predict that AUM for the hedge fund industry will grow faster than the market. For instance, Citi Investor Services (2014) predicts that the hedge fund industry is likely to nearly double from $2.63 trillion AUM in 2013 to $4.81 trillion AUM in 2018 with almost three fourths (74 percent) of those assets coming from institutional investors.
Such investors as pension plans, endowments and foundations remain key investors going forward. Citi Investor Services predicts that endowments and foundations are likely to maintain a steady allocation of around 18 percent to hedge funds through 2018. Sovereign wealth funds are also likely to increase their weight in hedge funds by about 150 percent from around 8 percent in 2013 to 12 percent by 2018. According to Preqin (2017), 54 percent of institutional investors plan to maintain their current hedge fund allocation with 15 percent planning to increase allocation and 31 percent planning to decrease allocation. Hedge funds face increased competition with capital inflows into the alternative investment arena. Compared to hedge funds, Preqin reports that institutional investors are far more interested in increasing their long-term allocations in many other alternative asset classes such as private debt (62 percent), infrastructure (53 percent), private equity (48 percent), and real estate (36 percent).
The key to sustained growth going forward appears to be in changing institutional investors’ perceptions of hedge funds. According to Preqin (2017), about 20 percent of institutional investors perceive hedge funds as a positive alternative asset class. By comparison, most of these investors have a positive view of several other alternative asset classes: private equity (about 80 percent), private debt (about 70 percent), and real estate (about 50 percent). Looking into the early 2020s, some subtle good and bad signs are present for market growth. On the upside, about 60 percent of hedge fund managers plan to expand their current array of investment strategies. On the downside, only 37 percent plan to broaden their global presence. Moreover, 17 percent plan to narrow their focus by repositioning their fund within a particular niche. Only 10 percent plan to acquire another firm, which suggests that most managers plan to grow internally with little consolidation from these activities (State Street 2014). The largest hedge fund managers are responding to current trends by moving toward multi-product asset managers (71 percent, up from 59 percent in the previous year survey) with fewer managers planning to offer only one core strategy (EY 2016).
Holzhauer (2017) notes that hedge funds are operating in a rapidly changing landscape. Because of lower returns generated since the GFC, the hedge fund industry faces growing pressure to lower fees while shoring up operational efficiencies. Thus, managers need to quickly adapt to new technology, especially in areas where it can decrease operating costs. In the future, managers must do a better job of convincing investors that their funds are worth the higher costs. The hedge fund industry has historically been quick to make changes. If managers can continue to find ways to meet investors’ increasing demands net of fees, the long-term future looks bright for the industry.
About the Authors
H. Kent Baker (DBA, PhD, CFA, CMA) is University Professor of Finance at American University’s Kogod School of Business in Washington, DC. He is the Author or Editor of 28 books and more than 165 refereed journal articles. The Journal of Finance Literature recognised him as among the top 1 percent of the most prolific authors in finance during the past 50 years. Professor Baker has consulting and training experience with more than 100 organisations. He has received many research, teaching and service awards including Teacher/Scholar of the Year at American University.
Greg Filbeck (DBA, CFA, FRM, CAIA, CIPM, PRM) holds the Samuel P. Black III Professor of Finance and Risk Management at Penn State Erie, the Behrend College and serves as the Interim Director for the Black School of Business. He formerly served as Senior Vice-President of Kaplan Schweser and held academic appointments at Miami University and the University of Toledo, where he served as the Associate Director of the Center for Family Business. Professor Filbeck is an author or editor of five books and has published more than 90 refereed academic journal articles.
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