By Nick Evans
"The hedge fund industry is doing itself a great disservice
by putting risk before return."
TCI founder Chris Hohn’s forthright message in
a compelling address to the EuroHedge Summit in Paris in late
May could hardly have been better timed. Nor could it have
struck a more resonant note among all those who are trying to
make sense of – and make money in – this long
period of financial markets upheaval, unconventional
economic/monetary policies and high investment
The notion that had been gaining currency earlier this year
that risk-on/risk-off (RORO) had gone away, and that markets
were being driven more by fundamentals than by policy-makers,
took a bit of a jolt at the end of May – and a rather
bigger one in June.
First it was Japan – which had been a core focus
for many of the managers that had been singing from the
'fundamentals are back’ hymn-sheet – that
hit the skids, with the Nikkei falling by 7% overnight between
the two days of the Paris Summit.
Then came the dramatic rise in government bond yields
– apparently vindicating those who believe that the
record-low yields that have been seen during the last few years
of zero rates and endless QE are unsustainable, and that
fixed-income as an asset class represents a return-free risk
that is heading for a bloodbath once the stimulus tap is turned
off or even 'tapered’.
Since then, sell-offs in emerging-market debt and equity
markets, in credit and in other asset classes have further
fuelled the feeling that the world is not such a rosy or
improving place as many people were allowing themselves to
believe earlier in the year – and that the old adage
of 'sell in May and go away’ would again have been
a good one to remember and act on.
Looming in the background is the growing concern that China
may be the biggest bubble of all – with the potential
for a shadow banking-style credit crunch that could rival or
even exceed that sparked by the US sub-prime meltdown in
2007-2008. And central in the minds of all managers and
investors is the worry of what happens – and how to be
positioned – if and when government stimulus starts to
dry up and interest rates begin to normalise.
In such a changeable and still potentially perilous climate,
it would not be surprising if many of the new institutional
investors that have entered the hedge fund landscape in recent
years are somewhat unclear as to what their objectives are in
terms of risk and return.
For some it is to achieve long-term compound returns, of the
type that Hohn and many other old-style hedge fund managers
have unquestionably delivered – albeit with a degree
of volatility that is not to everyone’s taste. For
others, it is to manage and mitigate risk.
For others still, it is to dampen volatility, provide
diversification or offer counterweights to the rest of their
investment portfolios. And, for some, it is a rather confused
and even contradictory combination of all of the above.
It does not help that the institutional investor world is so
prone to following rather faddish, pseudo-scientific, concepts
– like 'portable alpha’ a few years ago
or (much favoured of late) 'smart beta’ –
that tend to last only for a brief period before joining their
predecessors in the dustbin.
And the rather inconsistent nature of so many institutional
investors – in terms of what it is that they actually
want or expect from hedge funds – has in turn had an
impact on managers, many of whom are struggling to appeal to
and cater for a new clientele with which they feel much less
instinctively attuned or aligned than with their investors of
Despite very strong performances from several individual
managers and funds, aggregate hedge fund returns over the last
few post-crash years have unquestionably been disappointing
– and very much less convincing than those that have
been generated over the longer term.
This may be down to one or more of several factors: to
ultra-low interest rates; to the RORO environment; to the
challenges of having to cope with artificial markets that are
so in thrall to policy-makers; to an element of over-crowding,
or over-capacity; or to a degree of fear and risk-aversion on
the part of managers themselves.
But it may also be down to the fact that so many managers
are trying to provide a risk/return profile that they believe
is attractive to institutional investors – many of
whom, along with their advisers, seem to put short-term
volatility and risk management ahead of long-term returns
– but which, if it simply results in high fees for
mediocre returns, could ultimately undermine the rationale for
investing in hedge funds altogether.
And one cannot help feeling that, for hedge funds to thrive
in the new institutional world, they need – as Hohn
and many other like-minded managers believe – to
reconnect with some of the characteristics and convictions that
made them so compelling in the pre-institutional days.