Dear MJ:
About 10 years ago, I became involved with a very special investment. I had my eye on it for a while, you see, and had noticed things about this investment that really appealed to me. It was different than the other investments I had known, less restricted, and, dare I say it, maybe even a little uninhibited. But it seemed to always be there for people when the markets were down, and that really turned me on.
I started looking into getting involved with this investment and, based on what I was able to research, learned that others had a generally good, though occasionally volatile, relationship with investments similar to mine. I saw how happy those family offices and high net worth individuals were over the long term. I watched their investments support them through the tech wreck, and I wanted a that special relationship, too.
But as much as my heart screamed “invest!” my head, and the heads of those around me urged caution. So I gave in, but not without a few stipulations. The investment would have to change, you see. Not the things I loved – no, I wanted the long-term happiness and the unwavering support. But I didn’t want our relationship to be volatile. And the freedom, well, that made me a little nervous, too. And I really wanted my friends to like my investment, too. So I asked it to clean itself up, move into better digs, and I insisted it hire people to ensure it didn’t step out of line. I even hired people to monitor it, too. And several people close to the investment? Well, they promised it would never hurt me.
Now, 10 years later, our relationship has changed. My investment doesn’t make me as happy as it should. It’s like it’s not even trying. Some of my friends have become disillusioned with my investment, and a few are even pressuring me to dump it. They argue that I pay for everything and am not getting much out of it in return.
So, Dear MJ, what’s an investor to do?
Signed,
Hedged Up
My Dear “Hedged Up”:
I’ll be honest: I’ve received quite a few letters like yours lately. Egged on by a strong market, vociferous press coverage and contentious board meetings, there’s a lot of fed up investors all over the world right now wondering how we got here. I’m not entirely sure I have the answers, but as an investment voyeur for more than 18 years, I can definitively say that the investment you fell in love with? Well, it’s changed.
In the late 90s up through most of the tech wreck, I was working at Van Hedge Fund Advisors, which some of you may remember as one of the first consultants that worked with investments like yours. At that time, our proprietary database tracked just under 5,000 funds. Some were good. Some were bad. Some ended up being frauds. At least one, Long Term Capital Management (“LTCM”), blew up spectacularly during my first six months on the job.
Our clients were primarily high net worth individuals and small family offices. We worked with some endowments and wealth management firms, but, in general, the client base was not institutional. In fact, per Citibank, only $125 billion of hedge fund assets under management (or roughly 20%) were institutional prior to 2002.
Returns prior to LTCM were reported by fund managers to Van Hedge primarily quarterly, changing to monthly starting in 1999. By 2000, all of our funds were reporting at least monthly. After the market started melting down, most of our key hedge fund relationships also provided weekly estimates, although many portfolios remained relatively opaque. Funds had wide latitude to do what they wanted when they wanted, and the words “strategy drift” had not gained traction.
Staff was lean. The term “two guys and a Bloomberg” was used to describe funds and it wasn’t meant as an insult. The SEC periodically audited those funds registered as investment advisors, which most were not, and overzealous compliance had yet to become the norm.
Performance, on average, was quite strong, although more than a few “long/short equity” funds were more than 90% net long, capturing the returns of the “greatest bull market in history.” When the market began to sell off, hedge funds in general also flourished (although those 90% net long funds lost their butts). “If there is one thing at which hedge funds excel, it is in avoiding highly publicized, highly priced investments that indexes, by virtue of their construction, must own. Most hedge funds shone during the 2000-02 technology sell-off,” noted even a September 2016 article on the infamous “Buffett Bet” against hedge funds.
Was the relationship between funds and investors perfect?
Hell. No.
Did fund managers occasionally fake their own kidnappings or end up on 20/20?
Hell. Yes.
But it was what it was. And what it was spawned the investment profile you were so attracted to initially.
And now?
Well, now we’re in an entirely different ball game. The amount of money, the type of investor, the expectations, the regulations, transparency, the number of managers….well, they’re ALL different. And it would be ludicrous to think that those wholesale changes would not have an impact on your investment individually, and on the industry overall.
So what’s changed?
Assets Under Management – The size of the hedge fund industry more than doubled between 2002 and 2007. It grew from $625 billion to $1.8 trillion in five years per Citibank, and the main driver of that growth was some $750 billion in assets poured in by institutional investors. That’s a lot of cash for any industry to eat without some serious indigestion.
Number of Funds – The number of funds increased from the Van Hedge database of 5,000 to the widely accepted industry average of 10,000 between 2002 and 2007. That’s a helluva lot of new funds. Wannabe fund managers flocked to the hedge fund industry to capture higher than mutual fund fees and assets flowing like champagne at a P-Diddy party. And, because hedge fund-land ain’t Lake Woebegone, every fund is not above average. Some of those new entrants struggled to put up decent performance numbers. Prior to 2010, low barriers to entry meant those funds could bootstap a business for years with friends & family funds and few expenses. Now those funds are getting shaken out of the industry. Frankly, that probably needs to happen – those funds aren’t helping industry averages or its street cred. But, overall, I still believe there is a tremendous amount of talent in the hedge fund industry. You just may have to diligence more frogs to find it.
Type of Investors – The HNW individuals and family offices Van Hedge dealt with didn’t really care if they had daily transparency, if a manager invested in something off the beaten path, or whether there was a dedicated CCO, COO, and CFO at the fund. SEC registration wasn’t an issue, nor was an “institutional quality” back office. Concentration limits and stop losses were nice, but not necessary. Was this perhaps a little naive and potentially even a little dangerous for investors? Um, yeah. Sometimes you were the windshield and sometimes you were the bug. But, it has to be said, the expectations, controls, investing parameters and infrastructure that was expected by institutional investors starting in 2007 has a cost associated with it, both in terms of actual expenses (which reduce returns) and in lizard-brain opportunity costs. In today’s investing environment, you may never be the bug, but you’re also a lot less likely to be the windshield.
Marketing – In my early days at Van Hedge, hedge funds were pretty honest about what they were. Many fund managers did their own marketing and stressed strategy, smarts, nimbleness, and a willingness to adapt, adjust, and evolve. Over time, that messaging evolved. The concept of “absolute return” was introduced and almost immediately bastardized. I will never forget a business trip to Japan post-2008 when many of the investors I talked to had been sold hedge funds as a fixed income substitute. WT-Actual-F? Absolute return was never meant to imply that an investment absolutely generates positive returns every month, quarter, year or rolling period, and those that marketed that way did the industry, and investors, a tremendous disservice.
In short, the investment you fell in love with, Dear Reader? It HAS changed - in part, because you asked it to, in part because it was a victim of its own success and in part because expectations on both sides of the fence became disconnected from investment reality.
The question for you, Hedged Up, and for all of those who are disappointed with their “absolute return” portfolio is this: Can you remember what really attracted you to the investment in the first place? Was it the performance? Was it the diversification? Was it the correlation? Was it the belief that you’d never know a single moment of return sadness? Once you’ve figured that out, Dear Reader, you can take a step back from your former investment love and see if there are ways to achieve those goals within today’s hedge fund landscape. I just bet you can find true investment love this time..
