Sep. 2013

Welcoming the JOBS Act and the Six Biggest Threats to Hedge Funds

Today marks the day the JOBS Act rules go into effect. Funds will be targeting institutions and their consultants, and secondarily, financial advisors and their clients. I doubt we will see the launch of a major ad campaign by a hedge fund this week, but it may not be long until we do see one.

Why? Hedge Funds need to change perceptions, take full advantage of general solicitation and overcome their challenges. Here are the six relatively basic challenges facing the industry.

1)    The soaring S&P 500 / Low cost ETFs
2)    The calendar memory loss
3)    Fix Income fizzle
4)    The meteoric rise of Liquid Alternatives
5)    Media bias
6)    Understanding targeting and advertising

Ultimately I believe the JOBS Act will bring more convergence among asset managers. Although there are dozens of additional items I could cover in this post, these are the biggest threats to hedge fund’s continued rocket ship rise in AUM (asset under management).

As of the close on Friday, the low cost ETF (SPY) which tracks the S&P 500 index is up 19.88%, but that is without counting dividends, so it is easily exceeding 20%. There are very few hedge funds that can boast this type of performance after-fees and even fewer after taxes are considered. The issue, in an up market, is that everyone loves beta (market returns) and no one cares about risk adjusted returns or Sharpe ratios. In the back of the minds of most investors, is how well the market is doing. Oh, and SPY can be had for 0.09% (nine basis points) in fees.

The bigger knock on hedged strategies will come at the end of Q1 2014. Around March 9, 2009 was the bottom for the S&P 500 ending a scary time. Those of us managing money clearly remember how devastating January and February were to portfolios in 2009. Memories of these times will fade even further Q214. Most mutual funds and even institutional managers display 1, 3 and 5 years of performance. With performance advertising being placed into a level playing field for hedge funds, come April 1, 2014 the devastation of 2008/9 will be wiped out of general and traditional reporting, hurting the performance delta of down side protection offered by most hedge funds. Perhaps institutional investors and hedge funds will shout, “We see your five years numbers look great but show us how you performed in 2008!” This “out of sample” timeframe will remain critical for years for hedge funds, tactical managers and others offering hedged strategies, trying to include their strategies in the asset allocations of all types of investors.

Simply put, if we measure the performance of SPY beginning January 4, 2008 through the close of market Friday, its return is 15.9%, but when we start April 1, 2009 its 102.61%. The calendar is truly the enemy of hedge funds and frankly their potential clients; consultants, advisors and investors of all types.

Conclusion: Along with a fee of just 0.09% (nine basis points), and an up market, SPY makes the smaller returns of hedge funds charging 2% management fees and sharing 20% of the up side (known as 2 & 20) look really bad. The calendar will only exasperatethis situation; next year.

What can I say about bonds that hasn’t already been stated as an asset class; bonds have run their course. I attended a market outlook last week that basically said, get out of bonds, and if you’re a bond manager, sorry and if you are a bond manager with large fees, well… I cannot predict the real return of bonds, but perception is the only reality. Some quick proof of investor sentiment is that even with the fall of equities Friday, I read in Barron’s that $25.94 billion went into equity funds for the week ending Sept. 18, eclipsing the old mark set during the third quarter of 2007, according to EPFR Global. That is a lot of cake in a single week.

Next up are Liquid Alternatives. When first launched, they had many names in the institutional world and came from structured desks at investment banks. These have proliferated from numerous sources as the ETF industry has made it so many analysts and portfolio managers can be long and short trends, sectors, countries, currencies and commodities with a single trade. The ability for teams like the one I had back at Clear Asset Management / Clear Indexes to deconstruct strategies and zero in on the attributes of returns allowing the beta (strategy return without the specific skill of the hedge fund portfolio manager) to be duplicated with low cost vehicles like ETFs. Why pay 2 & 20 hedge fund fees when the manager may some years subtract from returns, and with the majority of managers, exposure to the strategy sometimes called “strategy beta” is all the investor really is seeking (evidenced at another recent event panel of three advisors each responsible for $5 billion in assets). Yes there are star managers who add out-performance, but we all can’t be in those funds and even those managers are capacity constrained. Liquid Alternatives can cost as little as mutual funds, all in. Their “logic” is spreading fast and the concept of strategy exposure makes sense to many institutions, consultants down to retail financial advisors.

The media loves to hate hedge funds. Hedge funds have been demonized in the press and there is fear in the eyes of the SEC and general public with the potential proliferation of hedge funds. Stories about mansions, horses and mega-yachts, vampire morals and fake managers such as Madoff get significant readers, which causes high ad rates and profits for publications. It is in their best interest to gain readers to sell advertising. Ultimately, there will be another crisis and investors with hedges will fare better than those that don’t have them. Why restrict this insurance against down markets only to rich people and institutions? Oh, and I can name dozens of hedge fund managers funding non-profits when the government and so many others can’t or don’t. Good press and community relations is readily available and sorely needed industry-wide. The JOBS Act may be of help as hedge funds are no longer forced to be frightened by the potential compliance fall out of appearing in the press.

My last point is a structural one. Hedge Fund marketing really means sales. Mutual Funds and ETF issuers are also staffed with sales people. However, Mutual Funds and ETF issuers also have formal marketing and advertising departments. This structural advantage, this already natural way of marketing themselves, will add months or even years to the ability for hedge funds to fully take advantage of the JOBS Act and compete. If it sounds like I am pulling for hedge funds, it is because I am. Many offer superior products to risk adverse investors. Most are honest, hardworking, smart, community minded professionals. Sure there are bad eggs and poster children for greed and excess. Tell me a successful industry that doesn’t have any.

Funds of all strategies and structures can now position themselves in the marketplace. Starting today they can develop the best messaging to target the best fit of investor types, their consultants or financial advisors and the most efficient and effective media to inform, engage, persuade and gain AUM. Hedge Funds have a long hard road ahead. Mutual Funds, Institutional Managers and ETFs beware. Armed with strong drives, powerful strategies, and great stories, hedge funds will adapt and leverage messaging, advertising and other media and marketing to rapidly gather assets.


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