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Posted by on Jan 5, 2017 in ETF Strategist, Investment Perspective, Market Insight

The Beginning Of The End Of Hedge Funds As We’ve Known Them?

The Beginning Of The End Of Hedge Funds As We’ve Known Them?

By Roger Nusbaum, AdvisorShares ETF Strategist

So proclaimed Bloomberg in an interesting column about investors losing interest in hedge funds due to poor performance, or perceived poor performance, and high fees. I won’t defend the fees but will point out that fewer and fewer hedge fund investors pay the full 2 and 20 (2% management fee with 20% of the gain) in the last few years.

Someone expecting 50% or 100% every year from a hedge will of course be disappointed but it is worth mentioning that the first hedge fund was founded in the 1940’s by Alfred W. Jones and was designed to reduce risk. A key point from the company which is still in business; Jones referred to his fund as a “Hedged Fund” not a “Hedge Fund” because he believed that being hedged was the most important identifying characteristic. Many “hedge funds” today are unregulated investment partnerships with performance compensation structures, but some of them may not actually be hedged.

Now is not the end of hedge funds as we know them. The fees have been going down for a while, assets may have flowed out in 2016 but at some point hedge funds will have a run of doing relatively well and money will flow back in. In past blog posts we’ve chronicled pensions allocating to, and then away from hedge funds. It is at least in part the behavior of chasing returns and it is a good bet that the behavior will repeat.

None of the assertions made by Bloomberg invalidate the strategic concept underlying hedge funds, especially Jones’ idea of being hedged or otherwise protecting the portfolio.

So where the objective is not based on unrealistic return assumptions but implementing a tool to manage volatility or deliver some other specific effect to a diversified portfolio, Barron’s reported in its mutual fund column a couple of weeks ago that starting in 2017 Morningstar will evaluate liquid alternatives with a style box that measures correlation and volatility. While style boxes have their limits, the attempt to provide more information for this segment is a big positive.

I’ve been writing about this idea for many years with the simple realization that whenever interest rates started to rise, bond portfolios as they have typically been constructed over the last 35 years would run into trouble.

Where a typical fixed income portfolio might have taken some form of the barbell approach with some longer dated and some shorter dated holdings, the longer dated holdings could evolve into a problem. As opposed to a barbell-ish approach, I think a mix of shorter dated holdings, higher yielding (but with less interest rate sensitivity) as well as alternatives will be the way to go.

Not all alternatives can be fixed income proxies. I am a big fan of a small allocation to gold but it is too volatile for me to think of it as a fixed income substitute. The Morningstar style boxes will help investors figure this out but I think merger arbitrage, absolute return, market neutral, possibly risk parity (if you think an actively managed risk parity fund will reduce exposure to fixed income) and for some investors I think managed futures could work (I believe higher rates will actually help the strategy as the cash they must hold will have a higher return).

One thing that will not work as a fixed income substitute, in my opinion, is equities. The current Barron’s cover story looks at Where To Find Yield and includes some equity sectors. If utilities drop 20% compared to a 50% decline for the S&P 500 in a bear market, that would be a very good relative return, that would be relative to equities but pretty lousy compared to how someone expects a bond to do.