The start of the year for hedge funds has been rocky at best. The global hedge fund industry experienced $15.1 billion in investor outflows in the first quarter of 2016, marking the largest quarterly outflow since the second quarter of 2009, according to Chicago-based Hedge Fund Research (HFR). It was also the first time since 2009 that the industry has experienced two consecutive quarters of outflow.
The redemptions have come as the industry copes with volatile market conditions. Low oil prices and underperformance in emerging markets have caused further issues in FX markets.
“Hedge funds have lost a lot of the easy pickings they have had in the past few years,” said Danielle Tierney, senior analyst with Aite Group. “Basically, they have lost a lot of the easier correlation plays.”
Investors that have publicly announced hedge fund withdrawals have included large insurance companies and public pensions. Last month, American International Group announced that it was redeeming $4.1 billion in hedge fund investments, and MetLife announced plans to withdraw most of the $1.8 billion it had invested in hedge funds. New York City Employees’ Retirement System (NYCERS) announced in April that it was shifting its $1.5 billion investment in hedge funds to other assets. NYCERS’ move came a year and a half after the California Public Employees’ Retirement System (CalPERS), the largest U.S. public pension, made news by announcing it was divesting its $4 billion hedge fund investments.
Massachusetts is reportedly planning to cut back on pension holdings in alternative investments, including hedge funds, and so is Illinois. The New Jersey Legislature is also considering a similar proposal.
Some see the bumpy start to the year as more than a rough patch, and potentially part of a larger trend. Others, however, say reports of the hedge fund industry’s demise are greatly exaggerated. Hedge fund manager Daniel S. Loeb’s firm Third Point, in a first-quarter letter to investors, called the industry’s first quarter “one of the most catastrophic periods of hedge fund performance that we can remember.”
Despite that brutal characterization, Third Point management noted that it viewed the current market as an opportunity. “We believe that the past few months of increasing complexity are here to stay, and now is a more important time than ever to employ active portfolio management,” the letter stated.
Aside from the beta-pressures of underperforming sectors or portions of the market, hedge funds are also facing new types of competition. Last summer, CNBC reported that exchange-traded funds had overtaken hedge funds in assets under management, according to hedge fund data from HFR and ETF data from research firm ETFGI. As passive investment vehicles, ETFs have been attracting investors with their low fees. This has been particularly attractive in a period when hedge fund strategies have struggled.
“The hedge fund community has had reduced, and in some cases negative returns, and with high fees you are seeing a re-evaluation of how you’re going to allocate your money,” BlackRock CEO Larry Fink told CNBC. BlackRock’s iShares business is the world’s largest manager of ETFs.
Hedge funds are also facing competition from another newer market competitor: automated trading. In fact, many hedge funds are themselves getting on board with automated strategies. This year, about half of the 25 highest-earning hedge fund managers topping Institutional Investor’s Alpha’s Rich List used computer generated strategies to produce either all or some of their investment gains.
Aite Group’s Tierney, who admits to having an active management bias, having previously worked on an equity portfolio at Wellington Management, expects skill to always trump automation. Yet even she admits hedge funds are moving toward more of a hybrid model.
“Ideally, you have an automated strategy combined with active management,” she said. “Strategies are going to become more automated any way you cut it, and they become more automated in less obvious ways. For active managers, the days of the completely traditional investment research, with managers just building models and conducting pure bottom-up or top-down stock selection techniques, are becoming more and more rare because they are using more automated tools to help analyze the massive amounts of available data to support even the most traditional types of fundamental analysis.”
Meanwhile, although automation and its impact on trading may be here to stay, Tierney sees the current market pressures that have weakened hedge fund returns, such as low oil prices and underperformance in emerging markets, as cyclical. She expects the industry to remain challenged for another 18 months, but notes that even since the financial crisis hedge funds have had ups and downs.
“If you look at the cycles over the last couple of years, after the crisis all people could talk about was the declining number of hedge funds because the markets declined and therefore the assets declined,” she explained. “Then, sure enough, as soon as markets started to rebound, and that really only took a couple of years, all people could talk about was the expanding number of hedge funds.”
In fact, the growth in the industry in recent years has been striking. In early 2000, according to HFR, there were 3,102 hedge funds managing $456 billion. Now HFR counts 8,474 hedge funds managing $2.89 trillion.
Meanwhile, for now, the challenging market conditions may be an opportunity for top hedge fund managers to demonstrate their skills. “It does allow the truly more talented managers and most effective strategies to rise to the top,” Tierney said.
Not all managers are as adept as others at spotting market signals. As Third Point put it in its quarterly letter to investors, “When markets bottom, they don’t ring a bell, but they sometimes blow a dog whistle.”
