Every January for the past two decades, a clutch of hedge fund titans and their top investors have cloistered themselves at Palm Beach’s plush Breakers Hotel to wine, dine and gossip in the balmy Floridian weather.
Although the exclusive Morgan Stanley-arranged event is one of the social occasions of the year for some of the lucky invitees, the mood has been downbeat for much of the post-financial crisis era — deflated by disappointing returns and dwindling investor faith.
Attempting to lean against the era of super-easy central bank monetary policy has been painful, and the market tranquility it has caused robbed many hedge funds of the opportunities they crave. Instead, they have had to watch rival private equity tycoons struggle to invest the piles of money they have raised, and trillions of dollars flow into cheap, passive index funds, some of which promise to replicate what hedge funds do at a fraction of the price.
This year, however, the fact that it was a virtual conference couldn’t quell an unmistakable sense of optimism. “This was the first time in many years Breakers felt like a celebration — as much as anything can feel like a celebration online. It had an upbeat feel to it,” says Sandy Rattray, chief investment officer of Man Group.
Despite a smattering of mishaps and debacles, the hedge fund industry on the whole acquitted itself well in the market turmoil of 2020, returning 11.8 per cent last year, according to data group HFR — the best year since the aftermath of the financial crisis in 2009.
The mood has only improved since then. This year they have already gained almost 10 per cent on average, the best start to a year in over two decades. It may fall short of the global stock markets’ 13 per cent gains in 2021, but hedge funds invest in much more than just equities, and with valuations now beyond or close to record levels, few analysts think those kinds of stock market gains can continue.
Investors are certainly taking notice of the hedge fund industry’s renaissance. After withdrawing more than $170bn during the previous five years, they invested a net $18.4bn in the first half of 2021, according to HFR. As a result, the global hedge fund industry’s overall assets under management have swelled to a record $4tn this year.
This time, hedge funds have largely learned to surf the tide of central bank bond-buying rather than fight it, and have found ample opportunities from the ebb and flow of various market trends — such as a splurge of corporate dealmaking, the tides of bond markets and stock market winners and losers from the pandemic lockdowns and reopenings of economies.
“We’ve seen significantly positive, double-digit returns across just about every strategy. That’s caught the attention of a lot of people, us included,” says Mark Anson, the head of Commonfund, which invests on behalf of charities and foundations. He doubts that hedge funds will return to their 1990s heyday, but thinks that a “silver era” may now beckon.
There are still some dark clouds on the horizon. The rebound in the industry is not just down to its own merits. Many hedge fund managers and their investors admit that the industry is also benefiting enormously from other financial trends.
The gloomy outlook for bond market returns in the coming decade has led to a scramble for plausible alternatives, and hedge funds are some of the biggest beneficiaries. Moreover, the fundraising environment for private equity and venture capital firms is so red hot that surplus investor money almost inevitably has to slosh over into hedge funds.
Even some industry veterans are sceptical that the current ebullience will prove durable.
“After a pretty tepid decade, hedge funds are clearly enjoying a good moment now. But you have to ask whether the trajectory for the next decade has fundamentally changed,” says Victor Khosla, founder of Strategic Value Partners. “I’m just not sure that is the case.”
Finding new talent
Few hedge funds are more emblematic of the industry’s post-crisis fall from grace and recent renaissance than Brevan Howard, a UK investment firm co-founded by the publicity-shy billionaire Alan Howard.
Brevan Howard once managed assets worth about $40bn and was viewed as the gold standard of “macro” investing — betting on global economic trends through the bonds and currencies of countries. From its launch in 2003 until 2013 its main fund never had a down year, even during the financial crisis. But many of its founders started leaving and performance fizzled dramatically, leading to a string of losses and an exodus of investors. Assets fell to as low as $6bn in 2018.
However, under the leadership of former chief risk officer Aron Landy the firm has staged a remarkable recovery since that nadir. The firm has moved away from a star manager culture towards a broader base of talented managers. Like the wider industry, Brevan Howard is also becoming a little less opaque, giving investors access to podcasts on how senior managers are thinking or offering interactive webinars.
Most importantly, results have picked up. Helped by several highly profitable bets — including against Italian bonds in 2018 and on bond yields tumbling early last year — Brevan’s main fund has posted double-digit gains in two of the past three years, according to an investor letter. Investors have returned, with assets rebounding to $16bn.
Global macro funds like Brevan Howard have been some of the standout winners from the financial turbulence triggered by the Covid-19 pandemic. But virtually every part of the oft-maligned industry is now basking in healthy returns and resurgent investor interest. Many point out that the hedge funds that have survived the past lean decade are generally the better ones, and virtually all of them have become leaner.
“Hedge funds are coming back, but it is a different industry now,” says Carlo Trabattoni, chief executive of Generali Investments, the asset management arm of the Italian insurer. “It has been cleaned up a little. The larger and more efficient ones have remained.”
The expensiveness of hedge funds — one of the biggest turn-offs for many investors — has also improved a little over the past decade. Historically the industry charged a 2 per cent annual management fee, and took 20 per cent of profits, with the best ones able to charge even more. Today, the average is 1.38 per cent and 15.9 per cent respectively, according to Eurekahedge, a data provider.
