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By Susan Barreto, Editor of Alternatives Watch

No one will argue that its been a tough year for hedge funds, with fund closures and even some legends in the industry underperforming the U.S equity stock market that continues to make records daily.

Should portfolio managers be partying like it’s 1999 or as though it is 2000 – which kicked off a decade of blockbuster returns and inflows?

Stanley Drunkenmiller this past week commented in an interview with Bloomberg that he didn’t take on enough risk this year and was only now reaching double-digit returns within his family office portfolio. Meanwhile, even the HFR Fund Weighted Index through November was up only 8.53%, leaving many wondering how many more fund closures may be on the horizon.

There are some troubling trends looking back at the past decade, according to a recent research paper that concludes it has been a lost decade for the hedge fund industry.

According to Joseph McCahery of Tilburg University and F. Alexander De Roode of Robeco Asset Management, the last 10 years has been dominated by both strong equity and bond markets, making it harder for hedge funds to add value for investors. 

Assets under management for hedge funds over the last decade slowed to 8.4% annually compared to a rate of 20.3% in the time period from 2000 to 2010. The Netherlands-based researchers say that the number of hedge fund liquidations has grown substantially as well. 

In 2018, the number of new hedge fund launches was offset completely by the number of hedge funds shutting down. 

The first three months of 2019 saw 213 funds closing, compared to only 136 funds opening. According to the research paper, “The Lost Decade for Hedge Funds: Three Threats,” the liquidations in part can be linked to high fees and poor performance over the last few years.

McCahery and De Roode point to three major challenges facing the hedge fund industry: current market performance; competition from mutual funds and tighter regulation of hedge funds. They mostly highlight the rise of liquid alternatives as a more transparent and less expensive form of access to hedge fund strategies. 

First in highlighting performance, the hedge fund indices have underperformed a 50/50 stock and bond portfolio from 2010 through 2019. 

While hedge funds, still have reasonable volatility-adjusted performance their alphas have turned negative. Oddly enough, the researchers found that a 50/50 portfolio has a Sharpe ratio of 1.18, which is stronger than any of the hedge fund indices. 

When it comes to competing with mutual funds, the research paper points to statistics that show liquid alternatives achieving similar performance to that of hedge funds, while charging lower fees.

Last, but not least, the pair’s take on tighter regulation of hedge funds is that activist hedge funds have caught the eye of policy makers and this may reduce the opportunity set for these types of hedge funds and affect their lock-up period. They conclude that the limited opportunity set and the focus on liquid strategies will create important advantages for mutual fund offerings.  

Meanwhile, in the trenches of institutional asset management, the hedge fund challenges are drawing the attention of trustees who have increasingly been allocating to private equity, private debt and private real estate offerings. 

In some instances, traditional hedge fund managers may be offering some of these private market strategies too as we see money management businesses morph into one-stop-alternative investment shops the likes of Blackstone and GSM Grosvenor. Goldman Sachs’ move into the alternative capital business is the latest example, as the firm reportedly reshaped its efforts to expand its client engagement in alternative investments, across both direct investing strategies and open-architecture strategies. 

Perhaps the most intriguing overview of the hedge fund industry was given by alternative investment consultant Albourne Partners at the December 18 board meeting for the Arizona Public Safety Personnel Retirement System.

In 2019, the top performing hedge fund strategy was that of activist hedge funds, which returned 23% through November, according to figures compiled by Albourne. The year has been one of exceeding expectations for activists many of whom struggled in the fourth quarter of 2018. 

Meanwhile, global macro, emerging market fixed income and relative value credit have struggled lately, as only one strategy – quantitative market neutral – has failed to turn positive for the year to date through November, according to Albourne.

Albourne added that despite the occasional positive movements and increased volatility in quant factors, quantitative market neutral continues to underwhelm, and managers remain focused on reducing exposure to crowded factors. 

The trends in management fees continue to slide lower too. The consulting firm told trustees that operating expenses have decreased as a percentage of average net asset value in recent years. There has also been an increase in regulatory scrutiny and focus on expense allocations. 

The firm continues to view hedge funds as historically achieving strong returns with less volatility of equity markets. Since 2002, Albourne said, hedge funds have exhibited half the volatility of a 60/40 investment portfolio.

Albourne said that those managers that are generating alpha consistently are highly sought after and therefore continue to the price setters in commanding premium fees. 

Still it seems the number of hedge funds providing that level of alpha are fewer, according to industry statistics. 

As activist hedge funds and long/short hedge funds have had the best returns in 2019, it could be argued that the majority of the gains came from their long-side of the book rather than the short side thanks to the continual spate of stock market record-breaking gains in 2019. 

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