The hedge fund industry has been criticized for underperforming, being overpriced and oversized, and having too few next-gen leaders. In other words, the industry has been accused of not keeping up with an ever-changing world. But what can we really expect from hedge funds in the future?
Why it is possible that hedge funds will disappear
The term hedge fund originated from the word hedge, which is created when betting on something and on the opposite side of it at the same time. The classic hedge fund technique, which is known as long/short, works in the same way. You will invest long in stocks or stock indices and later short them if they are overvalued. However, many hedge funds do not follow that hedging strategy anymore.
Nowadays, a hedge fund refers to a slightly regulated pool of private capital that is almost always doing something out of the ordinary – such as using huge amounts of leverage and borrowing to multiply the size of its bets. Hedge funds defend the fact that they are slightly regulated by the argument that access to them is exclusive to people who know them well and can afford to lose their money. Hedge funds can be considered expensive as they come with the so-called "2 and 20" standard fees – you are charged 2% of the money you have invested (in a yearly basis), as well as 20% of any returns on your investment that is above an agreed-upon benchmark.
A Hedge fund's average lifespan is about five years, and many of them don't even make that. A 2014 New Yorker article reported that out of an estimated 7,200 hedge funds in existence at the end of 2010, 775 failed or closed in 2011, as did 873 in 2012, and 904 in 2013. Within three years, about a third of hedge funds disappeared.
There are also reports of investors pulling out their money from the hedge fund industry. In a blog post, analytics firm eVestment reported that investors redeemed over $100 billion in 2016 – $23.7 billion in December and $43.2 billion in Q4 of the year. December marked the sixth month of outflows since 2009, which made Q4 the largest quarterly outflow from the industry since Q1 2009 (during the financial crisis). It appears that the lacklustre hedge performance in 2014 and 2015 has driven these redemption pressures in the industry.
In addition, many of the advantages the industry enjoyed for decades have started to disappear. Nowadays, more hedge funds are placing the same type of bets. As such, finding unique ideas or flaws no one else has spotted is becoming more difficult, especially at a time when many stocks are rising.
Why hedge funds will not disappear
Alternative Investment Management Association (AIMA) comes in defence of hedge funds. In a 2016 article Jack Inglis, AIMA’s CEO, debunked reports of hedge fund redemptions totalling $15 billion in Q1 2016, claiming that this figure represents only around half of one percent of the total assets under management. He asserted that over the past 25 years, hedge funds have significantly outperformed all other major investment types and have done so with less than half the volatility and risk of the equity markets.
In a recent article, Tom Kehoe, AIMA’s Global Head of Research, said that the continued capital investment into the hedge fund industry is a measure of the industry’s continued attractiveness to investors despite negative reports about it. According to him, over the past year, more than $70 billion of capital investment has been allocated to hedge funds.
Regarding high fees, hedge funds have made efforts to cut their fees amid the difficult return environment and the increasing pressure they face from smart beta products and exchange-traded funds (ETFs). According to Deutsche Bank’s 16th annual Alternative Investment Survey, the average management fee had dropped to 1.56% while the performance fee to 17.3%. Among the survey’s respondents, 42% have invested in a fund with a management fee that decreases as assets under management increase while 50% were able to negotiate lower fees for a longer lockup or larger allocation size.
What the future holds for hedge funds according to industry leaders
In a research paper, AIMA and Aberdeen Standards Investment (ASI) spoke with 25 leading hedge fund figures about the industry’s future. The industry leaders recognize the challenges they face as well as the need to embrace innovation to survive. For instance, they will need to employ artificial intelligence, respond to public opinion, reach out to potential investors and offer new solutions to existing ones. Yet, in spite of these challenges, they are optimistic.
Why be optimistic about hedge funds? Sir Paul Marshall, one of the industry leaders interviewed, gave two reasons. One is the fact that we live in an era where there is an explosion in the availability of information, which can be used in new ways to generate alpha (excess returns on investment). The other one is the explosive growth of fintech, which seeks to improve and automate the delivery and use of financial products and services.