The author of this commentary argues that the hedge fund sector is due for a strong comeback with a compelling set of opportunities lying ahead.
Beta strikes back
While some hedge funds called the shift into US equities as far back as 2012 and later embraced future trillion-dollar stocks like Apple and Alphabet, it was nearly impossible to keep up. Alpha, a measure of value added, was modestly negative. On a relative, if not absolute, basis, these may be deemed the Lost Years.
However, the common thread or lesson from both decades is that hedge funds do one thing very well – shift into the right markets at the right time. In addition to ample talent, the true competitive advantage of hedge funds may be their flexibility.
Most investors, by contrast, have stringent “constraints.” A US large-cap equity manager must still buy those stocks even at sky high prices; pension funds might tilt their portfolios by a few per cent, but no more.
Research on hedge funds shows that they change, and change in a big way, as market conditions evolve. A small-cap value investor in 2000 might have pivoted into emerging markets by 2005 and later to US large-cap quality stocks. In some circles, ‘strategy drift’ is a derogatory term; with hedge funds, it is a plus.
Which brings us to the 2020s. The S&P currently trades at 33x earning and a high percentage of US equity value rests in a handful of stocks with nosebleed valuations; history tells us the easy money has been made. On the fixed income front, treasury yields are alarmingly close to zero and corporate credit appears to be in a bubble. The 2020s may well be a lost decade for simple, passive portfolios.
We see evidence of hedge funds recognising that 2020 looks more like 2000 than 2010. Several investing legends now call tech stocks a bubble. On a relative basis, overlooked or forsaken areas like small-cap stocks, value investments, non-US equities and emerging markets are historically cheap. In fact, our risk models show over the past year that hedge funds have been shifting into many of those areas. We appear to be at an inflection point, although it will take some time to confirm this.
What could go wrong?
The biggest headwind would be if hedge fund fees were to remain too high. Many investors pay away $6 out of every $10 in returns, which simply makes it harder to make money in a lower return environment.
Another issue is that most capital today resides with the largest managers, who may not be as nimble nor as able to capitalise on more esoteric opportunities as their much smaller forebears.
A related concern is that institutionalisation may limit strategy drift, since pension funds place managers in narrower buckets than the family office investors of twenty years ago. Significantly, the rapid and broad dissemination of information means that markets have become far more efficient over time – a headwind not just for hedge funds, but all active investors.
Taken together, despite headwinds, hedge funds may have a more compelling opportunity set today and the hurdle to demonstrate value will likely be low over the coming years. The 2020s, then, might well be a Second Golden Age.