A recent paper by a scholar at Tilburg University and a market participant at Robeco outlines the difficulties that the hedge fund industry has faced over the last decade. These problems arose, at least in part, from the democratization of alternative investing.
There are three important challenges to the hedge fund industry “as a unique performer,” the two authors write: competition from other asset managers with similar underlying strategies; the way the bullish market environment has created a higher hurdle for alpha by pushing up the benchmarks; and shifts in regulation.
Joseph McCahery, of Tilburg, is the lead author of this article. His co-author is F. Alexander de Roode of Robeco. They begin with some numbers. In the last decade (which they call the “lost decade”) the growth rate of AUM of the industry has been only 8.4% yearly. In the industry’s best times (2000- 2010) it was 20.3%. At the same time, the rate of liquidations has increased compared to pre-crisis years. Liquidations have come to exceed new launches: meaning, the industry is shrinking in terms of the number of funds. In the first three months of 2019, for example, 219 funds closed, while only 136 opened.
Performance, Fees, Regulation
At least some of these liquidations can be, linked to a combination of two facts: performance has not been great compared to passive management; and fees are high.
The point about shifting regulations, according to McCahery and de Roode, is that the trend toward requiring transparency (and their focus here is especially on the US) has reduced the ability of the industry to produce results that justify its fees. Minimal disclosure, along with investor acceptance of lock-ups, gates, etc., is what has allowed managers to execute strategies that require the use of exotic and illiquid investments.
The Dodd-Frank Act of 2010 introduced two key changes to the law. First, as to firm/fund governance, it required registered investment advisers to adopt written compliance procedures, designate a chief compliance officer, maintain books for at least five years, adopt an ethics code, and follow guidelines on fees and relationships with third parties. Second, and related to this, there was transparency. Through both routine and for-cause inspections, the Securities and Exchange Commission was mandated to monitor extensive recording-keeping requirements covering investment style, investors, managers, assets under management, fees, accounting practices and disciplinary history.
How do these points affect fund performance? On the simplest level, as McCahery and de Roode observe in a footnote, the average regulatory compliance costs have ranged from $700,000 per year to $6 million depending on the size of the fund. But more important, as hedge fund operations become more transparent, they become more replicable.
Research and MiFID II
There have also been changes on the matter of who does the research supporting hedge fund strategies and who pays for it. In Europe, the period under examination here saw the adoption of a MIFID II requirement that managers must establish a price for investment research, and either pass along the costs explicitly to their investors or bear it themselves.
The new research rules are, as McCahery and de Roode observe, “highly debated.” There is concern that it presses most heavily upon the smaller funds and firms, advancing the consolidation of the industry. Beyond that, in general asset managers seem to have been absorbing the costs of their research rather than passing it along, at least in part to avoid the transparency that the latter course would entail. There have been delays in the development of any uniform standard for third-party research. In general, though, whether there is a pass-along of costs and a lot of disclosure, or an absorption of the costs and little disclosure, MIFID II has increased the pressures that the industry faces in creating alpha and distinguishing itself from more liquid alternatives.
As these authors do the numbers, the alpha generated by the industry in the period 2010-2019 is indeed negative, once adjusted for market exposure. To get more granular, McCahery and de Roode look at two specific strategies, merger arb and managed futures, which tend to perform well in equity down markets. They find that these strategies can be replicated through the use of liquid alternatives, as they each have exposure to investable factors.