What Hedge Funds Will Do After the Hedge Fund Model Dies
As long-short withers, firms turn to niches like private debt
This story is part of a series on the future of investing
The long and short on hedge funds is that long and short isn’t working so well anymore.
That’s the rather simple strategy that built the $3.2 trillion industry — the once-durable buying long when you figure an equity will go up and selling short when you reckon the opposite — and that basically put the “hedge” in hedge fund. These days it’s unreliable, at best.
The techniques of the future? Think niche, like litigation finance or private debt and equity, from Deere & Co. tractor dealerships to a banana plantation in Costa Rica.
There are any number of reasons trotted out for long-short’s fallibility: little volatility, low interest rates, so much passive investing in stocks by the likes of Vanguard Group and BlackRock Inc., too many quantitative funds in the business. What’s more, the number of publicly traded companies in the U.S. is, at about 3,700, half what it was in 1996.
The explanations aren’t just excuses. Low rates mean funds earn nothing on the cash produced when they sell a stock short. Passive investing and quants tend to push troubled companies higher.
“The one strategy that is facing an existential question is long-short equity,” Ted Seides, former head of hedge fund investor Protégé Partners, said recently at an investor conference at the University of Virginia’s Darden School of Business in Charlottesville.
Most everyone agrees the question will remain, at least until the almost nine-year bull market comes crashing down. Only then will it be clear whether stock hedge-fund managers can protect capital, or even make money.
Sure, some have continued to profit — Coatue Management and Light Street Capital Management, to name two — but they’ve managed to do so by betting on technology companies and limiting wagers of any kind on shares they expect to tumble.
The disillusionment with stock hedge funds comes as an increasing number of institutions have grown disenchanted with the industry’s returns overall, creating the worst climate for raising money since the financial crisis. Last year, investors pulled a net $106 billion as the private partnerships trailed global stocks, according to data compiled by eVestment.
Hedge-fund assets are up just 4 percent so far this year. The number of start-ups — 369 in the first nine months of the year, according to Hedge Fund Research — is the lowest since 2000, when the big internet bubble burst.
Cheap, esoteric and private investments may end up carrying the industry if recent activity is any indication: The biggest inflows this year have gone to long-biased or long-only products run by the quantitative funds, which use computers to decide what to buy and charge lower fees than most.
Renaissance Technologies, for instance, has pulled in $10 billion so far this year, while assets at Two Sigma have risen to $50 billion, up from $38 billion a year ago.
At Luxon Financial, investors have asked for products that can wager on rising and falling prices of securities but that charge much lower fees than hedge funds, said President Anson Beard, whose last job was an executive at a stock hedge fund that closed. Luxon's Cary Street Partners is a $2.5 billion firm of about 40 registered investment advisers whose clients are high-net-worth individuals in the Southeast U.S. and Texas.
Beard said he sees these so-called liquid alternatives taking the place of hedge funds in many investors’ portfolios.
Longford Capital Management raised $500 million for what’s known as a litigation finance fund: It focuses on financing corporate lawsuits and taking a piece of settlements or judgments.
Capstone Investment Advisors, which buys and sells the volatility of stocks, bonds and currencies, has seen assets grow by about $2.5 billion this year on performance and inflows and now manages $5.6 billion.
Family offices, which once seeded hedge funds, are also looking to private deals, whether it’s a swimming pool equipment company or an outfit working on nuclear-fusion technology. John Paulson, who has seen many clients jump ship from his hedge fund after years of poor returns, is trying to lure them back with those that invest in private equity and debt investments.
Even veterans have been getting trounced. John Burbank’s Passport Capital shot to fame for its lucrative bet against subprime housing ahead of the global financial crisis. His fund made 220 percent in 2007. Burbank told investors in a letter this week that he will shutter his flagship hedge fund. He wrote that the fund’s "returns over the past two years are unacceptable and cause me to rethink how to manage money in this environment.''
Or consider Lee Ainslie, who started Maverick Capital in 1993 after he left Tiger Management, where he trained with famed investor Julian Robertson. He lost about 10 percent last year and is down again this year.
Traditional stock hedge-fund managers remain hopeful. Ainslie told investors that he expects short selling to again be a profitable pursuit.
“On the short side, periods of frustration are not uncommon and are typically followed by periods in which short selling is actually quite rewarding,” Ainslie wrote in a letter this summer.
As long as the benign investment environment continues, with passive investing on the rise and the economy still growing, it pays to look in less traveled corners, said Marc Lasry, who runs the $9.8 billion Avenue Capital. “Right now, what the investing world offers you is niches.”
Brad Alford, who runs Alpha Capital Management in Atlanta, helps institutions find investment consultants, and the poor performance of hedge funds has created a boon for him. "I'm working with several large institutions who want to change their consultants because they are very unhappy that so much of their money has been directed to hedge funds," he said. "Now they want to double down on private equity and private debt."