Hedge funds have been much maligned post-financial crisis due a perceived lack of performance. Is this criticism fair? And what is the prognosis for currency funds in particular? Galen Stops takes a look.

Earlier this year, Cliff Asness, founder, managing principal and CIO of AQR, published an excellent piece explaining why hedge fund returns should not be compared to 100% long equities returns, as they so often are when people use the S&P 500 as a benchmark.

In the article, Asness was unequivocal in his conclusion that hedge funds not keeping up with equities during a nine-year bull market was completely predictable and is certainly not a reason to worry about the performance of these firms.

He added, however, that there are other legitimate reasons to believe that “winter may indeed have come to hedge funds”.

According to Asness: “The reason to worry is the evidence, from both their realised excess (vs their positive beta) returns and, importantly, their correlations to traditional active stock picking, that hedge funds no longer are what they once were.”

He said that there is no definitive proof of this decline, only anecdotal suggestions and supportive data.

“But I find the story that hedge funds as a whole are now much closer to regular old traditional active stock picking, and thus less special than before, quite plausible. Given traditional active stock picking is such a consistent long-term disappointment, this ain’t good,” is how Asness ended the article.

Before writing off the hedge fund industry altogether though, it’s worth inserting a couple of caveats here. Firstly, Asness’s analysis only looks at long-short equity, which is only one – albeit the largest – hedge fund strategy. Throughout the article he makes this clear by referring to “ELS” (Equity Long Short), but in the conclusion, he just talks about “hedge funds”.

Secondly, Ian Rayner, a hedge fund specialist and principal at Rayner Gobran, makes the case that we won’t know if winter has truly arrived for ELS strategies until the next downturn. He points out that as this narrative that hedge funds have been underperforming the market has taken hold, it’s not surprising that many ELS managers have morphed, for the time being, into active equity managers given that it’s hard to fight the trend, especially when the tide of passive investing lifts both junk and quality stocks.

In addition, Rayner notes that over the past nine years, ELS still outperforms active management after fees, although this is not perhaps terribly impressive considering that Asness shows that active has underperformed the market and even then, the ELS performance is only fractionally better.

But as Rayner points out: “The question becomes, given there is nothing to choose between ELS and active during a long bull market, and you can’t tell when the bull market will end, how do you position to protect yourself? ELS is more likely to protect you during a downdraft.”

Finally, he observes: “ELS strategies depend upon the predominant market trend, being longer during uptrends and shorter during downtrends. So the relationship between ELS and the market (MKT) plus ‘small vs large’ factor (SMB) is not going to be stationary over the course of 2-1/2 market cycles covered by the data. That means you can’t realistically build one model covering the whole period.”

Changing investor profile

The other trouble when talking about hedge fund performance more broadly is that, not only are these funds highly heterogeneous in terms of both their strategies and return profiles, but also that the “performance” being sought after by investors can vary significantly.

“When people make blanket statements about hedge fund performance, you have to look at what is good and bad in the context of the investor: what is good performance for them and how do you measure it? Are the surprises from a given fund good or bad? What are the drawdowns like? What are the correlations like in relation to the rest of their portfolio? The answer to these questions varies from investor to investor,” says Rayner.

For example, endowment funds and pension funds might allocate a portion of their portfolios to hedge funds because one of their biggest risks is sequencing risk, they have commitments that they have to meet and therefore a drawdown is difficult for them to accept. A big drawdown for an endowment fund might mean that a research project or scholarship can’t be funded, while pension funds obviously have beneficiaries that need to be paid, so the advantage for them – in theory – of including alternative investments like hedge funds in their portfolio is to help smooth out the equity curve. Yes, in some cases they might give away some returns compared to if they were just holding stocks for the longhaul, but – again, in theory – that means that they shouldn’t suffer from dramatic drawdowns as much. By contrast, for a firm like a family office, although wealth preservation is important, they are unlikely to be as sensitive to occasional drawdowns as long as the returns of that hedge fund are deemed acceptable.

This plays into a broader trend where the role of hedge funds within portfolios has in many cases changed, with the emphasis increasingly on diversification rather than returns.

“Ten to 15 years ago, hedge funds tended to attract high net-worth money, people who were looking for super returns on their investment. Back then, hedge funds were seen as a sector that, if it hits, could provide a real kick to the portfolio,” explains Howard Jones, a veteran FX trader currently launching a new fund that will trade under the name Event Risk FX, which will focus on macro and political conditions that create asymmetric risk return profiles, based in London.

He adds: “I remember going into offices in the mid-nineties and people were turning up their noses at 25% per year, which seems crazy now, but back then they wanted to buy Internet stocks instead. But the investor profile has changed, a lot of the money coming in now is from pension funds and huge reserve managers that, in reality, are probably happy if they get a 5% return per annum over the entire portfolio. There’s a structural element to this as well in that when returns on T-bills are low, people aren’t aiming as high on their risk profile. So, whereas hedge funds used to be seen as performance enhancers, they’re now increasingly seen as diversifiers within the portfolio.”

