Hedge Funds 3.0: The Continuing Evolution of Hedge Funds

Hedge Funds 3.0: The Continuing Evolution of Hedge Funds

Hedge Funds 3.0: The Continuing Evolution of Hedge Funds

By Ezra Zask, January 11, 2015

One of the most controversial questions in the investment world is: why do hedge funds keep gaining assets when their performance over the past decade has been relatively poor compared to stocks? After all, hedge fund returns have lagged the S&P for the past 7 years; a period that covers a full business cycle.

One way they have accomplished this feat is by changing the definition of “performance” over time to overcome the inability to live up to the preceding definition.  Thus, high return was replaced by downside protection, alpha and, most recently, diversification and risk reduction.

Hedge funds have faced a number of challenges over the past three decades that have led to fundamental changes in their objectives and operations.  A short list of these challenges includes the proliferation of hedge funds and hedge fund strategies; the institutionalization of hedge fund investors; economic crises in 1987, 1994, 1998, 2001 and 2008; and increased criticism of hedge fund performance and fees.

As with any evolution, some hedge funds thrived — at least in terms of increasing assets under management and generating income for their managers –while others either became extinct or are an endangered species. In the course of this evolution, the surviving hedge funds would not be recognized by investors of 20 years ago.

The performance criteria that hedge funds are expected to meet has changed dramatically over the years.  We can broadly identify three hedge fund performance regimes.

In broad strokes, Hedge Fund 1.0, which was dominant in the 1980’s and 1990’s, touted the outsized return that were available through hedge fund investments.  George Soros and Julian Robertson were the models for investors.  However, as the hedge fund field became crowded, they were forced to compete in well-arbitraged markets and these outsized returns became more and more rare.  The process was accelerated by the larger scale of funds who were unable to meaningfully invest in small markets.

Hedge Fund 2.0 focused on the downside protection and absolute return measure of hedge fund performance. as indicated by their relatively small losses compared to other investments during the Asian crisis of 1998 and the Internet bubble of 2001. This hedge fund meme was exploded during the Credit Crisis in 2008 when hedge funds as a group lost over 20%.  (While still lower than the S&P loss of over 40%, the loss was not supposed to occur under hedge fund 2.0)

Hedge fund 2.0 also included the notion that hedge funds added the elusive and sought after investment alpha (returns above market returns) which ostensibly resulted from manager skill or unexploited market opportunities.  This alleged benefit was also whittled away as new sources of beta were identified (specific to hedge fund strategies and markets) and reduced the size of the alpha.

In hedge fund 3.0 performance no longer holds hedge funds to a benchmark or, indeed, any return criteria.  The performance criteria of hedge fund 3.0 is summarized in a recent paper published by the Alternative Investment Management Association (AIMA), a hedge fund industry group, and the Chartered Alternative Investment Association (CAIA), which provides certification for alternative investments. The paper is titled “Portfolio Transformers: Examining the Role of Hedge Funds and Diversifiers in an Investor Portfolio.”  Hedge funds are touted as either portfolio diversifiers or investment substitutes (for traditional stocks and bonds).  The major hedge fund strategies are placed into one of these functions:

(Source: “Portfolio Transformers: Examining the Role of Hedge Funds and Diversifiers in an Investor Portfolio.”)

The benefits for investors that result from including hedge funds in their portfolios include the following:

  • a source of diversification
  • substitutes for traditional stocks, bonds and cash investments
  • provider of downside protection
  • lowered volatility
  • possibility of improving returns in an overall investment portfolio

According to the study,

Such hedge fund strategies ought to reduce the overall volatility (i.e. reduce the risk) of the portfolio’s public markets allocation, with a more attractive risk/reward profile. Other hedge fund strategies may have a low correlation to equity and credit markets and offer a higher probability of generating out-sized returns (albeit by taking on a higher level of risk).

Employing this approach (where hedge funds take on the role of a substitute or complement the equity or fixed income portfolio) offers the plan a way ofreducing the volatility (risk) within their public equity allocation, with little if any reduction in the portfolio’s total performance.

One of the interesting aspects of Hedge Funds 3.0 is that performance in terms of beating a benchmark (whether S&P or any other benchmark) is no longer required for a hedge fund to be successful.  The most that is held out to investors is that hedge funds “offer a higher probability of generating-outsized returns (albeit by taking on a higher level or risk,” which is a tautology that is true of any risky investment.)  The second crumb offered to investors is that diversification via hedge funds results in “little if any reduction in the portfolio’s total performance.”

Both of these measures of “success” may come back to haunt hedge funds because it places them squarely in competition with other “substitutes” and “diversifiers” such as smart beta, commodities, and index funds.

Ezra Zask is a 25-year veteran of the hedge fund and investment industries.  He is President of Ezra Zask Research Associates, an alternative investment consulting firm.  He is also the author of All About Hedge Funds, Second Edition (McGraw Hill: 2013)