Over the last few years the S&P 500 Index has gained approximately 65 per cent, while the Nikkei 225 has gained 113 per cent. The impact of quantitative easing has led to unparalleled growth in equity markets, to such an extent that hedge funds have largely lagged behind.
“In our opinion it’s not just “raw” underperformance but a combination of underperformance and fees. This is leading investors to ask, “Why do I pay so much to receive so little?” says Nicolas Rousselet (pictured), Managing Director and Head of Hedge Funds at Unigestion.
Put simply, today’s low rate environment has created a situation where hedge funds cannot expect to outrun the markets. Consequently, this magnifies the fees, creating a perfect storm of low performance and high costs.
“Back in ’05/’06, and indeed in ’08, when risk premia contracted, people used excess leverage and low and behold, when funds blew up following the financial crisis investors were disappointed that they behaved like levered funds. Today, they don’t behave like levered funds and this too is causing disappointment. So it’s quite ironic that even though investors learned their lessons from investing in levered funds the perception of hedge funds is still negative,” says Rousselet. “Uncorrelated returns are harder to produce and this makes fees look bigger.”
Hedge fund managers are meant to have an edge, based on their unique research capabilities and risk management expertise. Back in the 90s, when financial markets were evolving with the creation of new products like options and other derivatives, talented managers could manufacture an edge and generate massive returns. That’s no longer the case today.
“To justify their fees, the manager has to have a demonstrable edge. Today, the proportion of talented managers is small. They are rare, yet they are the ones who deserve the fees,” explains Rousselet.
But it is far from doom and gloom. There are ways to deal with the above issues.
Take fees. Firms like Unigestion, whose mission is to uncover talented managers, are making strides in negotiating fees that are more aligned to the investor and which incentivise the manager to perform, not just sit on the management fee and gather assets.
“The fee should be paid by investors when performance is good, not all the time. Transformation of fees is something we increasingly see. Managers who operate in the true spirit of what a hedge fund is are happy to look at this,” says Rousselet.
Another key development is the emergence of factor investing and alternative beta products, which are helping investors better understand the true talent of a hedge fund manager. Some managers have, in the past, been no more than one-trick ponies, says Rousselet.
“Maybe they were a small-cap Japanese equity investor, shorting the Nikkei 225 and making large returns until the market turned. Point being, these were not uncorrelated returns, it was a completely directional play. They were using a single factor (e.g. market capitalisation); that was the true driver of performance.”
With alternative beta strategies, such managers can be more readily identified and help investors build a portfolio of pure hedge funds and more cost-effective alternative beta funds.
“There is a much wider continuum being created and that is a positive development,” concludes Rousselet.
