Hedge funds have long been criticized for underperforming the bull market in stocks for the past decade. But as markets get more challenging and interest rates climb, it’s their risk-management skills – not their performance record – that could underpin an upturn in the industry’s fortunes. That’s because their biggest customers – public pension funds and endowments – place a high premium on loss mitigation, perhaps a higher premium than they do on returns.
These entities, which sit on trillions of dollars of capital, employ a variety of strategies to minimize their risk of loss, each of which dovetails with how the hedge fund industry is evolving.
First, is their appetite for diversification. In theory, capital allocators can diversify on their own, through multiple funds. But that has drawbacks.
In the old days, allocators used funds-of-funds to build diversified exposure to hedge funds. But having peaked in 2007, that strategy has been in decline. From a high of nearly 3,700, fewer than 500 funds-of-funds are now active, collectively managing half the $800 billion they once did. Their revenue pool has since been targeted by multi-strategy funds – funds like Millennium Management and Citadel – that collect investor money into huge pools that they parcel out internally.
A Bloomberg News Big Take recently noted that while hedge funds overall have drawn no new money since 2008, a sample of 20 multi-manager funds collectively boosted assets by 510% to $222 billion over the past decade, according to data compiled by Julius Baer.
Millennium alone manages more than $52 billion of assets. It employs 2,200 investment professionals, across 270 teams, which it turns over at a rate of 15%-20% per year. The fund’s biggest ever drawdown was 7% during 1998. While returns have been satisfactory – the fund was up 14% last year – the firm’s most compelling customer proposition lies in its ability to minimize the risk of loss through diversification.
Asset allocation can also help avoid the perception of loss: hedge funds are ramping up their exposure to private equity. Public market investments reprice every second of the trading day, injecting unwelcome volatility into portfolios. Private-market investments, by contrast, get revalued only once per quarter and that’s on the basis of “estimates and assumptions.” Dan Rasmussen of investment firm Verdad cites the chief investment officer of the Public Employee Retirement System of Idaho, who credits the smoothing effects of this valuation process for a “phony happiness.”
According to data from Goldman Sachs, the number of private investments funded by hedge funds increased from about 200 annually from 2010 to 2015 to 770 in the first half of 2021. Indeed, in the first half of 2021, hedge funds accounted for over a quarter of the capital deployed in private fundraising deals by all investors.
There are a number of reasons hedge fund managers give for their increased participation in private markets: synergies with their public market investing, access to initial public offerings and widening their investment opportunity set (especially with short books having been squeezed).
But another is the volatility dampening that comes from not having to mark to market the private portfolio at the same rate as the public portfolio. “There’s a sort of natural smoothing effect, which I think allocators appreciate,” says the author of the Goldman Sachs report.
Beyond strategies, hedge fund clients in these turbulent times can rely on the comfort of a name brand.
Marketing professionals have long suggested that a brand’s value lies as much in eliminating the degree of uncertainty associated with a product as in the absolute quality of a product – a key consideration in selecting an investment manager. Track record matters for brand, but longevity and social proof count too.
A key feature of the overall alternative-investment industry, including hedge funds, is that large firms with more established brands are winning greater share; as their customers look to manage risk, this makes sense.
Blackstone Group Inc., the biggest alternative asset manager in the world, sees it. “The most important advantage,” Blackstone President and Chief Operating Officer Jon Gray remarked at a recent investor event, “is the power of our brand, that this firm can raise capital without utilizing capital because we built up a reservoir of goodwill over 35 years and it's quite substantial. People trust Blackstone to be a steward of capital and that really matters.”
Not all allocators focus as compulsively on minimizing variance. The Massachusetts Institute of Technology Investment Management Company manages MIT’s endowment. It runs a program for small, unbranded investment managers. Over recent years, it has allocated to many emerging managers, including a single stock picker in Mumbai who manages MIT’s money alongside his own. Risk is mitigated by the small size of these allocations, but the process takes a lot more effort than simply allocating to a Millennium or a larger hedge fund that now does private deals – the MIT fund reviews plenty of prospective managers but passes on 95% of them.
For the past 10 years, buoyant markets have meant asset allocators haven't been especially rewarded for their focus on risk. As Howard Marks, co-founder of Oaktree Capital Management says, “risk is covert, invisible. Risk — the possibility of loss — is not observable. What is observable is loss, and loss generally happens only when risk collides with negative events.” As market conditions shift, the value of these risk mitigation strategies may become more apparent.
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