Put Into Perspective: Optimal Size For Hedge Funds, Skenderbeg Alternative Investments
“Biology gives you a brain. Life turns it into a mind.” – Jeffrey Eugenides
The big boys club
Hedge funds’ unlikely savior
The past two years have been tough on hedge funds, and active money managers in general. Sitting on an index fund provided better returns in almost every asset class. Donald Trump’s election as president of the US, however, has offered these managers a new lease of life. Since the New York real estate tycoon’s victory, the tight correlations between assets that have characterized markets in recent years have crumbled.
The 89-day correlations between various asset classes has declined since Donald Trump was elected
The collapse in correlations is the best news that hedge funds could have hoped for. Most active strategies seek to generate gains by identifying under- or overpriced assets, valuation anomalies that investors bet will correct themselves over time. Often, the approach involves buying one market or security while selling another. That long-short strategy is rendered powerless when everything rises and falls in tandem. If, say, a fund manager was betting that emerging markets would drop while the S&P 500 would rise and instead both move higher together, then the profit (if any) would be smaller than if the investor had just bought the US index alone.
The irony will not be lost on fund managers. As a candidate, Donald Trump railed against hedge funds, saying they were “getting away with murder.” Far from being their nemesis, he may turn out to have been their savior.
Equity, macro hedge funds look to bounce back from a tough year
Trump, central bank policy to create opportunities in 2017
For some equity funds and those betting on macroeconomic trends, which together make up a large chunk of the $3 trillion global hedge fund industry’s assets, 2016 has been another year to forget. A steepening of the US yield curve, greater reliance on fiscal spend and the prospect of lighter regulation and corporate friendly tax policies from President-elect Donald Trump could lend support to many stock and bond funds in 2017.
“With central bank policy in the States at least looking to normalize, (and) company fundamentals becoming more important after the rising tide of cheap money that lifted all boats, fundamental stock-picking will have more value,” said Simon Smiles, chief investment officer for ultra high net worth investors at UBS Wealth Management.
Darren Wolf, Head of Hedge Funds, Americas at Aberdeen Asset Management said he expected 2017 to be “considerably better” for hedge funds. “Irrespective of what the specific outcome is, there will be movement on the regulatory and political front post-Trump’s victory,” he said, pointing to the potential health care stock-boosting repeal of ‘Obamacare’, changes to rules limiting bank trading or those around energy regulation. “These are all events that can confuse the market and create uncertainty and provide a ripe hunting ground for hedge funds,” he added.
With the US Federal Reserve flagging a quicker pace of interest rate rises and the European Central Bank set to trim its bond purchases against a backdrop of fresh political risk in Europe, funds betting on divergent macroeconomic themes could also benefit. “More limited central bank appetite for QE [quantitative easing] could take away a significant element of market support,” said Anthony Lawler, head of portfolio management at hedge fund investor GAM. “An increasing range of economic outcomes and higher yields provide more fertile trading conditions for active managers, which we believe should prove beneficial across asset classes.”
Hedge funds doing their job
Despite investors’ displeasure over high fees and a skepticism of whether the asset class is worth the effort, hedge funds have done their job protecting the downside. Over the trailing three- and five-year periods, the HFRI Fund Weighted Composite index captured approxi-mately 34% of down markets relative to the MSCI ACWI IMI, while capturing 43% of positive returns.
Smaller hedge funds will outperform in 2017, predicts Agecroft Partners
Smaller hedge fund managers will continue to outperform during 2017, according to Don Steinbrugge, managing partner of Agecroft Partners, who has revealed what he sees as being the top hedge fund industry trends for the coming year. He sees one of the biggest issues within the hedge fund industry as being the high concentration of flows to the largest managers with the strongest brands with almost 70 per cent of industry assets invested with firms that have over USD5 billion in assets under management. Steinbrugge says that this has caused many of these managers’ assets to swell well past the optimal asset level to maximize returns for their investors. As they become larger, he believes it is increasingly difficult to add value through security selection. To retain assets, large managers also have an incentive to reduce the risk in their portfolio which, in turn, lowers expected returns.
“Small and mid-sized hedge funds will see increased flows during 2017 due to increased sophistication of institutional investors, poor recent performance of many of the largest well known hedge funds, the pressure institutional investors are receiving to enhance returns, and the belief that smaller, more nimble managers have an advantage in a performance environment increasingly dependent on security selection. This is especially true for small managers operating in less efficient markets or capacity constrained strategies. These flows will be concentrated in a very small percentage of managers.”
Increased alpha due to decreased correlations and higher volatility is another of Steinbrugge’s big predictions for the coming year. With President-elect Donald Trump planning to make major changes to the US tax structure, infrastructure spending, international trade deals, and health care spending, among many other initiatives, Steinbrugge sees these changes impacting companies, sectors, and markets dif-ferently, causing correlations to decline and volatility to increase closer to historical averages. “Larger price movements provide more opportunities for skilled hedge fund managers to add value through security selection in strategies that capture greater price distortions in the market and accelerate performance as security prices more quickly reach price targets,” he says.
Steinbrugge sees two major themes for assets flows:
- Greater demand for hedge fund strategies with low correlations to long only benchmarks. Capital markets valuations are hovering near all-time highs. There are potential economic time bombs in China relative to foreign reserves, a housing bubble, and the bank-ing system. Concern remains high regarding some of the weaker countries in the European Union, particularly Greece and Italy, amid anemic global economic growth and global monetary authorities with little dry powder left to stimulate economies. Against this backdrop, many investors are becoming increasingly concerned about downside volatility.
- Greater demand for hedge fund strategies that benefit from lower correlations and increased volatility. This is particularly good news for the long short equity sector, where many managers have recently experienced significant poor performance and outflows.
Steinbrugge’s final prediction for 2017 is that there will be a continued increase in the number of hedge funds shutting down. “The hedge fund industry is over