Hedge funds suffered their worst year since the financial crisis in 2018, largely due to high market volatility in the fourth quarter that ended up wiping out all of the year’s gains, causing the S&P500 to fall by 6% in total last year. Assets under management declined while investor redemptions increased, making last year the 4th in more than 20 years when more money left the industry than was invested at – yearly outflows of $34bn (around 1% of money managed by the industry) represents a significantly tumultuous period for fund managers. Particularly, equity market funds have seen the worst outflows and performance for the year.
One of the worst performers during the year was the BSF European Diversified Equity Absolute Return Fund, by BlackRock (the world’s largest asset manager). The world’s largest asset manager blamed trade tensions, a steady path of US Fed rate increases, Brexit uncertainty and an uncertainty to a possible future US recession/downturn for the fund’s staggering 19.9% loss. Long/short funds delivered an average loss of 6.8%, while activist funds (funds that make large investments in companies to be able to participate in management decision making) fell around 13.3%.
Indeed, managers have been complaining for years about quantitative easing and cheap liquidity since the crisis – while equities have largely seen the longest bull market in history (around 10 years), the lower volatility means that many active managers have struggled to beat passive funds (that simply track the market), that have much lower fees.
Not only this, but hedge funds have slowly been seeing worsening returns compared to their heyday in the 1990s – average returns of 3.4% since 2010 pale in comparison to roughly 18.3% in the 90’s. While many cite a crackdown on insider trading, more cautious pension fund investors demanding less volatile returns, and the rise of quant/high-frequency traders, arguably one of the most important reasons is simply the rise in the sheer number of fund managers who have emerged. This makes it harder to generate returns and ‘high-alpha’ stocks. Management fees are falling as a result. The most common fee structure in the industry used to be a ‘2 and 20’ regime – 2% management fees and 20% of profits made. Now, the average fees are around 1.4 and 17, according to Credit Suisse.
However, it is not bad news for the whole industry. The Hedge Fund Research team’s main index (a composite measure that monitors all funds) was only down 4.07% last year, faring better than the S&P500. Indeed, the poor performance of some large funds does not account for the whole industry – in December alone, while the index dropped by 2%, 93% of the index constituents beat the market! This still bolsters the case that active managers are better placed to beat the market when volatility strikes.
Going Forward – Hedge Fund Outlook for 2019
Investors should be preparing for higher volatility in 2019, which will usher in a very supportive investment environment – the unwinding of central bank balance sheets (and predictions of two further Fed rate rises this year) will remove major sources of market stability. The graph below, provided by Bloomberg, shows that the age of quantitative may be behind us for a good amount of time – markets are moving beyond the post-financial crisis era regime.
The most potential is likely to be in macro-oriented funds. Brexit, US-China trade relations, and the Italian economic crisis are just some of the situations where managers can capitalise. Positions on medium-term foreign exchange movements can also be very profitable going forward. Indeed, macro funds on average were up by 0.95% last year. I believe that the most effective hedge funds going forward are going to be the ones that can identify idiosyncratic events, and seek inefficient pricing opportunities, which should be much more numerous going forward.