Hedge Funds and the Art of ‘Phony Happiness’

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.