By Donald A. Steinbrugge, CFA of Agecroft Partners
With interest rates and credit spreads near historic lows and equity valuation above historical averages, many people are concerned that the Federal Reserve, by artificially keeping rates low, has created a 2007 type asset bubble in the capital markets where many securities are priced to perfection. What happens to the financial markets when the Fed begins to raise interest rates or there is some other economic shock to the financial system, and what impact will this have on the hedge fund industry? We recently saw a glimpse of this from mid-September to mid-October when we experienced a slight tremor in the capital markets which saw asset prices decline and volatility spike. This was followed by an onslaught of negative articles from the mainstream media relative to the hedge fund industry.
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Agecroft Partners believes there is a low probability of another 2008 type market selloff in the near future. However, if it were to occur, the outcome in the hedge fund industry would be very different than what was experienced in 2008. The hedge fund industry is structurally much more stable today than in 2008. As describe below, such stability would result in significantly less redemptions and an avoidance of a complete seizing of inflows.
- The make-up of the hedge fund investor base is very different from 2008. Pension funds over the past 6 years have been responsible for a significant percentage of positive net flows to the hedge fund industry. These institutional investors are much more long term oriented and stable. This trend could actually be enhanced by a market decline as pension funds strive to reduce their unfunded liability by enhancing returns and reducing downside volatility. Pension funds need to generate a return equal to their actuarial assumptions which typically are in the 7.5% to 8% range. This is difficult to achieve when the fixed income portion of their portfolio is yielding around 3%.
Endowments and foundations, which were criticized for their redemptions after the 2008 market correction, have repositioned their portfolios to better withstand “liquidity” events. These liquidity issues were primarily driven by the private equity portion of their portfolios, where common practice was to over allocate to private equity in order to maintain a targeted allocation. This caused significant issues when capital calls increased while return of capital came to a halt. Most of these liquidity issues have now been resolved. Going forward endowments and foundations will be much more active allocators to hedge funds given a similar sell off.
Finally, the fund of funds market place is much more stable. These organizations are using less leverage and their investors are better educated on what they are buying. Before 2008, many fund of funds were selling their funds as a t-bills plus 400 basis point product. Many investors did not realize that they could experience material negative returns. When investors’ experience is dramatically different than their expectations, they are much more likely to redeem.
- Significantly less leverage utilized by hedge fund investors and managers. In 2008, a majority of the highly leveraged fund of funds either went out of business, suffered heavy withdraws, or had their leverage reduced by their lenders. This in turn led to significant redemptions from the underlying hedge funds. Today there is much less leverage used by fund of funds. In addition, the average leverage used by individual hedge funds has declined, which should help their performance in a down market and reduce the amount of withdrawals.
- Better alignment of liquidity terms and underlying investments. Back in 2008, there was less regard for the mismatch in liquidity terms of a fund and its underlying investments. It did not matter if the fund strategy focused on asset based lending, distressed debt, or some other type of illiquid investment as long as the fund allowed for monthly or quarterly liquidity. This mismatch worked fine as long as there were positive flows to the fund; however, the large redemptions at the end of 2008 led to many funds raising gates and suspending redemptions. This also reduced confidence in the hedge fund industry and unfairly penalized liquid strategies by turning them into ATM machines for many investors who needed liquidity. Since then there has been a much greater focus among investors on liquidity terms and their alignment with the underlining investments. Investors are much more willing to accept longer lock-up provisions for less liquid strategies and are avoiding those funds with mismatches in liquidity terms. In addition, those managers who investors perceived as self-serving by employing a gate provision at the end of 2008, have been mostly banished from future consideration. We should see significantly less use of gates and suspension of redemptions in the future.
- Lower probability of another Madoff. The Bernie Madoff fraud caused a ripple effect throughout the industry which led to massive redemptions from investors in fund of funds that had Madoff exposure. It also temporarily reduced investors’ confidence in the hedge fund industry, leading to further redemptions and reductions in allocations. Since that terrible event, there has been a significant enhancement in the due diligence process of many investors to reduce the probability of fraud, including a greater focus on transparency, operational due diligence and the quality of service providers.
- Lack of good investment alternatives. Contrary to mainstream media reports of investors giving up on hedge funds, the recent spike in volatility of the capital markets has not led to large redemptions. This is because of a lack of investment alternatives for investors. Money market funds are yielding close to zero and generating a negative real return. The 10-year US treasury is yielding approximately 2.5% and could sustain a large market value decline if interest rates rise. Investors obviously don’t want to increase their equity holdings if they expect a major decline in the equity markets. We believe institutional investors view hedge funds as more attractive if they are concerned about a market selloff. In addition, once the market actually does sell off, investors’ emotional response is the market can always go lower, which again makes hedge funds look attractive.
Market sell-off will create winner and loser hedge fund organizations
Although we believe the hedge fund industry net-flow will hold up much better given a 2008 type sell-off in the capital markets, the impact relative to each individual hedge fund firm will be dramatically different. Instead of assets leaving the industry we will see a large rotation of asset flows within the industry creating winner and loser hedge fund organizations. How each firm does will be highly dependent on 1. their investment strategy 2. how they performed verses similar funds and 3. how they performed compared to investors’ expectations.
Investment Strategy: The hedge fund industry is very dynamic relative to what strategies are in demand and large market sell-offs tend to be a catalyst for major changes in the relative demand for various strategies. For example, after the market sell-off of 2008, long short equity strategies declined from approximately 40% of the hedge fund industry’s assets to 25%, while allocations to CTAs and structured credit expanded significantly. We expect to see similar shifts in demand, although not necessarily affecting these particular strategies.
Relative performance compared to peers Volatile markets cause significant deviations in performance across mangers in similar strategies. Those managers who significantly underperform their peers will experience larger withdrawals compared to other managers who successfully navigate through the difficult markets by better protecting their investors’ capital.
Performance compared to investors’ expectations: Hedge fund managers that have been truthful with their investors, done a good job of educating their investors on their investment process, along with how it does in different market environments, and treated their investors fairly relative to gates and other restrictions of liquidity will have a much easier time holding on to their investors.
In conclusion, if we experience a major market correction, net flows will be negative, but nowhere near the extent that was experienced in 2008. Most of the redemptions will be recycled within the industry creating winner and loser hedge fund organizations. Hedge fund organizations’ actions and quality of communications with their clients can have a major impact on which category they experience.