The Good Old Days “Are Surely Over” For Hedge Funds

“2 and 20” works fine when things are going well.

Not so much when things are going poorly. After all, who wants to pay someone 2% of AUM to lose money or to grossly underperform benchmarks. Not me. And while not everyone can win all of the time, when owning a simple HY ETF can get me 16% and owning SPY 14% both for comparatively nothing in fees, you’d better give me a damn good reason why I should pay you 2% up front.

That’s especially true if you can’t perform when the market is handing out tail events like candy. Consider the following bit from The Economist:

Until now, a fund’s typical excuse has been that massive central-bank intervention has dampened volatility, which hedge funds profess to benefit from. But as 2016, the most volatile year for markets in a long while, draws to a close, it is striking that hedge funds have failed to perform markedly better.

Fund closures are historically high, and only modest numbers of new funds have been launched. According to newly released figures from Hedge Fund Research (HFR), a data provider, 782 funds were closed in the first three quarters of the year alone; if the trend continues unabated, this year will mark the highest number of liquidations since the financial crisis. The number of new funds launched in the third quarter, meanwhile, was the lowest since the first quarter of 2009.

And while some individual macro funds have performed well around the year’s unexpected political turmoil (Crispin Odey comes to mind and God knows he needed a good run), on the whole they’ve fared poorly  despite black swans such as Brexit and Donald Trump’s November victory at the polls:

But individual successes do not mean macro funds as a whole have done well: indeed, HFR’s asset-weighted macro-fund index made only a dismal 0.1% return in the first 11 months of the year.

All of this is causing the industry to rethink its fee structure. Here’s FT:

Fee reductions and flexibility around incentives have become increasingly important in the hedge fund industry, where low returns in some funds have caused concern among investors about how much value their managers are generating.

The willingness to negotiate on fees shows how the longstanding 2 and 20 formula for hedge fund fees is becoming outdated.

While there has always been pressure on hedge fund managers to reduce their fees, some of the highest in finance, lacklustre performance this year by several of the biggest names in the industry has forced funds who once billed some of the highest rates in the industry to acquiesce to investor pressure and cut how much they charge.

“The days where everyone was on 2 and 20 and quarterly liquidity are surely over,” Barclays says.

Yes, “surely” they are. Meanwhile, some of the trendier strats like risk parity, vol targeting, and CTAs likely contribute to routs when volatility rises. That puts retail investors who (wisely) opted for low-cost ETFs at risk of becoming deer in headlights as systematic strats rebalance depending on market conditions (i.e. you get forced selling into an already depressed market). You can’t escape the influence of the hedgies even if you’re not invested with them.

Still, there’s something to be said for funds that guard against black swans and hedge against tail risks. Like Nassim Nicholas Taleb, managers of these funds will lose small when they lose but win big when they win. With 2017 set to be the year of geopolitical land mines, these strats may begin to look increasingly attractive. Here’s The Economist again:

Hugh Hendry of Eclectica Asset Management, a macro hedge fund, is just such a crisis-better. Convinced that Europe will see a systemic political crisis in the next year, he has moved to set up trades that will profit from such an occurrence but lose only modestly in the event of a benign outcome. If the job of a macro hedge fund is to “protect clients from Rome burning”, as Mr Hendry contends, at least “it is not terribly hard to buy fire insurance”–that is, for those willing to keep paying for it.

I’ll close with a few quotes from FactSet’s Sara Potter who has endeavored to explain why you should, as Hendry puts it, be “willing to keep paying for fire insurance”:

French Presidential Election in Focus

In the lead-up to the 2017 French presidential election, former Prime Minister François Fillon was the winner in the November center-right Republican Party primary. Fillon’s main competitors in the April election are likely to be Marine Le Pen, leader of the far-right National Front, and a still yet-to-be-determined candidate from the left, whose primary will be held in January 2017. Current president François Hollande (Socialist party) took himself out of the running earlier this month, faced with record-low approval ratings and stubbornly high unemployment, currently at 10%. Economic issues are at the forefront of the French election, but the candidates bring very different ideas to the table.

Mr. Fillon, who compares himself to legendary UK Prime Minister Margaret Thatcher, wants to reduce the size of government and end the 35-hour workweek in order to stimulate economic growth. Ms. Le Pen has a more populist approach, promising to enhance protections for workers and pensioners while rolling back free trade deals and pushing for a referendum on leaving the European Union. The first round of the election will be held in April, with a run-off two weeks later if no candidate wins a majority of votes.

German Election Looms in Late 2017

German Chancellor Angela Merkel will run for a fourth term in the country’s national elections to be held in late 2017. Ms. Merkel has served in this role since 2005, seeing Germany successfully emerge from the global financial crisis of 2008-2009 after leading efforts to provide euro bailouts to the ailing economies of Greece, Ireland, and Portugal. During her third term, GDP growth has not been remarkable, but it has remained steady, with quarterly year-over-year growth averaging 1.7% over the last three years.

Exports are key for Europe’s largest economy; more than one-third of Germany’s exports are sold to euro countries, but the weak euro will help boost exports to the rest of the world. However, the UK is Germany’s third largest export market (after the U.S. and France); as the details of Brexit unfold over the coming months, exports to the UK could suffer.

Political events dominate the outlook beyond these three countries. Austria held its presidential election in early December, with the Green Party’s Alexander Van der Bellen defeating far-right candidate Norbert Hofer of the Freedom Party of Austria. In addition, the Netherlands has an upcoming general election in March 2017 and this week the UK Supreme Court will hear arguments on whether Brexit can proceed without a parliamentary vote. That judgment is expected in January and could impact the timetable for triggering Article 50 of the Lisbon Treaty which starts the process of exiting the European Union.

Stay tuned. 2017 promises to be another interesting year in politics and economics.