Excellent Article on Big Data

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Will Smart Beta Replace Hedge Funds?

Will Smart Beta Replace Hedge Funds?

Issues with Hedge Fund Performance

Hedge Funds 3.0: The Continuing Evolution of Hedge Funds

Hedge Funds 3.0: The Continuing Evolution of Hedge Funds

By Ezra Zask, January 11, 2015

One of the most controversial questions in the investment world is: why do hedge funds keep gaining assets when their performance over the past decade has been relatively poor compared to stocks? After all, hedge fund returns have lagged the S&P for the past 7 years; a period that covers a full business cycle.

One way they have accomplished this feat is by changing the definition of “performance” over time to overcome the inability to live up to the preceding definition.  Thus, high return was replaced by downside protection, alpha and, most recently, diversification and risk reduction.

Hedge funds have faced a number of challenges over the past three decades that have led to fundamental changes in their objectives and operations.  A short list of these challenges includes the proliferation of hedge funds and hedge fund strategies; the institutionalization of hedge fund investors; economic crises in 1987, 1994, 1998, 2001 and 2008; and increased criticism of hedge fund performance and fees.

As with any evolution, some hedge funds thrived -- at least in terms of increasing assets under management and generating income for their managers --while others either became extinct or are an endangered species. In the course of this evolution, the surviving hedge funds would not be recognized by investors of 20 years ago.

The performance criteria that hedge funds are expected to meet has changed dramatically over the years.  We can broadly identify three hedge fund performance regimes.

In broad strokes, Hedge Fund 1.0, which was dominant in the 1980’s and 1990’s, touted the outsized return that were available through hedge fund investments.  George Soros and Julian Robertson were the models for investors.  However, as the hedge fund field became crowded, they were forced to compete in well-arbitraged markets and these outsized returns became more and more rare.  The process was accelerated by the larger scale of funds who were unable to meaningfully invest in small markets.

Hedge Fund 2.0 focused on the downside protection and absolute return measure of hedge fund performance. as indicated by their relatively small losses compared to other investments during the Asian crisis of 1998 and the Internet bubble of 2001. This hedge fund meme was exploded during the Credit Crisis in 2008 when hedge funds as a group lost over 20%.  (While still lower than the S&P loss of over 40%, the loss was not supposed to occur under hedge fund 2.0)

Hedge fund 2.0 also included the notion that hedge funds added the elusive and sought after investment alpha (returns above market returns) which ostensibly resulted from manager skill or unexploited market opportunities.  This alleged benefit was also whittled away as new sources of beta were identified (specific to hedge fund strategies and markets) and reduced the size of the alpha.

In hedge fund 3.0 performance no longer holds hedge funds to a benchmark or, indeed, any return criteria.  The performance criteria of hedge fund 3.0 is summarized in a recent paper published by the Alternative Investment Management Association (AIMA), a hedge fund industry group, and the Chartered Alternative Investment Association (CAIA), which provides certification for alternative investments. The paper is titled “Portfolio Transformers: Examining the Role of Hedge Funds and Diversifiers in an Investor Portfolio.”  Hedge funds are touted as either portfolio diversifiers or investment substitutes (for traditional stocks and bonds).  The major hedge fund strategies are placed into one of these functions:

(Source: “Portfolio Transformers: Examining the Role of Hedge Funds and Diversifiers in an Investor Portfolio.”)

The benefits for investors that result from including hedge funds in their portfolios include the following:

·        a source of diversification

·        substitutes for traditional stocks, bonds and cash investments

·        provider of downside protection

·        lowered volatility

·        possibility of improving returns in an overall investment portfolio

According to the study,

Such hedge fund strategies ought to reduce the overall volatility (i.e. reduce the risk) of the portfolio’s public markets allocation, with a more attractive risk/reward profile. Other hedge fund strategies may have a low correlation to equity and credit markets and offer a higher probability of generating out-sized returns (albeit by taking on a higher level of risk).

Employing this approach (where hedge funds take on the role of a substitute or complement the equity or fixed income portfolio) offers the plan a way of reducing the volatility (risk) within their public equity allocation, with little if any reduction in the portfolio’s total performance.

