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 risk/opportunity.
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 old.
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.