A Closer Look at Currency Funds

Given that it is difficult to talk about hedge funds broadly, however, is it easier to focus in on how currency funds have performed since the financial crisis?

Although clearly they use different methodologies and may have different reporting funds, the BarclayHedge and EurekaHedge indices that track currency manager performance broadly track one another, and both paint a fairly mixed picture of currency fund performance post-financial crisis. They show that although performance ticked up in 2010-2011, and then again in 2014-2015, this is only relative to the rather dismal performance in the intervening years. In fact, 2017 was the first time that the Barclay Currency Trader Index had ended the year in negative territory since 2006 and the first time that the EurekaHedge FX Hedge Fund Index has ever done so, although the index data only goes back as far as 2000.

Anecdotal evidence suggests that the poor performance of currency funds saw many of them rolled into other funds or incorporated into broader cross-asset class strategies, and although hardly a definitive corroboration of this by any means, the number of currency funds reporting into the Barclay Currency Trader Index is consistent with the theme that the number of currency funds has reduced significantly since the financial crisis. Back in 2008 there were 145 currency funds reporting into that index, a figure that has consistently gone down every year since to reach 53 today.

Yet again though, a number of hedge fund sources take issue with attempts to discuss currency hedge fund performance as a broad category.

“You’ve got to be careful when you talk about this broad category of FX funds, because there’s a lot of different strategies being deployed by these funds and some of them have done extremely well since the crisis. They’ve been disciplined, they’ve caught events and been leveraged at the right time. So it’s not right just to say that it’s been a poor time for all currency funds,” says Jones.

Likewise, Bill Lipshutz, the principal and director of portfolio management at Hathersage Capital Management, casts doubt on the idea that currency funds closing or being rolled up to include more active markets is evidence of under-performance, saying that this is something cyclical that naturally happens in the hedge fund industry.

Dampened Volatility

It is hard to argue, however, that the past few years have provided the optimal conditions for trading currencies. Central banks, walking in step following the financial crisis, pushed up correlations and dampened volatility across the board and the currency markets have been fairly quiet as a result. Even when there have been big risk events in the past few years, these have generally only caused a very brief surge of volatility.

“What we see now is that even when there is a big event that sends a shock through the system, the volatility dampens down very quickly,” says the CEO of one currency-focused hedge fund in New York. “The Brexit vote is a clear example of this, there was a big drop in sterling, but then it almost immediately became range bound again. The FX market has become so efficient at pricing in new information that the days of big, long trending moves after a risk event are gone, and they probably aren’t coming back.”

Prior to the events themselves, the 2016 US presidential election, the Brexit referendum and the Dutch and French elections in 2017 were all pointed to by some market participants as potentially significant risk events that could move the FX But David Campbell, CEO of Hunter Burton Capital, an Australian hedge fund, thinks that the importance of such political events on these markets is often overblown, however.

“A lot of people will talk about things like elections, but that’s more of a political issue, it’s something for the journalists to get excited about,” he says. “That’s why a lot of people didn’t make money in the last couple of years, because they were too focused on the political side of things.”

While other hedge fund sources agree that there is a big question mark about whether the days of sustained volatility are ever coming back, they argue that there’s still plenty of opportunities to make money from event risk in the FX market. They say the fact that follow-through on a lot of these events perhaps isn’t as dynamic as it used to be means that hedge funds need to be quicker on the profit take and point out that the funds that did catch the Brexit vote move will have made sizable returns overnight.

“Timing is everything”

Looking ahead, there seems to be genuine optimism amongst currency hedge funds that there are likely to be a number of tailwinds for them at the end of 2018 and start of 2019, not least that the interest rate policies of major central banks seem to be really starting to diverge.

“Developed market economies have seldom moved together in terms of monetary policy, growth or inflation for long and it appears unlikely that this dynamic has changed,” is the assessment of Lipshutz.

Asked about the potential drivers for performance for the latter half of the year, he comments: “As the US economic cycle continues to age and monetary policy divergence continues apace, we are likely to see global capital move accordingly. Global stocks will ultimately be vulnerable to a selloff, with capital then seeking rapid risk reduction and a flight to quality. As always, timing is everything. Whether the next large opportunity occurs in H2, or somewhat later, remains to be seen.”

Campbell says that he’s more optimistic about trading opportunities in the currency markets than he has been in four or five years, pointing out that for an Australia-based fund, the fact that Australian interest rates are below US ones for the first time since 2001 is particularly significant. This is because rising US interest rates traditionally lead to USD appreciation, which we’ve seen already in 2018, and this makes it harder for emerging market countries to pay off their USD-denominated debts and reverses the recent emerging market carry trade. Now, while Campbell’s fund doesn’t trade EM currencies, AUD is often used as a proxy for these markets and therefore is likely to see more volatility as a result of rising US rates.

“The interest rate moves in the US are increasingly going to affect other economies and other currencies, and volatility will pick up as a result,” he says.

Similarly, Jones thinks the central bank policies are likely to inject more volatility into the FX markets going forward.

