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Illustration: Lau Ka-kuen
Opinion
The View
by Peter Guy
The View
by Peter Guy

Over the hedge

Besides poor investment returns, innovative substitutes, new technologies and insurmountable regulations are burying the hedge fund industry

Hedge funds are facing a prolonged death rattle as their managers tenaciously cling to their beliefs that they have the sustainable ability to consistently beat the market even though signs are saying otherwise. Hedge fund managers used to represent some of the smartest, creative and audacious thinkers and investors. Today, they are facing obsolescence from rapidly changing technology and regulations.

The California Public Employees Retirement System (Calpers), the largest pension fund in the US, recently announced that it planned to eliminate all US$4 billion of its hedge fund investments over the next year. Calpers' decision looks small relative to its own US$300 billion size and the US$2.8 trillion hedge fund industry. However, the overarching reasons for its decision resonated with many investors. Hedge funds have become too complicated and costly. Superior, cheaper and more transparent alternatives and substitutes are starting to replace them.

Financial history suggests that times of high risk and uncertainty also offer big opportunities. However, hedge fund managers have been unable to capitalise on any of these fronts over the last five years. Their nemesis has been the S&P 500, which has returned more than 100 per cent in that time.

Many Asian hedge funds are long only and do not seem to offer enough uncorrelated performance to market indices. It was easy for them to be outperformed by their respective benchmarks. Managers point out that assets under management have grown over the last five years for hedge funds. According to data from Hedge Fund Research, almost US$57 billion has flowed into hedge funds in the first half of this year, reflecting investors' demand for more returns. However, the industry has become more concentrated towards larger, established hedge funds.

Many strategies pursued by hedge funds today no longer rely on very obscure skills

New or smaller hedge funds have experienced difficulties in raising money and surviving waves of redemption. Even experienced managers with verifiable track records have been unable to raise US$50 million to US$100 million from private sources, which is a starting point for new hedge fund operations.

Increased global regulations demand so much compliance and reporting that system costs have become prohibitive for new entrants. Before the financial crisis, a hedge fund manager was anyone who held a Blackberry with a mobile trading application and a spreadsheet for monitoring positions.

Creative hedge fund managers are also harder to find and cultivate. The Volker Rule has prevented banks from engaging in proprietary trading. In the past, proprietary trading desks at banks were a valuable training ground for future alternative asset managers. Banks provided capital, systems, research and supervision that were unavailable elsewhere. Proprietary traders are now an extinct breed. So where will the next group of super investors come from?

Innovative technology and creativity, once the advantage of hedge funds, is now being used against them. Hedge funds are being challenged by "liquid alternatives". They represent quantitative investment strategies such as equity long short, value and arbitrage that mimic hedge fund strategies and returns, but offer liquidity (with no lockup terms), more transparency and cheaper fees. Almost any investor can access hedge fund strategies and hedge-fund-like returns.

A recent Deutsche Bank study showed that liquid alternative investments are the fastest growing part of the asset management industry. They have grown more than 40 per cent annually since 2008, while the hedge fund industry has grown 13 per cent and the wider European mutual fund industry only 2 per cent.

Web- and mobile-enabled technologies that combine robust modelling with big data are widely offered by data services. They allow investors the same unprecedented access and tools that alternative asset managers use to test complex strategies.

Many strategies pursued by hedge funds today no longer rely on very obscure skills or strategies. Fewer hedge funds display real skills that justify the traditional "two and twenty" high fees. Persistence in superior hedge fund returns is harder to find.

Institutional and high-net-worth investors are turning to liquid alternative investments designed by banks not only because of lower fees, but because they are transparent solutions that are outcome and service-oriented rather than an opaque strategy with little liquidity and flexibility. Investors are moving away from direct hedge funds and fund-of-funds. Time for a new mousetrap.

This article appeared in the South China Morning Post print edition as: Over the hedge
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