By Bill Kelly, CAIA Association CEO
The satirical movie Network was released almost 40 years ago. The character Howard Beale, played by the actor Peter Finch, is one of the more enduring legacies of this film. He is a news anchor for the UBS Network, and he is to be terminated in two weeks for falling ratings. He decides to go out with a bang promising an on-air suicide and goes on crazy rants encouraging his viewers to get out of their chairs, open their windows and scream “I’m mad as hell and I’m not going to take it anymore.” Inexplicably, his ratings go up the more vocal he gets. In short, his message is finally heard.
The depths of the GFC now stand more than a decade in our past but the monetary intervention courtesy of the central banks is still very much with us; in fact, there are even talks of renewed rate cuts amongst some of the G4 crowd. The risk-on trade loves it and the true benefits of diversification have been muted, and in some cases forgotten, in a sea of stimulated froth. It should come as no surprise that strategies tied to any form of hedging have largely been left out of the warm embrace of investors, and quite often the media who regularly pile on for good measure and dramatic headlines. Perhaps the time has come to tally some of the challenges, misconceptions and, dare we say it, opportunities for hedge funds.
Put sympathy for the hedge fund manager in your search bar and watch what happens. As of this writing, it returned just two matches who will not be named in order to protect the innocent. Substitute the word blame for sympathy, and you get almost six million hits. It turns out that Gordon Gekko was right when he told his protégé Bud Fox, “if you want a friend, get a dog.” Misconception or not, the jury has already come back with its verdict on trust and maybe we are starting to feel a bit like Beale?
But what about this moniker of “hedge funds” and does it represent an industry or an asset class? The answer becomes readily apparent if you look at performance dispersion for any HFR Index, where you will find the top and bottom quartiles separated by well over 1,000 basis points. This does not sound at all like the asset class that it might have been a couple of trillion dollars ago, and the median manager returns that sit in the middle of this chasm show correlations that start to get very close to 1, as compared to the broader equity indices. We then perpetuate the myth that the S&P 500 is our bogey by challenging loveable billionaires to dumb bets in the most visible of ways (see Rhetorical Oracle)… #sigh.
The aforementioned low rates, and equally low cross-market volatility, have not been a friend to this industry. Some managers have resigned themselves to focus more on enterprise risk than on investment risk according to a recent report from Willis Towers Watson, which they identify as a contributor in the more recent shift to the southwest risk/return quadrant. Their view is that today’s investor is looking for more bespoke solutions accompanied by greater transparency and lower fees; sounds pretty simple, and one significant validation for this trend might just be the recent report that Harvard Management was putting about a third of its $39 billion portfolio into hedging solutions.
Rest assured, not every investor is as practical, nor do they all have the same time horizons or funding levels as a university endowment. Just look at most headlines in the public pension plan space and you will often see strong moves to exit hedge funds accompanied by an indictment of the entire hedge fund industry. Why?… Well, many of these plans are hugely underfunded and they are turning to any asset class that can quite literally bail them out. Hedge funds, or even a genie in a bottle, will not be able to close what is an $80T global divot on its way to $400T by 2050 according to the WEF (see Too Big, Too Frail). Guess who stands to take the blame when this spit hits the fan? Spoiler alert: it will not be the genie.
Turning to the opportunity category, hedge funds have the ability to hedge tail risk, and (over time) can very well be a complimentary catalyst for better risk-adjusted returns. Many hedge fund managers have also been early adopters of machine learning and artificial intelligence in the analysis of alternative data, which could provide a greater path to alpha; this same data could also potentially hold the key to unlock more sustainable ways to measure consistent ESG scores. Yet as an industry, we play very little offense to proactively establish our mission and purpose. Left unchecked, the future of the hedge fund industry is less clear, and the narrative will continue to be seized by those with ulterior motives; in a worst-case scenario, the retirement crisis will be yours to own.
It is time to be like Beale. Open your window and tell the world (the media, AIMA, MFA, CAASA, clients, and regulators too.), you are mad as hell and you are not going to take it anymore!
Seek diversification, education, and know your risk tolerance. Investing is for the long term.