• Wealth Management

Hedge Funds: Is Bad News Good News?

It’s been a tough year for the battered asset class. But there may be a silver lining for disciplined investors.

It’s no secret that hedge funds’ struggle with performance has been a hot button topic this year. Stagnant global growth, a commodity selloff and Asia woes have created a challenging environment that has the industry poised to log its worst half-year performance since 2011.

We at Morgan Stanley Wealth Management have argued for some time that hedge funds should be viewed as a unique set of strategies and managers with various objectives and not just by their overall asset class. However, even with that preface, there are certain realities investors must face in an industry that has expanded rapidly in the past two decades that should inform how to position future allocations.

Moving forward, we believe some of the recent bad news may actually set the stage for good opportunities for disciplined hedge fund investors.

Structural and Cyclical Changes

Let’s start by acknowledging that hedge funds face some structural headwinds that did not exist 20 years ago.

In the 1990s, the industry was far smaller both in the number of funds and in assets under management. The ability to extract alpha from the market by being quicker, smarter and having less competition was clearly more favorable in the past. According to Hedge Fund Research Inc. (HFR), the estimated assets under management in hedge funds have grown more than tenfold over the past 20 years, from $257 billion in 1996 to nearly $3 trillion by 2016. In addition, the tailwind of higher equity market returns seen in the late 1990s, as well as the benefits from higher interest rates, are unlikely to persist in the near future at the same levels.

The industry has evolved considerably since its early days as the variety of strategies has proliferated. Whereas early hedge funds focused on global macro or merger arbitrage, managers have moved into areas like activism and structured credit. Given the rapid growth in assets and number of funds, managers have had to evolve, too, increasing analysis and examination of their strategies.

In the early days of hedge funds, the investors were largely high-net-worth individuals, but that has changed. Now, with much more participation from institutional investors such as pensions and endowments, performance is not the only imperative. Hedge fund managers must focus not only on performance but also on risk management, steadier returns and maintaining a strong operational infrastructure. This has led to concentration in the industry, as scale has become more important. Only 12% of managers have $1 billion in assets under management, yet that small slice of managers has 88% of fund assets, according to Preqin, an alternative assets research firm.

Cyclical headwinds are also at work. Global central bank policy has suppressed market volatility since the financial crisis. As such, one can question the need to hedge investment risk if volatility is low and corrections are short lived. In the past seven years, there have been few periods in which to add value through active management, as market drawdowns, or peak to trough declines, have typically been smaller and quicker to recover. If this is the new status quo for financial markets, the value of volatility-reducing strategies and active management probably has been diminished. If volatility increases and drawdowns become more prolonged, active management and diversification will be needed to help guard investors in times of stress.

Recent Performance and Dispersion

If we had to single out one common factor for weaker performance during the past 18 months, we would cite the decline in the price of oil and the sharp reversal that began in February. The volatility in energy prices affected all asset classes and, as a result, almost every hedge fund strategy. Within equity long/short strategies, an increasing number of hedge funds had built up a long bias toward companies with positive earnings momentum in sectors like technology and health care and a negative bias toward companies in the energy and industrial sectors, where earnings had been coming down. This narrow breadth in the market gave rise to crowding on both the long and short side, which began to unwind at the same time, during February and March.

Considerations Moving Forward

We are often asked what investors should do now with hedge funds, given some disappointing results. Let’s first consider investors’ basic options between stocks, bonds and alternatives. Morgan Stanley Wealth Management’s Global Investment Committee (GIC) has been clear in its assumption that stocks and bonds may offer lower returns but also more-normalized volatility compared with history, based on its seven-year market forecast.

Based on the GIC’s seven-year capital market return estimates (as of March 18, 2016) for a 60%/40% stock and bond portfolio (using the S&P 500 and the Barclays Capital US Aggregate Bond Index), we see a return estimate of 4.1%, with a standard deviation of 10.6%, a relatively unattractive risk-adjusted-return scenario compared with most historical periods. To be sure, hedge funds will not be immune from this lower-return environment, but we believe the right managers can still generate a compelling return, risk and correlation profile compared with a balanced stock and bond portfolio.

The primary value proposition of most hedge funds should be able to deliver some portion of their returns based on skill or “alpha” and provide diversification benefits to a client’s overall portfolio. We believe this will be particularly true if your manager selection is correct.

Will Bad News Be Good News?

As noted, hedge fund performance has been affected by increased competition, higher correlations and an environment not conducive to active, risk-managed strategies in a low-volatility environment. While we would not expect the competition to abate overnight, we can envision a period of lower correlation and higher volatility, which might then act as a tailwind for hedge funds.

The good news about bad news is that it sells. While we occasionally read of the troubles of how the mighty have fallen within the hedge fund industry, we tend to see the culling of funds and a reduction of capital in the hedge fund industry in a favorable light. If this leads to less competition, lower fees and “survival of the fittest,” we think this should be good news for disciplined hedge fund allocators, especially if the market landscape evolves more toward its historical norms.

The above was excerpted from the alternatives special report, Hedge Funds—Is Bad News Good News? For a copy of the full report, please ask your Morgan Stanley Financial Advisor.

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