After the market decline of 2008, the hedge fund industry experienced a significant contraction that was driven by negative performance, heavy redemptions and almost a complete seizing of inflows. The major question running through the hedge fund industry today according to Don A Steinbrugge, managing partner of Agecroft Partners is – to quote Yogi Berra, the famous New York Yankee catcher – is it “déjà-vu, all over again”?
Agecroft Partners is in contact with over a thousand investors per month and they see two major trends developing within the hedge fund investor community based on the recent sell off in the equity market and the increase in volatility, that are very different than what was experienced at the end of 2008. The differences include expectations for hedge fund net capital flows and changes in investor demand for various strategies and types of managers.
Currently, investor’s appetite to make new hedge fund allocations and to meet with managers has seen very little change. Approximately 5% to 10% of investors have said they are on hold until they see how things play out, which is very different than the end of 2008 when a vast majority of investors were on hold or redeeming. Although we have had a dramatic increase in volatility, the S&P 500, as of August 19th, was only down about 10.5% year to date, which has made many investors nervous, but has not caused their behavior to change. The big question is what happens to hedge fund net capital flows if the market continues to decline? There is obviously a correlation between net fund flows and the performance of the capital markets, but Agecroft believes that the magnitude of change relative to net flows has declined dramatically since 2008. If we have another 40% plus sell off in the equity markets net flow should be significantly better than experienced in 2008 for several reasons.
1. The make-up of the hedge fund investor base is very different from 2008 and is dominated by institutional investors who are much more long term oriented and stable. Pension funds over the past few years have been responsible for a significant percentage of positive net flows to the hedge fund industry. This trend could actually be enhanced by a market decline as pension funds strive to reduce their unfunded liability by enhancing returns and reducing downside volatility. Pension funds need to generate a return equal to their actuarial assumptions which typically are in the 7.5% to 8% range. This is difficult to achieve when the fixed income portion of their portfolio is yielding around 3%. Endowments and foundations, which were criticized for their redemptions after the 2008 market correction, have repositioned their portfolios to better withstand “liquidity” events. These liquidity issues were primarily driven by the private equity portion of their portfolios, where common practice was to over allocate to private equity in order to maintain a targeted allocation. This caused significant issues when capital calls increased while return of capital came to a halt. Most of these liquidity issues have now been resolved. Going forward endowments and foundations will be much more active allocators to hedge funds given a similar sell off. Finally, the fund of funds market place is much more stable. These organizations are using less leverage and their investors are better educated on what they are buying. Before 2008, many fund of funds were selling their funds as a t-bills plus 400 basis point product. Many investors didn’t realize that they could experience material negative returns. When investor’s experience is dramatically different than their expectations, they are much more likely to redeem.
2. Significantly less leverage utilized by hedge fund investors and managers. In 2008 a majority of the highly leveraged fund of funds either went out of business, suffered heavy withdraws, or had their leverage reduced by their lenders. This in turn led to significant redemptions from the underlying hedge funds. Today there is much less leverage used by fund of funds. In addition, the average leverage used by individual hedge funds has declined, which should help their performance in a down market and reduce the amount of withdrawals.
3. Lower probability of another Madoff. The Bernie Madoff fraud caused total losses, including fabricated gains, estimated at USD65 billion and the court-appointed trustee estimated actual losses of USD18 billion. This caused a ripple effect throughout the industry which led to massive redemptions from investors in fund of funds that had Madoff exposure, and it temporarily reduced investors’ confidence in the hedge fund industry, leading to further redemptions and reductions in allocations. Since that terrible event there has been a significant enhancement in the due diligence process of many investors to reduce the probability of fraud, including a greater focus on transparency, operational due diligence and the quality of service providers.
4. Better alignment of liquidity terms and underlying investments. Back in 2008 there was less regard for the mismatch in liquidity terms of a fund and its underlying investments. It didn’t matter if the fund strategy focused on asset based lending, distressed debt, or some other type of illiquid investment as long as the fund allowed for monthly or quarterly liquidity. This mismatched worked fine as long as there were positive flows to the fund, however, the large redemptions at the end of 2008 lead to many funds raising gates and suspending redemptions. This also reduced confidence in the hedge fund industry and unfairly penalized liquid strategies by turning them into ATM machines for many investors that needed liquidity. Since then there has been a much greater focus by investors on liquidity terms and their alignment with the underlining investments. Investors are much more willing to accept longer lock-up provision and redemption cycles for less liquid strategies and are avoiding those funds with mismatches in liquidity terms. In addition, those managers who investors perceived self-servingly employed a gate provision at the end of 2008, have been banished from future consideration. We should see the reduced use of gates and suspension redemptions in the future.
5. Lack of good investment alternatives. After the market correction in 2008 there were many alternatives in which to invest to protect capital. Today the options are not as compelling. Money market funds are yielding close to zero and generating a negative real return. The 10-year US treasury is yielding approximately 2% and could sustain a large market value decline if interest rates rise. Gold has seen a significant rise in value and now is at an all time peak and investors obviously don’t want to increase their equity holdings if they expect a major decline in the equity markets. Hedge funds are a much more attractive option than they were at the end of 2008.
Hedge fund investors rethinking the type of hedge fund strategies and type of managers they are interested in investing in. The increased volatility and world equity market sell-off are causing many investors to rethink the types of hedge fund strategies and managers they are interested in placing money with based on their scenario analysis of the future. Many investors are looking for strategies that provide diversification benefits, downside protection or a focus on less efficient areas of the market. We will see continued strong demand for global macro funds and CTAs because of their historically low correlation to long-only benchmarks. In addition, there will be an increase in demand for market neutral, arbitrage and trading oriented-strategies. Within the long short/equity area there will be less demand for very long biased managers and greater demand for managers that can move their exposure around. Investors will continue to diversify their equity portfolios away from managers that focus on large-cap European and North American companies to those that focus on companies in emerging market economies which exhibit stronger growth rates, trade surpluses and lower national debt, such as China. Within the fixed income space, spreads on all non-treasury securities have contracted significantly since the start of 2009, creating a golden opportunity for those positioned correctly. Market participants have noted the recent expansion of spreads, but argue the beta trade is over. There will be a greater focus on managers that actively trade their portfolio and invest in less efficient parts of the fixed income market space, for example structured credit.
The volatile markets are causing significant deviations in performance across mangers in similar strategies, which will increase manager turnover. Those managers who significantly underperform their peers will be heavily punished by experiencing large withdrawals; in turn, that will benefit other managers who successfully navigate through these difficult markets by protecting their investors’ capital. Unlike 2009 and 2010 when performance was a secondary consideration in net capital flows to the size and “brand” of a manager, due to their perception of providing safety, expected future performance will be a major factor in investors’ decision making going forward.
We will not see a vast majority of inflows going to hedge fund managers with assets greater than USD5 billion, which for a period of time after 2008 was over 100% of net flows. Recently there have been a number of large high-profile hedge fund managers generating very poor performance, which is causing investors to question whether these large managers have morphed into asset gatherers at the expense of performance. Some of the most well-known hedge fund managers will experience heavy withdrawals in the coming months as investors continue to shift their assets to smaller, more nimble managers.
In conclusion, if we experience a major market correction, Agecroft believes net flows will be negative, but nowhere near the extent that was experienced in 2008. Most of the redemptions will be recycled within the industry to managers and strategies that provide downside protection for their investors.