Yet improving performance has been a bigger driver than falling fees. According to analysis by data group PivotalPath, 38 out of 40 hedge fund strategies made money due to their managers’ skills — rather than just overall market moves — over the year to June, their best year since 2010. This manager skill, known in industry jargon as “alpha”, is the sector’s prized asset and its best selling point to clients.
The possibility of market-beating gains is particularly attractive at a time when many analysts and fund managers are convinced that simply surfing the tide through cheap, passive index funds will not work as well in the coming years.
If a typical balanced portfolio of stocks and bonds is going to return just 2.1 per cent annually after inflation in the coming five to 10 years — as investment group AQR Capital Management forecasts, based on historical valuation patterns — then many investors that need 7-8 per cent a year to pay pension plan members or life insurance policies feel they need to find fund managers that will at least try to deliver that.
“It’s not going to be about putting up your sail and letting the market winds drive your portfolio,” says Jim Smigiel, chief investment officer at SEI. “You’re going to have to do some rowing, so investors are starting to look for rowers.”
The industry optimism is almost palpable. The Alternative Investment Management Association surveyed its members this summer, finding more than 90 per cent were optimistic on their business prospects over the next 12 months.
The surge in investor interest is also helping a number of hedge fund launches get off the ground for the first time in years. The number of funds being liquidated has outpaced the number being raised for six straight years, according to HFR, but in the first quarter of 2021 there were 189 launches and just 159 closures.
Some of them are sizeable. New funds such as Sparta Capital, set up by Franck Tuil, one of Europe’s most prominent activists; Nekton, launched by former York Capital Management executive Christophe Aurand; and Fifthdelta, set up by former Citadel managers, are expected to raise $500m or more each.
“Clients who for many, many years were burnt and didn’t want to hear about hedge funds, for the first time they’re willing to listen,” says Cesar Perez Ruiz, head of investments at Pictet Wealth Management. Earlier this year he went overweight — meaning he took a larger-than-normal position — in hedge funds for the first time in his five years at the firm.
However, Perez Ruiz admits that a significant reason for this is growing concern about exposure to bonds.
Fixed income has historically been a mainstay of most investors’ portfolios, thanks to their subdued but steady returns and ability to rally when stock markets are rocky. But with bond yields hitting record lows, the return outlook is dismal and their historical ability to buffer stock market losses is severely impaired, many investors fret. Moreover, if inflation does ignite then supposedly safe fixed income markets might even start losing money.
That means many investors are desperately looking for a “fixed income substitute” — something that could at least plausibly do well even if stock markets wobble. While these investors recognise that hedge funds will not match their 1990s heyday, they should do better than bonds, and may do well in times of market turbulence.
Moreover, with so much money continuing to gush into private equity and venture capital, some investors feel overexposed to those asset classes, and worry that they will inevitably see returns fade. The hedge fund industry is one of their few viable alternatives.
“There’s not much choice but to allocate more to hedge funds today,” says Rattray, who is leaving Man Group and the industry later this year. “This concern about what to do with bonds is pretty tangible, and putting all your money into equities feels like an unwise thing to do.”
However, one of the biggest challenges confronting investors once again enamoured with hedge funds is the fact that almost all of its top players with positive long-term results — such as Millennium, Two Sigma, DE Shaw and Citadel — largely remain shut to new clients. These funds believe that while higher assets equals fatter management fees, it can also hurt performance by making them less nimble.
“Capacity is a real issue across certain hedge fund strategies presently and access is vital,” said Michael Rosenthal, chief investment officer at Signia.
Indeed, the issue of evaporating investment capacity among the industry’s most prestigious firms is a growing phenomenon. With some hedge funds now bloated by large gains from the market rally and resurgent interest, more top-performing funds are shutting their doors to new investors.
Andrew Law’s Caxton Associates, which last year made a record 40 per cent in its flagship fund, has now shut the fund to new money. Verition Fund Management also stopped taking in money after having grown fourfold over the past two years to $3.6bn. Gresham Investment Management has also frozen its $900m ACAR fund, a computer-driven strategy which is up 32 per cent this year.
The fund perhaps most indicative of the sector’s resurgence — Brevan Howard, which just a few years ago was on its knees — halted new investments in two of its biggest funds this year.
However, this may force investors into second-tier hedge funds that could see their performance fizzle once markets are less buoyant. “We still believe alpha is out there, but it is getting harder and harder to find,” says Commonfund’s Anson.
The fundamental question is therefore whether this is truly a turning point for hedge funds — the beginning of a new era of more respectable performance and renewed investor faith — or merely a temporary reprieve for an industry that even some insiders say remains bloated.
Despite a modest shakeout over the past decade, there are still comfortably more hedge fund managers globally than there are managers of the Taco Bell restaurant chain — a common joke even inside the industry. And regardless of occasional bouts of enticing performance, many investors remain unconvinced that hedge funds as a whole add value over time.
“They’re bloody expensive,” Chris Ailman, chief investment officer of Calstrs, the $300bn Californian pension plan, told CNBC this summer. He feels that they are mostly able to keep growing thanks to their allure over their substance. “People love the idea of being in a hedge fund because it sounds mysterious and awesome . . . That doesn’t mean it’s going to produce long-term sustainable results.”