Murano’s Ole Rollag (pictured) reflects on the past year and makes his predictions for hedge funds in 2020…
It has been another challenging year for the hedge fund industry – asset flows were negative for the sixth consecutive quarter according to HFR data – and yet many managers seem positive overall.
We note both a more defensive view amongst many institutional investors and a better understanding within the asset management complex of what a hedge fund can and cannot do.
However, this comes with stark warning signs as many managers have yet to demonstrate their skills when a real bear market environment occurs. It has been over 10 years since the Credit Crisis and it turns out that one of the best performing ‘hedge funds’ has been the U.S. equity market. The S&P 500 has delivered about 17% as of the time this publication.
So what about 2020? To be honest, who knows. More of the same, perhaps?
We don’t see the trends changing in the immediate term. These, in general, are the major trends that we have observed at Murano over the past year:
1. There is a large dispersion of allocator skill. Allocating to 3rd party funds is a dark art and the craft is often learnt while on the job. There is a lot of divergence in what makes a good manager and there continues to be a plethora of momentum chasers. However, it appears as though the community as a whole is much more comfortable constructing hedge fund portfolios themselves, much to the detriment of the FoHF community.
2. Allocators have a tough job identifying scalable opportunities. Herd mentality and crowded trades have also been an issue. When finding a manager that can take advantage of a perceived edge, allocators often compromise on performance for AUM. One FoHF manager pointed out that on a dollar for dollar measure, nearly all (rising) managers don’t make money through the life of the fund. This is probably why we find that emerging managers perform better than their more mature peers. A number of the large investors find performance suffers when they are forced to invest in the largest funds at the end of their cycle.
3. The markets are priced to perfection (overpriced? yes, but I like perfection) and there is very little opportunity. In other words, there is too much money. So much wealth has been created over the past decade that there appears to be very little value in many asset classes. This has created a lop-sided risk/reward scenario.
4. Allocators who have longer time horizons are prepared to go into more niche opportunities in order to realise their return targets.
From the manager side:
1. We expect there will be fewer new managers launching product. As regulatory costs have gone up and fund buyers have become more savvy, the days of marching up and down Midtown and Mayfair to receive seed capital are gone. Managers are increasingly expected to have a true pedigree and a real business in order to get those early dollars.
2. CTAs have been trodden down and will probably continue with this beating until further notice when attitudes change. In my opinion, it is a vast asset class that is poorly understood. This attitude adjustment has happened before (2008), when they were the darlings in the rubble. Investment in this asset class seems to always happen after the fact when it is too late.
3. Managers will consolidate more.
Let’s be honest, there are a lot of managers around. Like in a supermarket, not only is it a challenge to get a product onto those valuable shelves, it is also a challenge to stay on them. Managers who have a great product, but lack the ability to get noticed might feel compelled to trade the result of the business P&L for sustainability and a smaller slice of a much larger cake.
From a markets perspective, it is difficult to predict what will be the catalyst that drives the industry into the next chapter and causes a shift in portfolio re-allocation, but it most likely will be debt-driven. If you look back at the last 30-years (and possibly longer), most crises were driven by debt, with the possible exception of the tech bubble in 2000. One could argue that the tech bubble was because those companies were over-levered.
If we look at the amount of debt in the overall system today, it would be reasonable to assume that history will repeat itself. The market has had several defaults and the high-yield markets are becoming a bit skittish in the U.S. However, there is also a great amount of disequilibrium within the credit markets.
With Euro-denominated high yield bonds yielding negative, while the S&P U.S. high yield index is currently trading at around 6.0 per cent, one needs to wonder if investing in European high yield is a smart undertaking. Most people we speak with agree it will end in tears. But how? And when?
Another issue that has drawn a few raised eyebrows has been the vast growth in passive ETFs. As a former derivatives trader, the issue of basis risk is very close to my heart. ETFs are essentially derivatives of cash products that need nearly perfect hedging. There has been a plethora of ETF bond funds that have come to market and because the infinite wisdom of the U.S. Government has changed the very structure of the bond market, the bonds that make up these indexes are not as liquid as they once were.
I am not targeting liquid ETFs with liquid underlyings here, but I am concerned about the liquidity mismatches that could exacerbate a problem and create a whole new one.
Will we see a blow-up of at least one ETF product in 2020? It’s highly likely we may.
