Some Good News For Hedge Funds
The closures of hedge funds run by superstar hedge fund managers such as Philippe Jabre, Louis Bacon and David Tepper in recent years has fanned the flames of hedge fund bears and is just one data point that these commentators point towards to justify their view that the hedge fund industry is in structural decline. Many of the industry data providers have produced data showing closures outweighing launches, leading to a net smaller number of products available to hedge fund investors.
Hedge fund research and intelligence provider PivotalPath also shows closures higher than launches, but sees the bigger picture a little differently. A recent report published by the firm claims that the number of closures of what it calls ‘institutional-quality’ hedge funds - those likely to be allocated to by institutional investors like pension funds as opposed to private money like family offices and high net worth individuals - in 2019 was 48, stemming a more significant decline in 2018 (101 funds) and 2017 (74 funds), but a parallel trend is that it says launches are becoming of a higher quality, meaning that the industry might begin to show a decrease in the number of funds shutting down within the first few years of operation in the coming years.
The falling number of fund closures isn’t the only reason to be optimistic, according to PivotalPath CEO Jon Caplis. He sees further encouraging signs for the hedge fund industry, one of which is a decline in the factor correlations of hedge fund performance. PivotalPath looks at approximately 200 global risk factors and analyses the pairwise correlation of these factors with each other to better understand the opportunity for hedge funds to generate alpha.
“The pairwise correlation (historically) averages around 0.2, which indicates a healthy environment of idiosyncratic risks”, said Caplis. “However, that number was elevated in 18 and 19 peaking in Q3 of 2019 around double the historic average and nearing financial crisis levels. The correlation number has been decreasing for the last 6 months, back to a much healthier level, which means that there is more idiosyncratic risk for a hedge fund manager to take advantage of.”
Data from PivotalPath also shows that the correlation between sub-strategies is also decreasing, meaning a hedge fund investor has a better chance of diversifying not only their overall portfolio but the hedge funds contained therein, regardless of whether the investor looks at hedge funds as part of an overall equity, credit or diversifying strategies allocation or whether they specifically set aside a portion of their assets for hedge fund products. Credit fund’s correlation to other hedge fund strategies was 0.68 in December, its lowest level since December 2017.
One theme emerging in PivotalPath’s data is that of sector-based strategies outperforming the average fund; in 2019, Equity-Sector was the best performing sub-strategy tracked by the firm, bringing in returns of almost 16%. Caplis uses the example of healthcare equity hedge funds to illustrate why this might be.
“Equity Sector focused Healthcare funds did very well in 2019”, says Caplis. “It’s important to understand that the managers who add the most value are those who are domain experts. Healthcare hedge funds have medical doctors and ex-FDA [the U.S. Food and Drug Administration] employees working for them. They can evaluate a manageable amount of companies and they understand things like trial approvals. Alpha is very difficult to find on a consistent basis so investors want to hire domain experts, and this is one area where hedge funds can and do add value.”
Caplis also points out that hedge funds really did generate alpha in 2019; the firm tracks 39 different sub-strategies, 35 of which produced alpha returns for their investors. Whilst many use ‘alpha’ to simply mean excess return, Caplis argues that the focus of hedge fund performance evaluation should be Jensen’s alpha, i.e. the excess risk-adjusted returns not explained by a fund’s beta or exposure to the S&P 500.
“This [Jensen’s alpha] is what institutional investors should be looking for when constructing a portfolio”, says Caplis. “If the value is positive, then the portfolio is earning excess returns. In other words, a positive value for Jensen's alpha means a fund manager has ‘beat the market’ with their skills.”
The hedge fund industry still faces challenges, and generating alpha in a low volatility, low interest rate market environment is difficult. Hedge fund bears will continue to point towards higher fees and the availability of low-cost beta exposure to equities as reasons to remove money from hedge funds. But for bulls like Caplis at PivotalPath, these investors are missing the point.
“Hedge funds are an extension of the exposures that investors want to an asset, whether it’s equities or fixed income. And then there are more diversifying strategies like managed futures, too. Last year, hedge funds did exactly what they’re supposed to do – deliver less correlated, risk adjusted alpha, and we’re seeing signs that the environment for hedge funds to generate those returns is improving. The noise around the demise of hedge funds isn’t nearly as accurate as people think.”
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