One of the interesting aspects of Hedge Funds 3.0 is that performance in terms of beating a benchmark (whether S&P or any other benchmark) is no longer required for a hedge fund to be successful.  The most that is held out to investors is that hedge funds “offer a higher probability of generating-outsized returns (albeit by taking on a higher level or risk,” which is a tautology that is true of any risky investment.)  The second crumb offered to investors is that diversification via hedge funds results in “little if any reduction in the portfolio’s total performance.”

Both of these measures of “success” may come back to haunt hedge funds because it places them squarely in competition with other “substitutes” and “diversifiers” such as smart beta, commodities, and index funds.

Ezra Zask is a 25-year veteran of the hedge fund and investment industries.  He is President of Ezra Zask Research Associates, an alternative investment consulting firm.  He is also the author of All About Hedge Funds, Second Edition (McGraw Hill: 2013)

Hedge Fund Returns vary with Economic Environment

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As is well known, the performance of hedge funds and liquid alternative investments (whose performance track that of hedge funds) has been abysmal, producing negative alpha (i.e., lagging the performance of the S&P 500) while maintaining the high fees and performance share. Despite this performance, funds continue to flow into hedge funds, especially from institutional investors.

Justifying Hedge Fund Performance

A number of arguments have been put forward to explain (or justify) the poor performance of hedge funds.  One such is the argument that the S&P is not a relevant benchmark for evaluating hedge funds because the latter's goal it precisely not to track the S&P.  Rather, hedge funds seek to reap absolute returns or provide a superior risk-adjusted return. 

In more recent times, the justification for hedge funds' performance has been that their true benefit is not to outperform the S&P, but rather to add diversification to investment portfolios, thus reducing their volatility and (possibly) producing increased gains.

Finally, hedge funds are rationalized as providing higher Sharpe ratios than the S&P even with lower returns because of their lower volatility.

Hedge Fund Returns are a Function of the Economic Environment

A better explanation of hedge fund returns is to view them in the economic and market environment in which they are generated.  After all, we have been tracking hedge funds since the early 1990s, yet the economic environment, financial markets and hedge fund strategies have changed radically since that time.  Trying to explain hedge fund returns without taking this into account is like trying to explain tides without reference to the moon.

A recent research report, "A New Era for Hedge Funds?" offers an extended discussion of this issue, reinforcing the points made above.  The report addresses the main problem head on: "...hedge funds have in fact underperformed traditional asset classes since 2009."   

Source: "A new era for hedge funds?" Lyxor Research, July 2015

But rather than using on the above arguments to explain this discouraging fact, they argue that "the absolute performance of hedge funds has been outstanding" since the early 1990s both on an absolute and risk adjusted basis.  The problem is in trying to make an argument for hedge fund performance for periods when they unarguably underperform.

Lyxor presents the factors that drive hedge fund performance, and which have driven hedge fund returns downward in recent years: 

"We evaluated the causes of the underperformance and find that the fall in bond yields in the wake of the Fed's QE program has negatively impacted hedge funds.  Additionally, the equity beta has fallen while stocks rallied and alpha generation has shrunk for the very same reason."

     Looking back at various business cycles over the past 25 years, Lyxor finds periods that were favorable to hedge funds and others that were not.  

Source: "A New Era for Hedge Funds?" Lyxor Research, July 2015

However, unlike many analyses that point to the same fluctuations, Lyxor looks for the underlying factors that drive the under- or over- performance.  The result is a forecast of hedge fund performance based on factor analysis that is as follows:

     "Going forward....we estimate that hedge funds could deliver annual excess          returns in the 5-6% range with low volatility....Hedge funds have                             demonstrated their ability to protect portfolios against wide market                         fluctuations, a scenario that we cannot exclude as the Fed turns the screw."

Implication for Hedge Funds and Investors

While many will argue with particular aspects of Lyxor's analysis, their analysis is more fruitful than the typical "hedge funds outperformed the S&P over the past week."  It provides a framework that is similar to that used to explain (and market) traditional asset classes; that the strategies will produce positive results, but only over a series of business cycles.  Any given one, or even 5 year period does not tell us anything about the future performance of the asset.

