by Adam Gruver, MMX Management
There has been a ton of talk recently about the demise of the hedge fund model. ETFs are overtaking hedge funds in total assets, hedge fund fee structures are under pressure, and performance has seemed underwhelming. Are hedge funds really losing their edge in the market?
Let’s touch on each of these issues in turn while trying not to get too excited…
Hedge Funds vs. ETFs
You read correctly, ETFs have overtaken hedge funds in total assets. From an institutional standpoint, this simply shouldn’t matter that much. Mutual funds are ETFs’ more relevant competitor. From the retail perspective, an ETF is a mutual fund’s more interesting and useful brother. There are bound to be continued flows to ETFs from investors of all shapes and sizes, and I think we’ll see a high growth rate in allocation to these instruments for the foreseeable future.
I’ll say it again, this simply shouldn’t matter that much to the hedge fund community or their investors.
Hedge funds are a diverse “asset class”, and I (among others) would argue that you can’t call hedge funds an asset class at all. Institutions (i.e. endowments, foundations, pensions, family offices, etc.) allocate to a wide range of hedge fund strategies for specific and uncorrelated return patterns and exposures. While ETFs can also be used for a wide range of return patterns and exposures, they are limited by their underlying base. Institutions invest in hedge funds because they are different, because you just can’t replicate what a few experts in a room can do with an interesting, effective strategy and a solid asset base.
The traditional 2% and 20% hedge fund fee structure is culturally dead. Institutions don’t want to pay it and managers usually shouldn’t charge it (with the exception of unique, abstract, and historically high performing strategies/managers). With that being said, there are plenty of managers out there that can and should charge something close, say 1.5% and 20%. This fee should be based on a combination of qualities that the investor deems important to them, and can include performance, lineage, ability, and differentiation of strategy.
The above mentioned fee is for longer standing managers. Spin-off and emerging managers should, at the beginning of their life cycles, be charging entry level fees (“founders’ series fees”) that take into account the fragile nature of their early stage businesses and lack of a track record. It is all too common for such a manager to underestimate the difficulty of running both a business and an investment strategy simultaneously, which generally results in the former being overlooked. Investors need to be given an incentive to allocate when managers don’t have a track record of running a fund and a firm on their own.
Despite everything mentioned, we really don’t believe average hedge fund fees are too high. You get what you pay for. If you want a passive strategy that tracks a sector or need a basket hedge, great. Buy an ETF. If you want esoteric and specific exposures and returns, even better. Invest in hedge funds. Investors pay higher fees for hedge funds for a reason. The BEST hedge funds have highly specialized teams with unique views and approaches that produce differentiating results, and these services can be understandably expensive.
It’s always all over the financial news – “hedge funds are underperforming.” Does anyone have any idea what this really means? A few things to think about:
•Which hedge funds are reporting to these sources?
•How are the sources delineating between strategies that have different risk and return profiles?
•Can sources stay consistent when reporting isn’t mandatory?
•How high is turnover in funds reporting?
*Our platform managers aren’t reporting to most aggregating sources, mainly because we lose control of viewership and message.
There are a number of online platforms and databases out there that claim they are producing aggregates of hedge fund performance. The industry is just too fragmented for this to be totally true. I see references to general hedge fund performance indexes, event driven indexes, long short indexes, etc. There’s no common sense basis here. When I see an event driven index, I have no idea what types of event driven managers are reporting (there are a few different types, with different risk profiles and return targets). I have no idea which managers within each category are reporting. It’s not mandatory for any manager, and we don’t always trust it.
Only the investors in these funds and sources that the managers choose to report to know exactly how specific hedge funds are doing. And even this is misleading from a total market perspective. There are hundreds of different hedge fund strategies out there. Again, hedge funds aren’t a normal asset class, if we must call it that. Some perform well in some markets, others don’t. Saying hedge funds are underperforming might be naïve. The hedge funds you are following or invested in might be underperforming, but another investor might have a hedge fund portfolio that’s killing it.
This is all pretty high level, but let’s be real – hedge funds are still cool. They’re extremely useful when used correctly and for the right reasons, and the right funds are still worth the relatively high fees they are charging. The hedge fund space is not built for generalizations, it’s too diverse. The best strategies, teams, and funds are right for different institutions, and will produce different results.
At MMX we love this space along with the rest of the alternatives arena, and we continue to be long term believers in the value it can bring to investors.
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