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Firms at the crossroads: Offer alpha or disappear

Cliff Asness
Clifford S. Asness sees hedge funds as a good argument for active management — if fees are fair.

Hedge fund managers have been put on notice: evolve, deliver or die.

Unless managers produce alpha, diversify institutional portfolios and protect their downside at a fair price, they risk more of the crippling outflows many experienced in 2016.

Industry bifurcation is inevitable, sources said. Likely survivors will be among the cadre of multibillion-dollar firms cushioned by healthy asset levels and good performance, and skilled niche managers whose chosen strategies often are capacity constrained, precluding management of big capital pools.

Between the largest and specialist niche managers, numerous midtier managers will be under immense pressure from institutional investor demands for lower fees, an ongoing low-yield environment and increasing complexity of business operations, pushing many out of business by the end of the decade, according to a new report from The Boston Consulting Group.

“It's a question of the value proposition of hedge funds. If managers are charging 2% and 20% and aren't producing returns, the jig is up,” said Brent Beardsley, managing director and senior partner based in BCG's New York office.

The impact of net negative flows and performance is already evident in the havoc wreaked on the assets of many hedge fund managers tracked by Pensions & Investments for the year ended June 30, 2016, according to annual survey data.

The majority — 70% — of the 99 hedge fund firms that returned P&I's survey in 2016 saw assets decline from the prior year. Of those managers, 40% experienced losses of 10% or more and 27% had declines greater than 20%.

The percentage with asset growth for the year ended June 30 was 28%; 14% saw AUM growth of 10% or more. For 2% of managers, assets were flat in 2016, survey data showed.

The story was different for the prior year — 73% had higher assets in 2015 than in 2014 and 27% saw declines. The universe for that year-to-year comparison was 75 firms that responded to P&I's survey in both 2015 and 2014.

Global market conditions in the past two years didn't make it easy for a wide swath of managers to generate the alpha expected by institutional investors paying high fees for market outperformance.

“Individual hedge fund strategies started suffering poor returns in 2014. In the summer of 2015, active management really started to struggle and on average, alpha turned negative,” said Kent Clark, managing director and head of the hedge fund strategies practice within Goldman Sachs Asset Management, New York.

“By the end of 2016, after nearly eight years of a global bull market, average hedge fund returns were what you would have expected after adjusting for average beta and performance of most strategies lagged long-only U.S. equities,” he added, stressing that “returns like this generated a lot of unrest among investors.”

GSAM managed $28 billion in hedge funds of funds as of Dec. 31.

Taking a hard look

The disquiet has led many to take a hard look at the hedge funds in their portfolios. “Many institutional investors are questioning what role hedge funds play in their portfolios. They are more routinely dissecting the contribution of alpha and beta returns, how to capture each most efficiently and what to pay for them,” said Michelle Noyes, New York-based chief operating officer of industry group Alternative Investment Management Association.

Despite a few high-profile “noisy” investor departures from hedge funds, by and large “investors have become more sophisticated and are much better at determining a manager's luck vs. talent,” said an executive at activist hedge fund firm who asked not to be named. “There are still a lot of investors that are making first-time allocations to hedge funds.”

“Institutional investors are more intent on picking firms in which they have confidence in the manager's ability to generate alpha,” said the executive.

Ironically, asset owners played a big part in reducing a manager's ability to uncover and exploit sources of alpha, sources said, due to the sheer volume of money invested over the last decade.

“If you go back 10 or 15 years, hedge funds sprang up when managers left traditional money management companies. But from that early pioneering phase, the hedge fund industry has moved to having so much money to put to work in the markets that it's become much harder to find alpha,” said Bruce Keith, noting institutional investors were responsible for much of the inflows. Mr. Keith is CEO of Infrahedge Ltd., London, a managed accounts provider.

At the heart of the matter is the question of whether active management can consistently outperform passive strategies. “At fair fees, hedge funds are a more efficient, clearer, risk-adjusted version of active management,” said Clifford S. Asness, managing and founding principal of AQR Capital Management LLC, Greenwich, Conn.

“We're hearing a lot of rumbling out there about hedge fund fees, which is something we've been talking about for 10 to 15 years,” Mr. Asness said, stressing “hedge fund managers are making too much of their money from being net long, which makes paying high fees even more egregious.”

Akin to the traditional investment management arena where institutions are moving with alacrity to passive strategies, Mr. Asness said assets are leaving hedge funds for systematic and passive approaches.

