Hedge Fund Environment: Is Capital Crowding Out Alpha Potential? by Versus Investments
In this annual hedge fund review, we shed some light on the market environment and resulting headwinds or tailwinds facing common hedge fund strategies. Most investors allocate to hedge fund strategies to capture return streams that are uncorrelated to equity and bond markets. This simplistic goal has been hard to achieve in an environment flooded with monetary stimulus, characterized by low security dispersion and limited areas of distress. Managers work harder to find unique ideas that can scale. As a now? $3 trillion industry pursuing similar strategies, capturing alpha is proving much harder than in years past. There is no short rebate available to short sellers, the borrow is often more costly and almost everywhere they turn, hedge fund peers already hold significant stakes in portfolio companies securities. We suspect episodic sell?offs and rebounds driven by liquidity concerns and “crowded?ness” could become more normal than unique.
The macroeconomic environment may be evolving from one of continued easing to one of inability to ease, or even tightening. Tightening could impact corporate confidence which has driven M&A activity and could set off a new distressed cycle. While many activist and merger strategies have benefited over the past two years, many other equity managers have suffered as their short positions rise in anticipation of potential takeovers.
Slowing global growth has impacted commodity?oriented sovereigns and corporate securities, and oil prices continue to remain volatile. This should be helpful for CTA and global macro managers able to identify strong directional trends and differentiate between countries and currencies positioned to benefit or suffer from lower oil prices.
Still?high equity valuations suggest potential for alpha in short books since further return potential from margin improvement or P/E expansion appears more difficult. Distressed strategies bemoan a dearth of existing opportunities, but salivate at what may be just around the corner, especially in the energy complex. Funding costs for levered strategies remain extremely low, but then again so does volatility; selling any sizable position is likely to incur significantly lower realizations from what we hear.
While our annual hedge fund environment will generalize many hedge fund styles, we recognize each hedge fund is unique in a number of ways; there is a very wide distribution of individual skills, styles and approaches. Paying careful attention to the headwinds and tailwinds that may affect hedge fund betas is an important part of hedge fund selection, as is careful diligence on managers that are capable of producing unique alpha.
Hedge fund industry growth
Is capital crowding out alpha potential?
As hedge fund assets have grown to nearly $3 trillion, beta?adjusted returns suggest broadly declining ability to capture alpha.
Hedge fund performance (1-year)
One tough year
Recent negative hedge fund returns are partly a function of their underlying exposure to broad based equity and credit markets. These environments have been challenging; so has hedge fund performance.
Hedge fund performance (7-years)
End points still dominate the optics
Over the past seven years, which includes the last half of 2008, broad equity market exposure retains significant explanatory power over hedge fund returns – exposure investors may not recognize or want.
Hedge fund styles review
Alternative beta – Good climate for momentum, mild to harsh conditions for others
Alternative or “exotic” beta strategies hinge on the existence of common factors that many hedged strategies employ to generate a substantial portion of their overall returns. Many of these factors can be obtained with relatively less expense.
Examples of “naïve” strategy or factor replication include merger arbitrage or delta hedged convertible bond trading.
Over longer periods of time, some of these factors have demonstrated persistent ability to explain significant proportions of active hedge fund manager returns; this in turn argues for active risk benchmarks or explicit fee reductions.
The data presented below suggests the performance of a set of factors, while variable, has generally been positive. Recent experience reflects the significant influence of momentum throughout 2014, but a reversal has been coincident with weakness in the S&P 500.
Dispersion of these factor returns enhances the risk?adjusted return for strategies that employ a mix of these strategies despite lower aggregate return expectations; active sizing decisions among these factors may enhance value?added returns.
Event driven – The house is getting crowded
Event Driven strategies target equity or debt securities involved in mergers, acquisitions, corporate spinouts, debt refinancing and distressed, bankruptcy and restructuring. This category of funds represents 10% of the broad index and 900 funds.
These strategies are driven by M&A volume and deal spreads, debt maturities leading to defaults, credit availability, the level of activism and general corporate activity.
Many claims related to crisis?period vintage bankruptcies are now being realized; biopharma and other healthcare?related M&A has been strong the past 9?12 months.
Anecdotally, managers admit short positions and forays into the energy space appear to have been so far premature.
Best opportunities for investment have typically been near inflection points in the economic cycle: beginning of pro?growth upturn or beginning of distressed cycle brought about by slowing economy; we are likely closer to the latter today.
Long/short equity – Strong trends for growth and quality continue for now
Fundamental long/short equity strategies pursue views of intrinsic value or growth estimates that differ from consensus. More than 3,400 funds representing 27% of the index apply this most common strategy.
These strategies are driven by dispersion of fundamentals, operating margins and general M&A activity in addition to volatility in the market.
Companies that have levered the balance sheet (at the expense of bold holders) or which have pursued accretive acquisitions have been rewarded with higher stock prices by growth oriented investors.
Anecdotally, most short positions have been a drag on performance; more recently they have offset some of the damage done by abrupt market sell?offs but not enough to overcome losses on net long positions.
Many managers state they expect increased market volatility will be helpful to their cause because it will push their short “poor outlook” companies down more than their “quality company” holdings.
See full PDF below.