Merrill Lynch: “New Alternatives in Alternative Investing”

By: Benjamin Bowler, Heiko Ebens, John Davi & Giovanni Amanti, Merrill Lynch
Published: October 18, 2006

The end is nigh!  The end is nigh!  A new report from Merrill Lynch suggests the hedge fund industry faces the dreaded “Y2011 Problem”.   

They point out that the growth trajectory for the number of US mutual funds in the 1980’s and 90’s is a dead ringer for the growth trajectory for the number of hedge funds (globally) in the past 15 years.  If this pattern continues, the number of hedge funds in the world will peak at around 8,000 or 9,000 in 2011 (see chart).  

Passive Strategies to Inherit the Earth… 

Okay, maybe not the whole Earth, but a serious chunk of it.  Why?  Because passive alternatives will begin to crowd out new entrants – just like they did in the mutual fund industry.  Like the quants at Barclays, JP Morgan and SocGen, the authors of this report espouse a new form of quasi-active hedge fund than produces exotic beta at fees above pure passive management (e.g. an ETF) but below pure active (hedge) funds:

“…it may be increasingly difficult for investors to justify paying hedge fund fees for the performance of the average active manager. Passive alternatives to active hedge funds represent a natural evolution in an increasingly mature industry.”

Displaying a penchant for double negatives, the report suggests that, “Tradable benchmarks offer potential to hedge hedge funds”, but to do so requires: 

“Liquid and transparent hedge fund benchmarks [that] also offer the ability for hedge fund investors (or managers) to use them as tools, similar to the way traditional asset managers use index-linked products. For example, by shorting a hedge fund benchmark, an investor could extract the outperformance of a specific manager, or hedge against a downturn in a particular hedge fund style.”

Lars Jaeger and Christian Wagner who set down a “true test” for an investable hedge fund index would surely agree.  They envision a world where you could short an investable hedge fund index to refine the quality of alpha in a hedge fund.

But if you plan to short a hedge fund index against a hedge fund manager to isolate “true alpha”, don’t get your hopes up.  According to Merrill Lynch: 

“The ability to generate alpha or excess returns above the systematic risks contained in hedge funds (sometimes referred to as hedge fund beta) has become increasingly difficult over time.”

For Hedge the Bell Tolls?

Aside from the growth in passive alternatives, the report says that increasing industry concentration is an early warning sign of “industry maturity”:

“According to a recent article by Alpha magazine, the largest 100 hedge funds managed $720bn or 65% of total single-manager hedge fund assets at the end of 2005, leaving 6000-7000 funds managing the remaining 35%. This is an increase in concentration from 2004 when Alpha reported that the largest 100 managed only 58% of total hedge fund assets.”

As an aside: When we first saw this statistic, we concluded that the “non-top-100” hedge funds actually experienced a net outflow of assets during this period.  Assuming the industry stood at $900b at the end of 2004 and $1.1 trillion by the end of 2005, our thinking was:

  • The top 100 hedge funds grew from (0.58 x $900b) or $522b in 2004 to the stated $720b in 2005.  That’s a gain of about $200b.
  • The rest of the industry grew from (0.42 x $900b) or $378b in 2004 to (0.35 x $1.1 trillion) or $385b in 2005.  That’s a gain of $7b.
  • That $7b represents growth of about 2% ($7b/$378b). 
  • Since returns for this group were surely higher than 2% for the year, we could only assume there had been a flight to quality and that the bottom 5,700+ hedge funds actually experienced net redemptions.

So it appears the top 2% of all managers experienced growth while the other 98% (taken together) shrank.  The media didn’t seem to pick up on this, but I can tell you from experience that many in the “other 98%” certainly did.    

So What Next? 

The report goes on to review three alternatives to actively choosing hedge funds:

  1. a passive funds of funds (i.e. an investable hedge fund index),
  2. an investment in the litany of new and exotic risk factors identified by academics (Merrill calls this a hedge fund “clone” strategy), and,
  3. a systematic trading strategy – known to many quantitative hedge fund managers as: A HEDGE FUND (!)

They find the clone strategy to be a formidable adversary to the traditional passive fund of funds, although with a lower Sharpe ratio (1.2 vs. 1.6 for the fund of funds).  Still, they say, funds of hedge funds have shown a higher “return persistence” (i.e. that it’s possible for some funds of funds to outperform – or underperform – persistently). 

They also gush over the “systematic” alternative and serve up merger arbitrage as its flagship example.  They suggest a rules-based approach to trading such a fund would yield very similar returns as an active fund – with a lower cost.

In the end, Merrill might have a point.  A lot of ink and pixels have been dedicated to specific investment strategies.  But far less has been spent on discussing the industry as whole.  Like many similar industries before it, the hedge fund industry leverages new intellectual capital to exploit the Achilles heal of an entrenched and mature industry.  But these new cottage industries almost invariably evolve beyond their humble roots as “industrialization” takes hold.  We see no obvious reason why the hedge fund industry shouldn’t evolve in a similar way. 

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