In the third quarter of 2015, hedge funds, as a category, were experiencing their worst quarter of flows since the bottom of the financial crisis six years before. There were an avalanche of stories about the industry's nearly systematic underperformance. It looked and felt like an inflection point.
At the time, I asked aloud whether it could mean an actual net outflow at some point — an improbable musing given the seemingly one-way stampede through the in-door. Turns out, we all underestimated what would turn into a profound sea change in investor attitudes around the country.
One by one, the public retirement systems of various states and the endowments of universities made it clear that they were rethinking hedge funds for the first time since David Swensen's revolutionary Yale Endowment model took the world by storm. Some announced their commitment to alternatives but mentioned that they would be lightening up their exposure. Others decreed that a wholesale retreat was coming, with redemptions across the board.
And now, it appears the wave is finally crashing upon the beach.
Virtually every "name brand" hedge fund is facing redemptions to the tune of billions of dollars. The retirements of industry legends as well as the wind-down of once invincible firms make the news on a regular basis.
We're also hearing about fee cuts — both management and performance fees — something that at one time was unthinkable. Fee cuts send the wrong message to the tony investor set — it's the equivalent of seeing Michael Kors products at TJ Maxx. To some extent, hedge fund access had always been seen as a "Giffen Good," which economists define as an item that people consume more of as it goes up in price. "That guy charges 3 and 30 — he must be amazing! Shut up and take my money!"
Bear in mind that this is occurring during a year in which stocks are up, bonds are up, and the dreaded dispersion problem of correlated stock returns is at an ebb. The superstars with household names haven't been immune. In fact, to some extent they're getting it the worst. The media loves these stories and with every quarterly performance stumble, their coverage acts as an accelerant of future outflows.
There are those who say this is a cyclical thing.
The narrative goes something like this: Right now, because the Federal Reserve has suppressed the risk-free rate and juiced the returns of vanilla asset class index products, investors are prioritizing low fees and transparency. But when the cycle turns, index products will disappoint and the skill of hedge fund managers (stock selection, market-timing, risk management, etc) will once again shine through. The assets will follow performance and boomerang right back into alternatives.
I would say that there could be some truth to this. But there's also a lot missing.
There is a secular component here that's worth discussing. The onset of Regulation FD (Fair Disclosure) over the last decade has slowly but surely removed a lot of what was once referred to as "edge" from the available toolkit of professional investors. Corporate executives no longer have their favorite analysts when it comes to the dissemination of material information. Fund managers can no longer simply flood The Street's trading desks with commission dollars to secure the vaunted "first call" ahead of estimate cuts, price target bumps or rating changes.
The size of the industry and the sheer amount of competitors is another secular roadblock to outperformance. There are 10,000 funds managing $3 trillion today, whereas in 1990, it was a few hundred funds managing $39 billion. Size is negatively correlated with outperformance; this is an immutable law of finance. If there are ten times the amount of people doing the same trades, with ten times the amount of money, there is not going to be a correspondingly larger amount of alpha to go around. It doesn't work that way.
Then there's the problem of how talented and well-equipped the competition has gotten. Credit Suisse's Michael Mauboussin refers to this as the Ted Williams problem — imagine if the absolute skill level of today's baseball players were present while guys like Mantle, Ruth, Williams and DiMaggio were racking up their records? It could never happen.
There's also the matter of a shrinking pool of securities with which a manager can distinguish themselves. Even when the IPO calendar is full, it gets us nowhere near the heyday of the 1990s. Buybacks, private equity and the development of secondary private markets means there are less stocks (even the Wilshire 5000 can't find 5000 names to include). This leads to more crowding into a smaller cadre of names — which only works sometimes (momentum!) but is destructive for returns most of the time.
The retreat of the mom & pop retail investor removes what was once a reliable source of investment mistakes that talented professionals could harvest. Once upon a time, the pond was stocked with greater fools, not so today. And the bad news is that they aren't coming back. Gens X and Y show nowhere near the same proclivity to speculate in stocks or gamble in general as their baby boomer predecessors once did.
Finally, and this is one of the least remarked upon secular changes to the investing landscape but perhaps the deadliest for the hedge fund business, there is the issue of social signaling. It's no longer cool to be seen worshipping at the feet of star managers. The spell has been broken.
So off went the Emperor in procession under his splendid canopy. Everyone in the streets and the windows said, "Oh, how fine are the Emperor's new clothes! Don't they fit him to perfection? And see his long train!" Nobody would confess that he couldn't see anything, for that would prove him either unfit for his position, or a fool. No costume the Emperor had worn before was ever such a complete success.
"But he hasn't got anything on," a little child said.
"Did you ever hear such innocent prattle?" said its father. And one person whispered to another what the child had said, "He hasn't anything on. A child says he hasn't anything on."
"But he hasn't got anything on!" the whole town cried out at last. (Hans Christian Andersen)
Leaving aside the fact that the performance simply isn't there, investors are not immune to the shift in society at large toward data-driven decision making. Smart beta strategies and even some liquid alts have taken the "alpha" that was once handcrafted, trade by trade, and have distilled it into a "structured alpha" pursuit using factors, formulas and algorithms to do what was once the province of the emperors. Even Warren Buffett's stock-picking prowess can be reconstructed this way (turns out he's more a growth-at-a-reasonable-price story than a deep value story. Who knew?).
The next generation of investors has a new religion and it doesn't involve the apotheosis of Men In Suits or a spiritual pilgrimage to Greenwich. As further evidence of this, the hedge funds that do have positive flows (and returns?) these days are more akin to what Jim Simons is doing at Renaissance Technologies than what Alfred Winslow Jones was up to when he invented the thing. Systematic is what everyone is looking for these days, no one in the allocating or consulting world wants to be seen as old fashioned or a Luddite.
I don't believe that the hedge fund industry will go away, but in order for the very best managers to shine again in a reliable fashion, it probably needs to shrink. The good news is that this process is already underway. The bad news is that it doesn't look pretty or feel good while in progress.
And in the next downturn, whenever the monetary authorities allow us to have one, there will be a revival. New kings will be crowned, lending some credence to the views of the cyclical-not-secular camp.
But the golden age is not coming back, perhaps not ever again.
Commentary by Josh Brown, creator of The Reformed Broker blog, a financial advisor for Ritholtz Wealth Management and a CNBC contributor. Follow him on Twitter @reformedbroker.
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