Since the financial crisis of 2008 it has become a popular anthem for the investment community at large to criticize and call for sweeping hedge fund reform. Champions to this cause include investors suffering at the hands of hedge fund managers who either misappropriated or mismanaged their funds, institutions with unfulfilled target investment goals, regulators working to appease investor sentiment for better information and access, and politicians jumping on a cause that works to increase their popularity with a voting base.
From this mélange, we have created a discourse on hedge fund investing that currently is in danger of serving none of these parties to the cause with any substantial improvements. Although the issue is complex and there are multiple causative factors, this piece addresses a few of the more popular disagreements between investors and the investment managers—those centered on liquidity, transparency, fees, and communication.
Let’s begin with a working definition for a hedge fund, found within the US government: “’Hedge fund’ is a general, non-legal term used to describe private, unregistered investment pools that traditionally have been limited to sophisticated, wealthy investors. Hedge funds are not mutual funds and, as such, are not subject to the numerous regulations that apply to mutual funds for the protection of investors – including regulations requiring a certain degree of liquidity, regulations requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest, regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of leverage, and more.” ¹
A hedge fund essentially is tasked with providing asymmetric returns over time to the broad market and a protective measure against downward trends in the same. In so doing, a hedge fund manager needs to find both ideas and strategy constructs that allow for this return profile. While the evolution of hedge funds has created a broad continuum of strategies and styles that seek to achieve these twin goals, investors seem to have abandoned their acceptance that hedge funds are, by nature, different.
Recent demands by investors and related parties call for more liquidity, greater transparency, lowered fees, and a better articulation of strategy. They want a better understanding of “how are you doing what it is you do?” from hedge fund managers across the spectrum of styles, strategies, and sectors. While all of these issues appear to be beneficial to the investors, a different perspective might be to split them into two camps, one working to enhance the investor experience, with the other leading to an erosion of that same experience.
Considering the potential value erosion, let’s put both a desire for lower fees and a demand for greater liquidity into the ‘against” camp. The demands that fees come down to compete with retail-focused investment products, such as can be found throughout the more traditional asset categories, including mutual funds and other public offerings, and that hedge fund managers provide a much higher level of liquidity to satisfy investors’ desire to move in and out of hedge fund investments like they do in mutual funds, begins to degrade the key components of what allows a hedge fund to achieve the type of alpha and downside protection that it was created for in the first place.
It takes a considerable amount of working capital and fee income to build a hedge fund into a stable and successful business. Much of these costs are absorbed by talent acquisition and retention, as well as retention of service providers, operational infrastructure and information platforms, research and data costs, and so on. The two-tiered fee income for most hedge funds was designed to address the needs of both building and running a business while providing the incentive income for performance which serves both managers and investors alike. Protective measures, such as hurdle rates and high water marks, were developed and instituted into the offering memorandum that investors subscribe through to incentivize the profit-sharing relationship. This partnership investment structure is integral to the private placement vehicle that most hedge funds operate within.
Similarly, many hedge fund strategies rely on a singular ability to execute investment strategies which are unique and provide an ‘edge’ over traditional investment options. Hedge fund managers are all too sensitive to the real-time fact that, if one does not offer some tangible difference in achieving value for investors, the likelihood of success in retaining and accruing capital is extremely small. Liquidity control can play a key role in many of these unique strategies. Some managers rely on overlay strategies within their overall fund approach to mitigate short-term market conditions and to preserve the essential investment philosophy and trading approach. Some rely on investment options which, by their nature, involve markets with far less liquidity than traditional equity and bond markets. In many cases, forcing the hedge fund manager to offer liquidity beyond what their essential value ‘edge’ allows is detrimental to both the fund’s performance and the investors’ returns.
In essence, the investor demands for lower fees and more liquidity likely will assure that hedge funds that morph into retail-like investment options will be unable to achieve alpha or downside protection in declining markets. If it walks like a duck and talks like a duck, it will ultimately perform like a duck.
On the positive side, let’s turn to the additional investor demands for greater transparency and a better articulation of strategy by managers, e.g. the ‘for’ camp. If one accepts that hedge funds are meant for sophisticated and institutional investors, there certainly can be a better effort made to discuss how objectives are to be achieved and to report on the ongoing performance attributes of the investment, once made. Great strides have been made by solution providers in addressing the need for detailed and concise reporting, and this trend benefits both investors and managers in the long run. Managers can do a better job in monitoring their own risk management at both the individual investment and portfolio levels. Investors and advisors can ask better questions of their managers to gain a deeper understanding of how their investment is meeting/exceeding/underperforming expectations on both an absolute and a risk-adjusted basis.
Managers also need to ramp up their investor communication efforts. While the investment partnership is formed of sophisticated and institutional investors, this doesn’t necessarily imply that all investors are market savvy in the strategy and nuances of their fund manager’s approach. The burden to communicate to the investors clearly and with purpose falls squarely on the fund manager. Greater frequency and regularity of discussions about the fund’s performance vis-à-vis the appropriate benchmarks and the broader market can strengthen the investor’s understanding and commitment to a fund and to a manager. If a manager has done a good job in matching the objectives of his investors with his fund, this communication should be an organic continuation of the initial investment dialogue and reinforce the long-term investment goals of the limited partners.
It’s time to reestablish the relationship of hedge funds to more traditional asset classes. Hedge funds exist to serve a vital component in investment allocation. They are meant to behave differently and not to correlate to broader market moves. Hedge funds are costly to build and maintain, but the global markets need their presence to provide both an attractive investment allocation and to support the overall liquidity of multiple asset classes. Investors should not be asking for affordability and liquidity beyond the parameters of a hedge fund product, but rather for a greater understanding of what makes a hedge fund valuable. By so doing, the investor can separate the hedge fund wheat from its chaff and make better, and more informed, investment decisions.
¹ SECURITIES AND EXCHANGE COMMISSION, INVEST WISELY: AN INTRODUCTION TO MUTUAL FUNDS, available at http://www.sec.gov/investor/pubs/inwsmf.htm
Diane Harrison is principal and owner of Panegyric Marketing, a marketing communications firm founded in 2002 and specializing in a wide range of strategy and writing services within the alternative assets sector. She has over 20 years’ of expertise in hedge fund marketing, investor relations, sales collateral, and a variety of thought leadership deliverables. A published author and speaker, Ms. Harrison’s work has appeared in many industry publications, both in print and on-line.