“The currency markets have been dull for too long, but what’s interesting about this space is that currencies are political in the sense that they’re used by central banks and governments from time to time to get their way in the marketplace or influence trade one way or another, and that’s when tensions come into the market. For me, the “America First” slogan isn’t just politics, it’s about economics and the US Fed doing what’s right for America and not necessarily what’s right for people around the globe. All of this creates an interesting cocktail and I think that as a result, currencies look ripe for a bit of a resurgence, particularly in emerging markets that have seen a massive amount of money pouring in, in recent years,” he says.

This positivity is being reflected by an uptick in performance after a difficult 2017, according to the hedge fund returns indices available. The Barclay Currency Traders Index was up 3.58% for the year at the end of July, despite the fact that trend reversals in a number of G7 crosses meant that 77% of the funds reporting to the index ended July in negative territory. The Eurekahedge FX Hedge Fund Index is slightly less positive, showing returns of 1.47% seven months into the year.

The Big Get Bigger, the Small Struggle

Broadening out the view again, there are still some significant challenges facing the hedge fund industry. As already noted, it’s difficult to talk about hedge funds both broadly and accurately, but it’s perhaps fair to say that the industry needs to prove that it can provide good returns in the post-financial crisis world for a sustained period of time if it wants to truly dispel the rumours of its decline.

Another potential issue for the industry is the continuing consolidation of funds towards the larger, more established hedge fund managers.

“Getting the first $20 to $50 million under management is not that difficult, because there are people that are prepared to invest with managers that they either know as individuals or have strong track records,” explains Jones. “Where it becomes difficult is going from that $100 million to $250 million mark.”

This is because for large potential investors, such as a pension fund, their mandate often states that they can’t be more than a certain percentage of any fund’s assets under management, and the minimum amount that these firms are allocating at one time means that they would be above this threshold with any of the smaller managers. So the larger a fund is, the larger their potential investor audience is, which inevitably leads to assets consolidating within these larger funds.

Another difficulty facing smaller hedge funds today is what Rayner terms the “herding effect” amongst allocators.

“When allocators see that everyone else is allocating to a specific manager, they assume that they must be good. There’s also an element of career risk here because if you find an interesting manager with only a three-year track record and it doesn’t go well, then you’re putting your career at risk, whereas if you invest in a large manager with a lengthy track record, there’s less blame if the performance is poor,” he says.

Lipschutz also sees the barriers to entry for new FX hedge funds getting higher, not lower, citing increased prime brokerage requirements, the need for more infrastructure in order to be able to engage the real money and consultant communities and greater regulatory overheads as the reason for this.

Cause for Optimism

Despite these challenges, there are reasons for optimism too. Asness may be correct in asserting that “hedge funds no longer are what they once were”, but that doesn’t mean that they can’t become something else and serve a different function within investors’ portfolios.

Increasingly, there are some larger funds looking to invest in smaller hedge funds in more of a joint venture model, where they help the smaller fund get over the difficult AUM hurdles and boost its profile in return for being able to participate and benefit in the growth of that fund.

And yes, hedge fund fees have been under pressure in recent years, but managers have responded by creating innovative new fee structures that actually better align investors’ interests with their own.

Also, while the barriers for FX hedge funds may be going up, this isn’t necessarily deterring the latest generation of fund managers who are looking to new technologies, such as artificial intelligence, to help give them an edge in the market.

In terms of performance, the picture for hedge funds overall is much more positive than it was a few years ago. The Barclay Hedge Fund Index ended 2017 up 10.36%, the Hedge Fund Resource Index (HFRI) Fund Weighted Composite Index was up 8.68% and the Eurekahedge Hedge Fund Index was up 8.24%, in each case this was the highest returns posted by the indices since 2013.

After six consecutive quarters of outflows from Q4 2015 through Q1 2017, hedge funds welcomed a return of inflows in Q2 2017 on the heels of this sustained positive performance, according to data from Barclays. Data from Deutsche Bank, meanwhile, shows that 50% of investors planned to increase their hedge fund allocation this year. If winter is coming for hedge funds, no one seems to have informed investors of this.

Looking at allocations to FX hedge funds specifically, amongst the various investor sentiment surveys conducted by the major banks, Deutsche was the only one to break out FX as a separate hedge fund strategy and note respondents’ allocation plans to it. The results show that a net total of 4% of investors expect to increase their allocation to FX hedge funds going forward, although the results indicate that the net AUM allocated to these funds is expected to drop by 1%.

Drilling down into this data slightly further to look at net allocation plans by investor type, the survey shows that 5% of family or multi-office funds, funds of funds/asset managers and pension funds are planning to increase their allocation to FX funds, while 4% of investment consultants/advisors and 2% of endowment/foundation funds plan to do the same. By contrast, 3% of private bank/wealth manager respondents said that they plan to decrease their allocation to FX funds.

All of which largely suggests that investors are neither deterred by some of the difficulties faced by currency funds in recent years nor especially excited about their future prospects for the year ahead. But again, it certainly doesn’t really suggest that these funds are on a downward spiral. Indeed, given the reasons for optimism amongst FX hedge funds outlined earlier, one could perhaps make the case that, having survived a particularly nasty winter, they can at last look forward to spring.

Galen Stops

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