Chart of the Month – Is the lifecycle of the hedge fund industry over?

Is the lifecycle of the hedge fund industry over?

Numerous academic studies have shown that small funds outperform in their first few years of existence before they become victims of their success and subsequently attract too much money to perform in the investment strategy initially intended.

Recent history shows that an increasing number of launches are failing to gain traction and end up liquidating or long-standing managers converting into a family office after returning outside investor capital following disappointing returns (before they start outperforming again with their own money). One of the principal reasons is that the larger sized funds have become increasingly larger and competitive as they have been more successful in hiring new talent as they earn more fees. This new talent has come in the form of small and nimble investment managers that are able to actively trade limited amounts of capital within a particular sector (hence the multi-pm model with narrow stop losses e.g. Millennium, Citadel and Point72) to PhDs with a non-investment background that have been able to develop quantitative algorithms (e.g. D.E. Shaw, Renaissance and Two Sigma). The end result is that they have been able to challenge the classic old school hedge fund manager with a buy and hold approach in a concentrated portfolio of non-consensus trades with the ability to stomach volatility in exchange for outsized returns. As the traditional investor base in hedge funds has shifted from HNWI to institutional investors (endowments, SWF, pension funds etc.) that have a low tolerance to drawdowns and are happy with single digit returns, the average returns in the industry have deteriorated significantly. A declining industry is by definition less crowded which is a good thing for existing managers and the barriers to entry are much higher today than they have ever been.

At Notz Stucki, we pride ourselves in finding talented managers that are off the radar of large investors and can deliver the punchy but volatile returns and combine these with the larger multi-PM/quant managers with whom we have had long standing relationships, to attenuate the volatility of our overall portfolios. Yes the hedge fund industry remains challenged but still offers compelling opportunities particularly when markets are volatile. The short book for the average equity long / short hedge fund has clearly been a drag on performance in the last 10 years, yet there are a few outstanding managers that continue to be successful in this space. One often forgets the fact that in the past when interest rates were much higher, the cash from the short book was a source of returns whilst now it can cost you in a negative interest rate environment making it even more challenging for the industry.

The future of the hedge fund industry is still bright but one needs to be more selective in choosing the right talented managers that will continue to outperform over time.

Chart of the Month: 1986 – 2016 « LIVE TO TELL » (MADONNA)

Chart of the Month

1986 – 2016. « LIVE TO TELL » (MADONNA)

In 1986 Madonna was singing a very nice song titled « Live to Tell » which rapidly became a hit.

Although the song was by no means a reference to financial markets, it’s easy to extrapolate with the title and imagine the great singer wondering what would be the best way to invest the revenues generated by the huge sales of her record over a 30 years horizon. Now that this 30 years’ time period comes to an end, she has lived to tell the right choice that was to be made in terms of investment in 1986.

Here below is a simple table of the annualized returns of the S&P 500 with dividends, a 30 year Treasury Strip, Money Market (less than 12 month T-bills) and Gold:

As a reminder, inflation (CPI USA) has run at a 2.62% annualized pace over this period, so one 2016 dollar is worth 2.2 times less than a 1986 dollar.

It appears clearly, with hindsight, that in terms of absolute performance nothing compares to equities, but the 8.92% annualized return on the US 30 year Treasury Strip is unbelievable (for a liquid Aaa fixed income instrument). Otherwise, for those who wanted to avoid risk, money market has done its job by providing investors with a decent return, well ahead of inflation. And finally, Gold has done barely better than money market (but with much higher volatility).

Are there lessons to be drawn from this quick summary? Yes, certainly: over an extended period of time, equities are unsurprisingly the best investment, especially in the US where there is extremely low influence of the State on the stock market (as opposed to Europe and Japan where some companies are deemed strategic and are under pressure from their respective Governments). In the considered period, there were not less than 6 episodes of severe drawdowns (1987, 1990, 1998, 2000-2002, 2007-2009, 2011) and despite that the overall performance of the stock market remains more than compelling.

Another lesson is that the incredible performance of the bond market can’t be repeated with current yields at 3.1% on 30 years Treasury Strips. We have enjoyed an unprecedented bull market on bonds, and even if it can eventually deliver decent returns, they will by no means get close to those of the last 30 years.

At last, history seems to favor short term US T-bills over Gold for safety. The volatility attached to Gold makes it difficult to call the shiny stuff a safe investment.

As a conclusion, looking at past returns does not make sense for fixed income or money market because future returns will very largely depend on interest rates at entry levels. What is really interesting is that US Equities have the good habit of returning close to 10% annualized over the long term, whatever the start date. And the odds are pretty favorable for this to last!