“The last few years have been terribly difficult for active management. Hedge funds are just another type of active management,” said Luke Ellis, CEO of Man Group PLC, London.

“If active managers can't produce (outperformance), they can't earn fees. It's the same equation for hedge funds,” Mr. Ellis said, noting the result of hedge fund managers not generating alpha will be a “very healthy shaking of the tree. The hedge fund industry has always exhibited an incredibly Darwinian evolutionary process. There have always been fund closures as a result.”

Man Group managed $34 billion in hedge funds and $12.7 billion in hedge funds of funds as of Sept. 30.

“Nothing has changed,'' said an executive of a large multistrategy hedge fund firm who spoke on condition of anonymity. “The hedge fund industry has always been an incredibly competitive space where the strongest survive. Capital is taken away from those managers who don't perform and given to those who do.”

“I think we've reached the point where there's too much money invested in the space but I think more money will flush out in the first part of this year because investors can't tolerate poor performance,” the source said.

Fewer managers chasing the same sources of alpha around the globe would benefit surviving firms immensely, sources said.

That's because the vast majority of the 8,300-plus active hedge funds are very small and only “a couple hundred offer a compelling value proposition,” said Jon Hansen, managing director and hedge fund specialist at investment consultant Cambridge Associates LLC, Boston.

“Because of the trillions invested in hedge funds nowadays, experienced talent is spread thin and much of the capital is crowded around the same opportunities with a highly short-term focus,” said the activist hedge fund executive. “It's a lot harder for most managers to produce alpha in that situation. What's needed is the talent, experience and conviction to do things differently from everyone else, and not many firms have that.”

Hedge fund gainers and losers
Ranked by one-year change in assets under management as of June 30, 2016. Assets are discretionary assets managed in hedge funds worldwide, in millions.
RankManager2016
assets
Change,
2015 to
2016
Change,
2014 to
2015
 
