Gabriel Burstein explains why hedge funds are a poor long-term bet, despite a recent upsurge in returns.
Recent hedge fund returns have improved significantly for the first time since 1999. This, however, does not represent a reversal in the long-term contraction of their returns.
Hedge funds gained momentum in the 1980s as the indirect outcome of research and trading strategy innovation. This was sponsored by the generous research and development budgets of investment banks and securities houses acting almost as hedge fund training camps. So what has changed that might explain why they won’t be able to match the past?
Cutting research
As the number of hedge funds grew exponentially and assets under management went from tens of billions to more than one trillion, research and innovation came under attack from investment banks and hedge funds. Instead of being seen as a source of ideas, research was seen as an unnecessary cost in a trader’s market, in which anything other than trading was seen as redundant.
First, legal actions against investment banks’ research departments offered an excuse to cut research because profits were falling. Some of the laid-off analysts and strategists moved to hedge funds, but not that many, and mainly the youngest and the cheapest.
Second, hedge funds, as entrepreneurial partnerships, did not want a big rise in overheads so they paid only for a few analysts. As hedge fund’s profits shrank, management fees became more precious, so they replaced experienced strategists with juniors with only one-to-three years’ experience.
Lack of strategy innovation
In 2006, much the same 15-20 hedge fund investment strategies exist as in the 1980s, but much bigger assets are often chasing the same set of cyclical corporate opportunities. The biggest style drift environment in hedge fund history is taking place as lack of innovation is replaced by diversification. Large hedge funds now look increasingly like funds of funds, invested in every asset and using every strategy, including long-only, to grab assets from traditional investment management when the building block of hedge fund strategies was short-selling.
Due diligence
Was there due diligence in the 1980s? The hedge fund industry boomed and created new strategies because nobody was asked to classify them, so innovation was unrestricted. New strategies now have to fit into existing definitions for the sake of due diligence. Investors used to work directly with hedge fund managers; now there is an intermediate layer of due diligence analysts deciding on behalf of investors what is good and what is not – filtering innovation.
Track record
How can a new hedge fund strategy be implemented if an established track record is a prerequisite? Was track record the key of the amazing hedge fund performance in the 1980s? No, the keys were experiment, trial and error, under the umbrella of a portfolio of existing profitable strategies.
Policy transparency
There is a big difference between a transparent US Federal Reserve Board, which evolved in the past decade, with Alan Greenspan and now Ben Bernanke warning months in advance of changes in economic data, and the policy of the 1980s and early 1990s, when Mr Greenspan used to play the surprise factor. There is now little to guess and bet. The Fed is protecting consumer wealth by indirectly collapsing market volatility, thus preventing further wealth. This transparent policy impacts not only on, say, global macro strategies, but also on fixed income and credit strategies.
Leverage under pressure
Leverage was a big component of the high double-digit returns of the 1980s. The collapse of LTCM turned leverage into a dirty word and due diligence makes sure there is less and less leverage. It is wise to prevent such uncontrolled leverage as in 1998, when LTCM imploded, but there is now a disproportionate, destructive reaction against leverage.
Gabriel Burstein is a global macro investment strategist, formerly head of a hedge fund strategy group at HSBC and president of Burstein Macroarb Capital.
