Hedge Funds in the New Age

For a long time I thought I wanted to be a hedge fund manager. A large part of me still does, truthfully, but it’s important to understand how these funds have changed over the years. This week I want to talk a bit about how investment strategies are changing in general and the larger economic landscape behind these changes.

As I mentioned in a previous newsletter, technology is a big motivator for all of this. Investor risk tolerance has also changed, and a general shift in how retirement funds are utilized has led to several new investing strategies. Long story short, retirement funds are managed in a completely different way now. This, combined with the rise in technology, has ushered in a new era of investing.

The Wild West

The 90’s and early 2000’s were, in many ways, the “golden age” for hedge funds. The total number of funds were limited, and there was a tremendous amount of alpha (excess performance above benchmarks) to be found. A wide range of strategies worked, and funds could charge fees commensurate with their returns.

At this point it’s important to distinguish “hedge funds” as really nothing more than a strategy and a compensation structure. They are able to play both sides of the market, creating strategies that benefit when the market is up or down. The managers are also compensated for performance, with funds during this period charging “2 and 20” or a 2% management fee and 20% of positive returns.

In the 90’s and 2000’s, hedge fund managers could take bigger risks and concentrated bets. The best performing managers were able to take contrarian positions with strong conviction, betting big against common market sentiment. It was as much art as science, and the managers who did well did very well. So what happened?

Pensions and 401(k)’s

If we look back to the market environment during the “golden age” of hedge funds, it was a perfect storm of factors that helped these alternative investment vehicles grow. Many funds had pension plans as clients; these pensions posed significant financial burdens and risks to employers due to guaranteed payouts and the need for long-term funding. The pool of money needed to grow over time in order to make the guaranteed payouts promised to employees.

While 401(k) plans were introduced in 1978, they have risen in popularity slowly. While pension plans put the burden on employers, modern 401(k) plans place the onus on employees to contribute a portion of their paychecks. While employers may match funds placed in a 401(k), they are no longer responsible for consistent payments after retirement.

This shift in how employers offer retirement plans has caused large pools of investment funding to dry up, leading to an exodus of many large hedge fund clients. Since 401(k) plans are handled by wealth managers who simply look to mirror the broader market, lower risk, more consistent investment vehicles have gained in popularity. There has also been a rise in ETF’s which mirror certain indices or baskets of stocks that are available to everyday investors.

Regulation and technology

Increased regulatory scrutiny has also changed the way many investment funds operate. Prior to the financial crisis of 2008, there really wasn’t much oversight at all. This is part of what led to the ticking time bomb of sub-prime mortgage lending. Hedge funds could operate with impunity and access a wide range of alternative investments.

While these funds still have much more leeway than a standard wealth management firm, they now have more guard rails than in the past. Compliance costs are higher, and these burdens have added complexity and reduced speed. This is where technology has stepped in, but this technology has also fundamentally altered the way many hedge funds operate.

In the first issue of Monday Momentum we discussed the rise of quant funds and how these strategies have grown over time. As computers have become more powerful, trading algorithms drive much of the daily action in the markets. This algorithmic trading, in conjunction with regulatory scrutiny, has led to more efficient markets. There are far fewer inefficiencies to take advantage of and, therefore, fewer opportunities for outsized returns.

Modern risk appetites

All of these factors have changed the standard risk profile of the modern investor. Hedge funds require investors to be accredited, which means that they need to either manage institutional pools of money or be high net-worth individuals. These investors have gotten savvier over the years, and are fully aware of the return history for index funds and ETF’s. They expect fund managers to be able to consistently beat these returns, but this is getting harder to do for the reasons mentioned above.

The end result of this is that many hedge fund managers simply cannot outperform the benchmarks. If they chase risk to do so, they open themselves up to cataclysmic tail events like the Covid pandemic which wiped out several funds. If they try and compete with the quants, they are either too slow or have no way of gaining an information advantage with universal access to the internet.

There is less alpha to go around, and less risk tolerance to go with it. The most successful funds have cornered the market on their strategies. They operate surgically, with groups like Citadel building highly-specialized, small teams. Each investment team must know everything about a niche part of a specific industry, and they are tasked with building low risk, market-neutral portfolio strategies. The main portfolio, containing all of these small teams, is then leveraged to generate returns from the entire basket of investments.

There really isn’t any room for (or advantage gained by) the “shoot from the hip” investor of old. The Bobby Axelrod’s (of the show Billions) don’t really exist anymore. While some titans of the industry remain, they exist simply because of their established reputations and client base. The path to the industry now often comes from math, science, and software engineering backgrounds. That, or you come from a decade or more of experience in a very niche industry and you’re able to explain that knowledge to a surgical investment team.

The “golden age” of hedge funds is very much behind us, and it will be interesting to see which investment vehicles and strategies gain popularity in the future. AI will definitely play a massive role in these changes, and crypto/blockchain has shown promise with decentralized finance applications. Time will tell, but one thing is certain: investors must continue to adapt with changing times or get left in the dust.

TL; DR - Hedge funds had a hell of a run in the 90’s and early 2000’s. Part of this was due to massive pension funds needing to earn outsized returns to make payouts. The financial crisis in 2008 led to increased regulation, and technology has forever altered the efficiency of the market. Add 401(k) plans being the default retirement fund to the mix, and hedge funds have declined in popularity as investment vehicles.

What I’m interested in this week

1. “U.S. Department of Treasury Releases Request for Information on Uses, Opportunities, and Risks of Artificial Intelligence in the Financial Services Sector”

2. “New Texas Stock Exchange Takes Aim at New York’s Dominance” in the Wall Street Journal

3. “Tesla likely to spend $3 bln-$4 bln on Nvidia hardware this year” in Reuters

4. “Dalio Flags US-China ‘Economic Warfare’ Among Top Global Risks” in Bloomberg