In 1933, US president Franklin D. Roosevelt said of the great depression: “The only thing we have to fear, is fear itself.” Which is precisely the problem as far as many of today’s hedge fund managers are concerned.
Fear kicks in, when a real, or imagined threat comes to our attention. It is debilitating, because it undermines the power of reason, as well as market liquidity. It makes an impact for decades. And it has led to a syndrome called chronophobia, or fear of the passage of time.
Necessity, however, is the mother of reinvention and hedge funds have become successful in attracting business from large institutions
Nearly 40 years after a debilitating stock market slump, wary Japanese investors are still repaying debt to strengthen their balance sheets, instead of investing for the future.
The Great Financial Crisis of 2007-9 forced central banks to work with governments to rescue banks, slash interest rates and inject cash into the system.
Ten years on, fear remains near the surface, stopping the US Fed’s tightening of interest rates in its tracks. It has intensified concerns over President Trump’s trade war with China and issues with Iran, through theories they could produce stagnation or worse.
Fear is frequently evident in the $3 trillion hedge fund sector, following recent outflows, as many of its gunslingers have retired to dabble in tech-driven venture capital, and/or turn their hedge funds into family offices.
Back in the day, in the 1980s and 1990s, hedge funds were delivering returns for wealthy investors by leveraging to take advantage of stock market gains. The family offices which backed them earned returns of easily 15% a year.
Performance became so good that investors turned a blind eye to hefty fees charged by third parties to get access to hot funds. As recently as 2004, I came across a Man Group guaranteed multi-style fund which charged base fees of 5% and 30% of performance. At SAC Capital, and elsewhere, performance fees of 50% have popped up.
The bursting of the internet bubble in 2000 started a slow retreat, as wealthy clients started to take profits, to reinvest in the credit sector. Lower returns made them increasingly leery of fees, particularly at funds of hedge funds.
Necessity, however, is the mother of reinvention and hedge funds have become successful in attracting business from large institutions.
The problem was that their new clients were fearful of failing to cover their future outgoings. They tolerated underperformance when markets were rising, but complained if their funds weren’t protected during a down period.
They opted for big hedge funds, not small. They frowned on excessive leverage. And they changed the very nature of the sector, as hedge funds worked overtime to retain their clients by becoming fearful in their own right.
Volatility became a big concern and monthly drawdowns have become closely scrutinised by all parties. The amount of data demanded by institutions is way in excess of the monthly newsletter of the old days.
David Finstad is a visiting professor at Bodhi Research Group, which advises family offices and pension schemes on alternatives. He confirms that the hedge fund industry has changed to accommodate its institutional client base.
In research published by Institutional Investor last October, he noted excess annualised returns from hedge funds of 6.6% in the four years to 2005, fell to 3.3%, -0.9% and 0.2% in the four years to 2009, 2014 and 2017. Bloomberg reckons hedge funds performed even worse with a loss of -4.1% on a weighted basis in 2018.
Unlike hedge funds, and their clients, indices have some optimism, through their exposure to large technology growth stocks. Finstad said: “The data suggests that over the last decade, investors could have replicated average hedge fund returns by putting 40% of their assets into an equity index fund and the rest in cash.”
Hedge funds can take consolation from the fact that their clients are too fearful of future events to pull the rug on them. It probably makes more sense for them to be cautious now, than ten years ago.
But it must be said that chronophobia has now been a costly condition, for quite some while.