Hedge Funds: Trends to Watch

Before diving into recent developments within the hedge fund sector, it is vital to answer the following question:

What is a Hedge Fund?

Hedge funds are alternative investments using pooled investor funds to make strong returns for their investors. They look to also make a high level of alpha* – the difference between their hedge fund’s performance and the wider market’s performance. Hedge funds are aggressively managed and make use of derivatives (a financial product that derives its value from its relationship to another underlying asset) and leverage (investing with borrowed money) to achieve higher returns than the average equity fund.

*In case you’re still confused about the concept of alpha, here is an example:

If the FTSE 100 rose by 10% last year, and my hedge fund investment increased by 26% in the same timeframe, the alpha is the 16% difference. The higher the alpha, the better the hedge fund has performed for its investors.

Why Invest in a Hedge Fund?

Hedge funds are attractive to investors as they face less regulation than mutual funds and other investment vehicles, which in theory should lead to higher returns. However, this makes them more expensive. They often have a 2 and 20 fee structure, meaning they charge two per cent to clients to manage their assets, and then take a further 20 per cent of the overall profits as fees. This high management fee, alongside poor historical performance versus the market, has led to lacklustre returns over the last decade for hedge funds, which has pushed investors away from them.

Why are Flagship Hedge Funds Closing?

If you follow the news, you may have come across the headline, ‘Lansdowne to shut $2.8bn hedge fund after weak returns.’ Most likely, you will have skipped past it and moved on with your day. However, in the industry, this came as very big news and gives retail investors an insight into the recent market trends.

This is an important development as Lansdowne Partners is one of Europe’s best-known hedge fund managers and is planning to close its $2.8bn Developed Markets fund. This, according to a source close the closure plans, is because it is becoming harder to find attractive bets against overpriced companies. Essentially, the market is becoming a harder place to find a bargain or good-value investment.

The fund’s failings can be attributed to the first six months of 2020, in which it lost 23 per cent. But, more alarmingly, the fund only gained one per cent in last year’s bull market. In comparison, Scottish Mortgage, Bailie Gifford’s actively managed and low-cost investment trust, gained some 30 per cent in 2019, and almost a further 60 per cent so far this calendar year. Moreover, this was at a fraction of the fees that hedge funds charge. One has to ask if there is still value in investing with hedge funds, or if they are a dying breed.

Lansdowne’s shortcomings come from a few developments. Firstly, their short bets had not beaten the market since 2008. Secondly, their bullish bets on U.K. stocks have not fared well due to Brexit uncertainty and market volatility, as well as the U.S. equities’ high returns in comparison over the same period. Therefore, when pitted against the S&P 500, Lansdowne’s gains have been very disappointing for investors. Finally, the fund’s long-term investment positions on airlines have disappointed recently due to Covid-19 and the subsequent travel restrictions and global lockdown. Even Warren Buffett, arguably the most notorious investor in history, has since sold all of his U.S. airline investments (worth up to $7bn), highlighting that the aviation industry’s problems.

How is the rest of the sector coping?

Considering that Lansdowne has been one of the most active shorters over the years (meaning that it actually bets that a company’s share price will fall), it is no surprise that they are struggling. But their failure shows the wider challenges that the hedge fund sector is facing. The decade-long bull market, with trillions of dollars of quantitative easing, as well as cuts in interest rates, have been disastrous for the sector’s profits.

Lansdowne is not alone in its fall from grace. Paulson & Co recently shuttered their flagship fund, while the CEO of Russell Clark Investment Management claimed that he would have gained more wealth buying bonds than running his short positions over the last eight years.

However, the breadth of the sector means that the hedge funds as a whole are by no means in a poor position. Wirecard’s share price collapse this month (if you don’t know about this, read our article here) allowed for U.K and U.S. hedge funds to profit over €1bn Euros, with Marshall Wace and TCI doing particularly well. Other such winners include Brevan Howard, who have gained about 21 per cent over the first half of 2020. DE Shaw is another success story – its recent strong performance has allowed it to increase its fees to a three and 30 structure. As such, it is definitely wrong to conclude that the sector is not doing well; certain players in the sector are just struggling due to the current economic climate.

Recent changes within the sector

The rise of the Robinhood trading platform and ETFs, alongside the diminishing returns of hedge fund investors, has the sector on the backfoot. Consequently, the sector clearly needs to evolve to continue attracting investors, and to justify the high management fees associated with hedge funds. In recent months this has started to take place.

Recently, the U.S. Securities and Exchange Commission (SEC) proposed to allow most hedge funds to keep their equity holdings secret. This new plan would mean only the top ten per cent of investment managers would have to publish quarterly reports, reducing unnecessary burdens on smaller managers. This change will decrease public transparency, but ultimately will have greater benefits in terms of costs for hedge funds. The public has 60 days to submit comments to the SEC, before the commissioners vote on the final proposal, and it will certainly be interesting to watch these developments.

In addition, the world’s most successful hedge fund has started to become more transparent to the public. With Aron Landy taking over from Alan Howard at Brevan Howard, he has already shown more transparency than Mr Howard has done in years. Mr Landy recently allowed for an interview over Zoom – a “demonstration” of the fund’s new transparent nature.

Final Thoughts

Hedge funds have been big money-making machines for decades. However, in recent times, they have been put under pressure due to lack of shorting opportunities, and the growth of new investment vehicles. With quantitative easing seemingly continuing, and investors funnelling into other low-fee investment opportunities, change in the sector is very much needed. This has been seen with hedge funds closing, new SEC proposals, and changes in hedge fund transparency. It will be interesting to see if hedge funds will continue to attract investors, if they will have to decrease their fees to compete, or if low-fee investment vehicles will be the future.

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