The Future of Hedge Fund Regulation

The Obama administration’s proposal for a financial regulatory overhaul continues to send shockwaves through the financial services sector. The virtually unregulated hedge fund and alternative investment industry is likely to receive heightened government oversight under any reform efforts. As this scenario unfolds, the usually low-profile hedge fund community has stepped up its presence in Washington with the goal of influencing new regulations. Despite this renewed outreach, there remains little doubt that this sector will soon face further restrictions both in the U.S. and abroad. These reforms will affect a wide range of issues including registration, transparency, risk management, investor relations, derivatives, due diligence, and capital requirements.

Hedge fund experts Ezra Zask, an affiliate with Analysis Group and former hedge fund manager, and Gaurav Jetley, a vice president at Analysis Group who specializes in securities valuation and risk management, answer pressing questions about the future of hedge fund regulation and litigation:

1. Will the reforms that have recently been proposed by the Obama administration be approved by Congress and become law?
Zask: “Yes, in some shape or form. The majority of time spent over the last few weeks has centered on figuring out exactly what the provisions of the legislation should be, like the level of disclosure and registration. There is a significant amount of public scrutiny and international pressure in favor of regulation. The registration of hedge funds by a central authority, such as the SEC, will certainly pass. Beyond this, the specific details of additional guidelines and disclosures are still unclear.”

Jetley: “Ezra is correct and there is agreement on all sides that additional regulation is good, but disagreement on what type of funds should be forced to register or increase their level of disclosure. For example, large hedge funds without much leverage may argue that they do not pose a risk to the financial system and do not believe they merit the same stringent oversight as highly leveraged funds, which are much riskier.”

2. How do you think these new regulations will affect the hedge fund industry?
Jetley: “New regulations may actually benefit the industry, which helps explain why parts of the hedge fund community are supportive of change. For example, legislation currently in Congress could be advantageous for hedge funds because it would make them less secretive and create a stable regulatory environment. In addition, hedge funds may attract new investors that were traditionally hesitant to participate.”

Zask: “In addition to the new business opportunities, these reforms could be good for hedge funds because they will bring parts of the industry in from the cold, giving funds legitimacy. The potential information that will be available to the public as a result of these proposed regulations will help to lift the veil of secrecy that currently surrounds hedge funds.”

3. Will there be any effect on hedge fund litigation?
Jetley: “Hedge funds will continue to face increased litigation involving issues related to Madoff fraud (lack of due diligence), liquidity levels, margin calls, and misinformation about both risk and return. Legislation or new regulations, though, are unlikely to have a direct impact on hedge fund litigation. There is a relationship between legislation and litigation in the sense that legislative and regulatory action is the government’s attempt to fill gaps in the current system that are highlighted by these lawsuits.”

Zask: “Even though the legislation will not have a direct impact on litigation, as Gaurav mentioned, hedge funds will continue to face lawsuits. We’ve already seen the SEC become more aggressive and I anticipate we will see more and more investigations and litigation from the CFTC and the SEC.”

4. How will hedge fund regulations play out across the globe?
Zask: “I believe one of the biggest hurdles American legislators will face is taking into account how the European Union intends to approach hedge fund regulation. As of late, the EU has been taking a more forceful and stronger view towards hedge fund oversight, and financial regulation in general, than the U.S. Any successful effort will have to meet somewhere in the middle, engaging governments across the world.”

Jetley: “I agree that the call for hedge fund regulation across the globe remains strong and that these efforts must be collaborative in order to succeed. If countries are not working together on these reforms, hedge funds may gravitate to a country or area with less regulation.”

Analysis Group (www.analysisgroup.com) provides economic, financial, and business strategy consulting to leading law firms, corporations, and government agencies. The firm has more than 475 professionals, with offices in Boston, Chicago, Dallas, Denver, Los Angeles, Menlo Park, New York, San Francisco, Washington, and Montreal.