CORONAVIRUS: Ten Impacts on Hedge Funds
What impact will the COVID19 crisis have on the global hedge fund industry?
The hedge fund industry has been in the doldrums since the financial crisis of 2008, when the majority of alternatives managers failed to deliver the alpha returns they promised. Indeed, the ten years since 2008 has been a lost decade for alternative asset management, thanks in part to low interest rates, a long-running US bull market and high stock valuations.
And the market turmoil and economic aftermath of the coronavirus pandemic seem set to deal another body-blow to the industry.
In this article, we posit ten possible impacts of the pandemic on the global alternatives industry. The horizon is not rosy for hedge fund managers.
- More investors will be satisfied with performance. Few hedge funds in today’s pandemic-stricken markets will get close to emulating Pershing Square’s success, as the New York City hedge fund banks a US$2.6 billion profit on a US$27 million bet that coronavirus would trigger a crash in world markets. Still, these times of plague present a perfect opportunity for the alpha male- types that most alternatives managers consider themselves (perhaps necessarily) to be, to prove themselves adroit and adept in turbulent markets, in particular those of them that singularly failed to deliver the uncorrelated returns they were promising back in 2008. Tanking and volatile markets present profit opportunities that your average master-of-the-universe should be able to exploit (why else would you be paying him 1 and 20?), and there are significant price distortions in these markets that are up for grabs.
- Fewer investors will be satisfied with performance. As we have just suggested, the sad (and seldom voiced) truth about alternative asset management is that the majority of hedge funds fail effectively to do what it says on the tin: hedge. For every Pershing Square, there will be at least thirty (probably more) managers, of all sizes and in all strategies and asset classes, that do not truly deliver the kind of hedged returns for which investors are paying large fees. It would be fun to guess the ratio of dissatisfied hedge fund investors to satisfied, once the pandemic has abated, but now is not the time, and this is not the place!
- Greater downward pressure on fees. The standard “2 and 20” fee model has taken many knocks, and estimates now suggest that fees at this level are levied by around a quarter of hedge funds, with the majority of managers lowering their fees in return for higher, locked-in allocations. This has been a steady trend since 2008, with downward pressure being exerted by institutional investors on both the asset-based (“management”) fee and on the upside “performance” fee. Few alternatives managers these days can command “2 and 20”, and investors have increasingly been demanding sizeable discounts and other performance-oriented concessions from managers. The fallout of the COVID19 pandemic will see hedge fund investors augmenting their negotiating power when it comes to the manager’s fees, and the alternatives industry will see a continuing evolution of its fee models in direct proportion to its contraction over the coming decade.
- Strategy rotation. Many managers will re-evaluate the investment strategies that they have been pursuing, most obviously by making a major readjustment of their fund’s alignment with capital markets. CTA/managed futures, arbitrage and market- neutral strategies will come to the fore, as will forays into the illiquid space as many managers, finding themselves high and dry with illiquid positions as the tide goes out, sidepocket and spin those investments into a revised investment strategy (a trend that was very visible post-2008 financial crisis).
The market turmoil and high volatility caused by the pandemic has slammed global equity funds. The chief beneficiaries of outflows by spooked investors has been long/short equity and CTA/managed futures funds, strategies which have been in the doldrums largely since 2008. You can read more about how alternatives managers in Switzerland benefitted from high COVID19 market volatility in our blog here:
CORONAVIRUS: How will Swiss Hedge Fund Managers Respond?
- Increased outflows. With increased focus by institutional investors, post-2008, on individual manager performance and fees, with large allocators being all-too-aware of the peer group benchmarks in each strategy and asset class, those managers who underperform their peers in coronavirus markets will suffer sizeable redemptions. Investors who are thinking about heading for the exit should ready themselves for an increase in gating or redemption suspensions. Now would be a good time for them to familiarize themselves with the terms of the fund’s prospectus, with a view to understanding what the manager may and may not do when it comes to keeping their investment locked in the fund. They might even care to take a look at our “Liquidity Management 101” video, below. Monies that are redeemed from hedge funds will not necessarily be repatriated to the alternatives industry: we think that long-only, “actively managed” funds will benefit from inflows (see 9, below).
- Shutters coming down. Despite the contraction and consolidation seen in the decade following the financial crisis, the hedge fund industry remains overcrowded. There are an estimated 15,000 individual fund vehicles, domiciled across the globe from Delaware, to Cayman, to Singapore. The managers of a majority of these funds have not, and do not, generate enough alpha, as opposed to beta returns, to earn their high fees, particularly when benchmarked against long-only, actively managed funds. Even stellar, well-established managers with a track record of performance may no longer be positioned to generate the true alpha because of high stock valuations and, ironically, the sheer size of their funds. Some large managers are simply too large to maintain an edge. The industry has yet to evolve a natural counterbalance to this situation, however, with small funds (broadly those with AUMs lower than US$200 million) being marginalised and ultimately eliminated. This unhealthy position will likely rectify itself in the years following 2020.
- More opportunities for small- to medium- sized funds. Given the saturation (stagnation?) of the hedge fund industry, managers of small- to mid- sized funds (those with AUMs of between US$200m and US$1bn) who are nimble enough should be able to attract institutional allocations by offering discounts and flexibility on their fees that larger, MFN-encumbered funds are unable to do. Post-coronavirus pandemic, we expect to see such funds making greater use of arrangements like lock-ups, wherein the investor pays a lower performance fee in return for committing its capital to the manager for a guaranteed period.
- More manager- added value. With capital markets disrupted for the foreseeable future, the attendant sell- offs will cause correlations to rise and create large inefficiencies in debt pricing. Managers should be able to capitalize on these inefficiencies.
- More inflows into long-only, actively manged funds. Monies redeemed by investors from hedge funds will need a home, and as they ask questions about whether the returns produced by alternatives managers are worth their fees, long-only “actively managed” funds look like the most likely candidate to receive their money. The extent to which those monies are reallocated back to hedge fund managers remains to be seen.
- Continuing contraction in the hedge fund industry. The US$3 trillion hedge fund industry has been contracting since 2008. Based on (i) the measured contraction and consolidation that was observed in the industry following the 2008 financial crisis, (ii) the current demographic of global single managers and FoHF firms and (iii) the industry evolution throughout the long US bull market with high stock margins and credit spreads, it seems reasonable to expect that assets under alternative management will decrease by a minimum of around 15% to 20%. A significant proportion of redeemed investment monies will not return, instead being allocated to long-only, actively-managed funds with consistent returns and lower fees.
Hedge Fund Industry: Outlook to 2030
The market turmoil caused by the coronavirus, together with the regrettable fact that many alternatives managers will fail (just as they did in 2008) to hedge their portfolios and deliver uncorrelated returns to their investors, seem set to force many funds and management companies to the wall; particularly if the pandemic ushers in a global recession or something worse.
The contraction and consolidation ongoing in the industry since 2008 will continue into the third decade of the 21st century, under dual pressure from the markets and from investors to whom the pandemic’s economic fallout will hand more bargaining chips in their commercial interface with managers.
Thank you for reading! You might be interested in our article on the evolution of hedge fund fees in light of the coronavirus pandemic: