At an investor conference in December, Cliffwater managing director Chris Solarz bluntly declared that “90 per cent of hedge funds are not worth their fees.” The data supports Solarz. According to Hedge Fund Research, with the S&P 500 up almost 8 per cent through Nov. 30th hedge funds were up just 4.6 per cent after fees.
Hedge fund managers are good at picking stocks and identifying esoteric correlation trades. They are less good at constructing sustainable portfolios, hedging or managing complex risk. In comparison to hedge funds, asset-management firms may not be world-class at generating alpha. But they excel at managing large pools of capital with consistent performance.
Sovereign wealth funds, pension funds, mutual funds and other large investors are balking at the high fees and volatility associated with alternative investments — hedge funds specifically. They are, consequently, moving assets toward market-neutral platforms with relatively tighter risk limits and consistent records of capital preservation.
Here’s the evidence: by the fourth quarter of 2016 $77 billion had pulled out of what had been a $3 trillion hedge-fund industry. According to eVestment, in October alone 61 per cent of funds recorded net outflows as large investors went in search of high-capacity beta.
Large, well-established hedge funds with consistent returns are benefiting from the reallocation of funding. The money is concentrating among its best players. But they may not have the expertise to manage the extra capital.
True alpha in fundamental investing is becoming rarer across asset classes. No wonder the “2 and 20” model conventional among hedge funds has been under pressure. In 2016, Pershing Square, Brevan Howard, Tudor Investment and Och-Ziff Capital Management all lowered or eliminated management fees.
Hedge-fund stars like Paul Tudor Jones, George Soros and Alan Howard have publicly discussed difficulties in generating revenues and beating market averages. Portfolio managers who built fortunes on fundamental, momentum-based trading are aggressively refocusing on beta neutral long and short quantitative strategies. Quant funds like Winton, AQR and Bridgewater are raising billions to create a hybrid investment style.
Asset managers — and hedge funds with asset-management aspirations — will be beneficiaries of the trend if they have the technology and deep research capabilities to capitalise. With these they can run high-capacity beta strategies with alpha “overlays”, taking advantage of market altering events such as Brexit or a new IPO. Their discretionary counterparts, meanwhile, struggle to navigate such events successfully.
Too many traditional asset managers have difficulty beating benchmarks like the S&P 500. And too many asset managers are still executing their trades via out-of-date systems and overpaying Wall Street platforms for help.
The talent challenge
Shifts in funding and investment styles create challenges for hedge funds and asset managers alike. Their challenges cannot be solved with their existing talent configurations. In the next three years this will have sometimes unlooked-for implications for the existing talent pools of both businesses.
One quite likely response among hedge funds and execution platforms will be investment in asset-management talent — talent previously unavailable to them and relatively overpriced. Electronic-product development and trading staff will be hired away from hedge funds and platforms. Banks will become less desirable employers to electronic traders, quant researchers and developers.
We can expect to see portfolio construction talent begin to move from asset-management firms to the top-performing hedge funds and banks along with other quant-equity and quant-macro researchers. Asset-management researchers with extensive portfolio construction experience will be indispensable to running high-capacity strategies. Researchers at asset-management firms have been comparatively underpaid relative to their hedge-fund counterparts even though performing similar work with comparable qualifications.
That disparity is about to be history.
 Investing in 90 per cent of hedge funds isn’t worth it: critics. C. English. The New York Post. December 7, 2016.
 October Sees More Hedge Fund Asset Outflows. P. Laurelli. eVestment Blog. November 22, 2016.