Michael Butler is chairman and CEO of investment bank Cascadia Capital. He is writing a book titled Financing the Future and the Next Wave of 21st Century Innovation, and is serializing it here at peHUB. What follows is an excerpt from the third chapter.
I wonder what Alfred Winslow Jones would think if he were alive today. The father of the modern hedge fund industry, Jones married two speculative tools – leverage and short-selling – to create what he considered to be a very conservative investment approach in 1949. It worked, because his investors only lost money in three of the next 34 years.
I wonder what Alfred Winslow Jones would think if he were alive today. The father of the modern hedge fund industry, Jones married two speculative tools – leverage and short-selling – to create what he considered to be a very conservative investment approach in 1949. It worked, because his investors only lost money in three of the next 34 years.The current market turmoil has shown us that many hedge funds are anything but conservative, and that excessive leverage can generate calamitous losses on a scale that Jones could never have imagined.
Jones would also be surprised by the crucial crossroads and critical choices the industry he created now faces. Clearly, the hedge fund business as its founder once knew it – and as we have recently experienced it – will have to change. I believe the coming shifts will be profound, meaningful and structural. And I think they will have to take place soon in order to shore up damaged credibility and the possibility of additional erosion in investor confidence.
The scope and sweep of the $6 trillion hedge fund industry today makes this transformation imperative. Indeed, hedge fund activity in the public securities markets has grown substantially over the past decade, and it now constitutes approximately 30 percent of all U.S. fixed-income security transactions, 55 percent of U.S. activity in derivatives with investment-grade ratings, 55 percent of the trading volume for emerging-market bonds, as well as 30 percent of equity trades. In addition, hedge funds dominate certain specialty markets such as trading in derivatives with high-yield ratings and distressed debt.
Secrecy – as well as size – seems to characterize a number of hedge funds, and their veil of marketplace mystery has been reinforced over the years by a lack of regulatory oversight. Legal requirements that permit less-than-thorough disclosure and a reduction of transparent public information haven’t kept return-hungry investors from flocking to hedge funds, though. In fact, clients have recently been willing to pay 2 percent annually – in addition to a 20 percent performance fee – to have their money invested by hedge fund managers.
Investors have also been willing to sign lock-up agreements with hedge fund managers, ensuring that their money stays put in a given fund for several years. Locking up investors has enabled managers to shift from rapid-fire investment strategies such as convertible and merger arbitrage, where competition is fierce, into more exotic and less liquid areas like distressed debt, activist investing, lending, and buy-outs. Obviously, managers couldn’t make three-year investment commitments if their own investors could cut and run within a year; the mismatch of assets and liabilities would be disastrous.
With tremors reverberating throughout the hedge fund industry in the wake of the market shake-out – and more and more portfolios cracking apart – many fund managers are enforcing these lock ups with a fierce militancy so they don’t have to sell beaten-down assets to raise cash.
As Draconian as that sounds, if mangers have to start dumping assets, there’s a real danger that big banks, which provided hedge funds with capital to amp up returns through leverage, will demand their money back as collateral shrinks. Those successive margin calls would prompt additional asset sales and set off a vicious cycle that could create extended chaos and crisis.
Assuming that this worst-case scenario never unfolds – which is certainly my hope – the real question at this juncture is where the hedge fund industry is headed.
For years, hedge fund managers have boasted of their ability to produce consistently superior risk-adjusted returns, or alpha.
But a number of analysts are questioning that assertion and asking if hedge funds are really delivering alpha or whether they are delivering a beta correlated with the market. Some researchers suggest that the correlation between hedge fund returns and the S&P 500 index is already high and getting higher.
It’s also possible that hedge funds are becoming more strongly correlated with each other. Although the hedge fund business is very diverse, there have been times in recent years when nearly all the sectors in the industry have fallen in unison. This suggests that all of them may be exposed to some common underlying factor – and that there is systematic risk in the hedge fund asset class.
And it’s worth asking at this point whether hedge funds – minus leverage and short-selling – are really that different from traditional funds. After all, hedge funds still mostly invest in conventional equities and bonds.
A recent study by the London Business School focused on this by analyzing the hedge fund industry’s performance over a decade. In the end, the study pointed out, “trend-following” investment strategies seem to be responsible for the majority of hedge fund returns. And these strategies, according to the study, can actually be reproduced at lower cost in the market.
Finally, the skill of a hedge fund manager has always been exploiting market anomalies, but are there enough anomalies to generate alpha for every fund today – especially given the widespread use of technology, which has more or less leveled the playing field?
So, the real issue is whether the hedge fund model is broken. And does the industry need to undergo significant structural change in order to successfully move forward after the latest market tumult?
I’m not sure how to address the first issue; it’s really up to investors to decide that one. But I do think the answer to the second question is “yes.” Like the commercial and investment banks, the hedge fund industry will soon be forced to undergo major alterations and adjustments.
There are four shifts to watch for:
• New Constraints on Leverage – It’s unclear whether the market will demand this or whether regulators will mandate it (or whether a combination of both forces will be brought to bear), but the type and amount of permitted leverage will definitely be spelled out and bracketed for hedge funds over the next decade.
• A Two-Tier Industry – The industry will shrink in size and there will soon be just two types of hedge funds: behemoths and boutiques. The behemoths will resemble traditional mutual funds, mimic the market and live off of management fees; the boutiques will search for alpha. Any fund in the middle will have a tough time making a go of it.
• Investor Activism – I can’t speak for the vast numbers of high-net-worth individuals, pensions and endowments who have invested in hedge funds over the past decade. But I do think their losses in recent months will prompt a review of the fees they are currently paying hedge fund managers. And the odds are pretty good, in my view at least, that big investors like CALPERS will demand greater accountability from hedge fund managers.
• Adjustment of the Supply / Demand Imbalance – With hedge funds generating outsized returns in the bull market, albeit mostly through leverage, traditional limited investors such as endowments and pension funds have poured more money into the asset class. Unfortunately, there is more money than opportunity. There are only so many market inefficiencies that can be arbitraged. As those inefficiencies became less economically attractive, the economic shortfall was made up by leverage. Looking ahead, I believe that as absolute and relative returns fall, limited investors will reduce their hedge-fund allocation and this will serve as a self-correcting mechanism that reduces the size of the industry.
I have a number of good friends in the hedge fund business, and they’re among the best and brightest in the financial markets today. The way they handle the delicate balance required in leveraged transactions is an art form; and the way they calibrate the risk-reward ratio when selling short feels like sheer science.
But not all art is good art, and sometimes science runs amok. That’s pretty much what happened between 2002 and 2007, when the market’s appetite for robust returns grew exponentially and excessive leverage and lax credit standards kept feeding the beast.
Financial corrections are painful, but they usually result in improved capital efficiencies. Unfortunately, the hedge fund industry will probably struggle in the next cycle. But I believe – whether they wrestle with regulators, investors or their own business model – that fund managers will come out the other end more grounded and in solid shape, ready for the next wave of opportunities in the global markets. Alfred Winslow Jones would be proud.