1Paloma Partners$5,300 65.6%45.5%
2AQR Capital Mgmt.$63,030 38.2%44.3%
3Hitchwood Capital Mgmt.$3,681 33.6%N/A
4Graham Capital Mgmt.$12,666 27.4%42.2%
5Two Sigma Investments$27,600 27.2%59.6%
6 Gramercy Funds Mgmt.$3,955 21.7%12.0%
7 Renaissance Technologies$32,000 18.5%5.9%
8Capula Investment Mgmt.$14,100 15.6%13.2%
9HG Vora$2,400 14.3%31.3%
10Birch Grove Capital$797 13.9%58.4%
11The Children's Investment Fund$12,500 13.6%N/A
12Marshall Wace1$23,000 13.3%12.8%
13Saba Capital$1,700 13.3%N/A
14Winton Capital Mgmt.$33,045 10.9%21.3%
15Millennium Mgmt.$33,302 9.5%31.3%
16Pacific Investment Mgmt.$16,979 8.3%-3.2%
17Ionic Capital Mgmt.$2,700 8.0%19.0%
18Elliott Management$28,834 7.6%8.6%
19Nephila Capital$9,983 6.4%N/A
20Highline Capital Mgmt.$2,856 6.1%17.1%
21Kepos Capital$2,200 5.3%28.5%
22Man Group$46,300 4.3%6.5%
23Tilden Park Capital Mgmt.$3,862 3.5%6.6%
24Passport Capital$3,900 2.6%-3.4%
25D.E. Shaw Group$27,018 2.5%9.9%
26GoldenTree Asset Mgmt.$11,555 2.2%19.2%
27Farallon Capital Mgmt.$21,000 1.9%0.5%
28Waterfall Asset Mgmt.$4,200 0.3%N/A
29Canyon Partners$14,200 0.0%N/A
30UBS O'Connor$5,600 0.0%3.7%
31Fortress Investment Group2$13,588 -0.2%-2.4%
32 Bridgewater Associates$102,930 -0.7%13.6%
33Ivory Asset Mgmt.$2,991 -1.0%18.4%
34Anchorage Capital$15,600 -1.3%7.5%
35 Ramius$9,082 -1.3%17.3%
36Davidson Kempner Capital Mgmt.$25,250 -1.4%7.6%
37Highfields Capital Mgmt.$12,200 -1.6%N/A
38Napier Park Global Capital$1,881 -2.0%-4.2%
39Silver Point Capital$7,500 -2.6%N/A
40Solus Alternative Asset Mgmt.$5,039 -2.6%36.2%
41Autonomy Capital$3,500 -2.8%2.9%
42PointState Capital$10,190 -3.0%N/A
43Moore Capital$15,000 -3.2%4.4%
44Citadel$24,002 -3.6%18.6%
45Ellington Mgmt. Group$5,300 -3.6%17.0%
46Lone Pine Capital$12,400 -3.9%N/A
47Eton Park$8,500 -5.6%-2.2%
48BlueMountain Capital Mgmt.$14,099 -5.7%-2.1%
49Senator Investment Group$8,485 -6.1%17.0%
50Strategic Value Partners$1,400 -6.7%N/A
51Magnetar Capital$13,200 -7.7%30.0%
52Eminence Capital$5,900 -7.8%16.3%
53Samlyn Capital$5,000 -9.1%26.7%
54Viking Global Investors$19,780 -9.4%5.7%
55Brenner West Capital Partners$1,305 -9.8%N/A
56Hutchin Hill Capital$3,700 -9.8%78.3%
57King Street Capital Mgmt.$19,000 -10.0%-5.0%
58Contrarian Capital Mgmt.$3,140 -10.3%N/A
59Marathon Asset Mgmt.$8,700 -10.3%-1.7%
60Three Bays Capital$1,600 -11.1%N/A
61MKP Capital Mgmt.$7,391 -11.7%-4.0%
62Cevian Capital$12,619 -11.8%-4.9%
63Highland Capital Mgmt.$1,061 -11.8%55.2%
64Blue Ridge Capital$7,000 -12.5%-11.1%
65Conatus Capital Mgmt.$2,000 -12.9%-23.4%
66Blue Harbor Group$3,100 -13.4%11.9%
67 BlackRock (BLK)$28,600 -14.3%-2.6%
68Goldman Sachs Asset Mgmt.$13,000 -14.5%5.6%
69Pine River Capital Mgmt.$8,100 -14.7%-9.4%
70Carlson Capital$8,354 -14.8%11.4%
71York Capital Mgmt.$18,300 -15.7%0.5%
72Seer Capital Mgmt.$1,630 -16.0%N/A
73Folger Hill$1,000 -16.7%N/A
74Hudson Bay Capital Mgmt.$2,700 -17.3%41.1%
75LibreMax Capital$2,700 -17.3%-0.7%
76Tudor Investment Corp.$11,000 -17.9%7.2%
77Glenview Capital Mgmt.$9,460 -19.6%27.9%
78CQS$11,600 -19.7%7.2%
79Capstone Investment Advisors$2,732 -20.0%32.6%
80Wexford Capital$1,600 -20.0%N/A
81Structured Portfolio Mgmt.$2,120 -20.5%N/A
82DW Partners$4,100 -21.2%-21.2%
83Greywolf Capital Mgmt.$1,385 -21.4%N/A
84Perella Weinberg Partners$1,125 -21.8%-32.4%
85Kingdon Capital Mgmt.$2,063 -22.8%-3.8%
86Finisterre Capital$1,850 -23.3%N/A
87Aurelius Capital Mgmt.3$3,605 -24.2%5.8%
88Tricadia Capital Mgmt.$3,100 -24.4%16.7%
89400 Capital Mgmt.$1,475 -25.1%86.9%
90Taconic Capital Advisors$6,190 -25.7%-9.0%
91Fir Tree Partners$9,600 -26.6%0.4%
92Greenlight Capital$8,600 -27.1%N/A
93Brevan Howard Asset Mgmt.$19,400 -28.1%-25.0%
94Och-Ziff Capital Mgmt.2$26,100 -31.2%11.6%
95JANA Partners$7,435 -37.0%7.2%
96Impala Asset Mgmt.$1,482 -46.8%-11.6%
97Salient Partners$1,781 -57.6%N/A
98J.P. Morgan Asset Mgmt.$6,446 -77.3%10.4%
99Claren Road Asset Mgmt.$836 -80.1%N/A
Notes: 1 Data are as of April 30, 2016, from external source. 2 Data are as of June 30, 2016, from company earnings report. 3 Data are as of July 31, 2016, from survey.
Source: Pensions & Investments survey unless otherwise noted

Surviving the shakeout

Among large hedge fund firms likely to skillfully plumb a less-competitive alpha landscape, sources pointed to AQR Capital Management, The Baupost Group LLC, Bridgewater Associates LP, The Children's Investment Fund Management (U.K.) LP, Citadel LLC, Elliott Management Corp., Renaissance Technologies LLC, Rokos Capital Management LLC and Two Sigma Advisers LP.

