Mutual Funds Can't Criticise Hedge Funds
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After a Niagara of uninformed speculation, finally an oasis or two of calm rationality: "Closer scrutiny won't stop 'hedge fund express'" writes Chet Currier for Bloomberg. Currier's thesis: that hedge funds are essentially and merely mirroring the growth explosion that mutual funds enjoyed in the 1990s.
"With assets at $1 trillion and rising fast, hedge funds stand at the same point mutual funds reached in 1990. For mutuals, $1 trillion was only the beginning. Today, they are eight times that size, and worldwide mutual fund assets have hit $16 trillion, according to the Investment Company Institute. The rate of growth has slowed, but not stopped, in the last five years even as stock markets around the world declined."
Straightforward comparisons are misleading, however, since mutual funds are essentially targeted at smaller investors whereas the core constituency for hedge funds is wealthy investors (and increasingly, institutions). More to the point, mutual fund performance and growth prospects for the mutual fund industry are intrinsically linked to the health of the market pools from which they invest, whereas genuine hedge funds are largely unconstrained, either by investment product or by market direction. (Perversely, hedge funds are becoming victims of their own success, as the growing size of the industry makes it more prone to the sort of institutionalised "switch brain off" box-ticking that led earlier managers to set up hedge funds in the first place. Given the regulators' confusion toward and fear of hedge funds and the promotion thereof, their growth in assets is little short of miraculous.)
Just as equity managers might argue that the stock markets were fundamentally mispriced - too cheaply - during stages of the late twentieth century and underwent a value re-rating upwards during the 1980s and 1990s, so hedge fund managers and hedge fund allocators might well argue that investors were structurally underweight less correlated investments during the same period and that hedge funds are now experiencing the same sort of secular re-rating as a type of investment as global portfolios (both individual and institutional) are slowly realigned with more of an absolute return focus and less emphasis on more traditional constraints. Note that this does not mean that late entrants to the hedge fund party will necessarily secure higher investment returns (there are no free lunches in a low nominal return environment), but - depending on their ability to identify talented managers - they may well secure lower volatility within their overall portfolio structure.
Indeed, if investors are pursuing hedge funds or funds of hedge funds primarily out of an appetite for pure return superior to what they might achieve from fundamentally riskier asset classes, they are likely to be disappointed.
Far from representing an unsustainable bubble, the rise of hedge funds could easily have much further to go. Currier points out that "a doubling of assets in five years is nothing new in the land of mutual funds. They did that or better in every half-decade from 1975 to 2000." The difference is that stock mutual funds and bull markets are joined at the hip. And if the hedge fund marketplace is crowded, what adjective describes a mutual fund marketplace where there are more stock mutual funds listed on the New York Exchange than there are stocks? While a few poorly timed or badly managed or overleveraged speculations in corporate debt and debt structures have recently created suppositions of an industry-wide blight afflicting hedge funds, the reality is that hedge funds represent a peculiarly broad trading and investing church that is more likely to compress market volatility than cause it to rise. Currier is not slow in making a causal connection:
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"Can it be only coincidence that measures of stock-market volatility have declined steadily in recent years as hedge fund assets have ballooned? According to my Bloomberg, the Chicago Board Options Exchange Volatility Index of the Standard & Poor's 500 Index averaged 27 in 2002, 22 in 2003, 15 in 2004 and 13 in the first four months of 2005."
(One might also theorise that the compression of volatility derives in part from the last decade's stunning improvements in the speed and efficiency of communications, transactional and information infrastructure, not least as a result of email and the web.) The apparent contraction of (equity) market volatility does, of course, carry its own problems for hedge funds - perhaps most noticeably for the macro and commodity trading managers, both systematic and discretionary, who ordinarily thrive on the stuff. And for the sector as a whole, it may well mean that the returns of the past decade get compressed in the next. But that is exactly what has happened to equity market returns in the period since 2000 and it is surely likely to be what happens to G7 equity market returns for the foreseeable future unless yet another secular value re-rating occurs. As Michael Stastny writes in his Mahalanobis weblog,
"Hedge funds, since they have much more flexibility to go long, or short, or have positions in various derivatives, add liquidity. They don't make the problem (of positive feedback loops) worse, just the opposite.. While many see hedge funds as creating instability, I see it as making things more stable and efficient.. Options, bonds and equities are now priced more equally in all contexts.."
This is not to get Pollyanna-ish over hedge funds, since market volatility of one sort or another can be presumed for as long as human beings and leverage are involved in markets, and hedge fund managers are not immune to either irrationality or overconfidence. Part of the problem is semantics. Many of the hedge funds launched in the last few years have been anything but hedged. If anecdotal experience from third party managers is any guide, what causes hedge fund and fund of hedge fund performance to suffer is invariably what causes mutual fund performance to suffer: conflating asset gathering ability (or plain good fortune) with asset management ability. It's better for the investor to concentrate on one, but managing both well for the manager beyond a certain critical mass in assets is effectively impossible, particularly given some of the niche and specialty strategies that hedge funds tend to employ. As we have suggested before, the future - at least for the hope of alpha generation - almost certainly belongs to boutiques.
Tim PricSenior Investment StrategisAnsbacher & Co Ltd.
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