Smaller, newer and niche managers include Autonomy Capital, Park Presidio Capital LLC, Pelham Capital Management LLP and Redwood Capital Management LLC.

The success of these firms puts them at an advantage in terms of generally not having to concede to demands for lower fees, observers said. A number of the largest, most institutional managers closed their strategies to new investors some years ago to maintain performance.

“We're interested in hedge fund managers that are focused on a particular asset space as opposed to being huge asset gatherers. These specialized managers often are closed or semi-closed and very protective of their strategy's capacity. And they definitely are very performance focused,” said Tracy McHale Stuart, partner and CEO of hedge funds-of-funds manager Corbin Capital Partners LP, New York.

“A surprising number of our "nichey' managers don't want press exposure,” she added.

Goldman Sachs' Mr. Clark said “there are two groups of hedge fund companies. The successful firms are not making changes because they don't have to. The world hasn't changed for them.”

The multistrategy hedge fund executive who declined to be named said the firm's funds are closed and fee concessions haven't been made. And because of institutional investor interest, the firm — like many other high-demand companies with closed funds — does offer capacity at regular fee levels to “good partners.” Those are desirable institutional investors, particularly corporate pension funds, endowments, foundations and sovereign wealth funds.

By contrast, many members of Mr. Clark's “other group” of managers with declining AUM, performance problems or out-of-favor strategies are being pressured by asset owners to renegotiate both management and performance fees as well as other contract terms.

Last year, institutional investors got more assertive and pushed managers on a variety of issues, said Steven B. Nadel, a partner in the hedge fund practice of law firm Seward & Kissel LLP, New York.

Demands ranged from more liquidity, performance hurdles, multiyear incentive schedules and managed accounts to funds of one and customized strategies such as a partial investment sleeve of a multistrategy fund, Mr. Nadel said.

The problem, Mr. Nadel said, is that “costs are rising for hedge fund managers, especially for institutionally oriented firms, in every aspect of their businesses including cybersecurity, IT, record keeping, artificial intelligence, rent and overhead. The question is how managers can deal with higher costs when investors want lower fees. The only thing they can do is raise and maintain assets in order to meet increased expenses.”

Making changes

But managers are listening to institutional investors and making changes.

To hold on to assets, Cambridge Associates' Mr. Hansen said he's seen a “180 in the market in the past year. Years ago, when we engaged a hedge fund manager on the issue of fees or alignment, the manager thought, `If I do this proactively, it will be taken as a sign of weakness.' Conceding is not considered so dangerous any more.”

Mr. Hansen said he and his colleagues have had “a lot of success” in getting management fees down because “as returns get lower, that fee really eats into an investor's return. We've been able to get managers to really focus on what it costs to run their business and lower their fee accordingly. The management fee is the capital the manager needs to run the business, not a source of profit.”

The next evolutionary step for managers is to start focusing on fairer fees by introducing sliding scales or performance hurdles, Mr. Hansen said, adding the effort is “still a work in progress. It's to no one's advantage if we disadvantage the manager by requiring a lower performance fee,” thereby reducing the incentive for portfolio managers to strive for performance.

Other stay-alive adaptations being contemplated include new fund structures such as hybrid private equity-hedge fund vehicles that require a three- to five-year lockup in exchange for lower feesproviding investors with a good illiquidity premium, said Douglas A. Smith, a New York-based senior investment consultant, hedge fund manager research with Willis Towers Watson & Co.

Other possibilities include concentrated funds of particular alpha sources and developing co-investment opportunities for institutional investors, Mr. Smith said.

Success and survival for midtier hedge fund companies depends to large degree on the manager's self-assessment of skills and value to institutional investors.

“Good questions for all hedge managers are: What return can you produce? When? How? And for how long?” said Kevin P. Quirk, principal, Casey Quirk, a practice of Deloitte LLP, Darien, Conn.

“Hedge fund managers have an opportunity to define what kind of return they can provide that will help institutional investors meet or improve return expectations,” Mr. Quirk stressed, adding “the next three years will be very interesting in the hedge fund industry.”

This article originally appeared in the March 6, 2017 print issue as, "Firms at the crossroads: Offer alpha or disappear".