Thanks to the rise of Fintech and robo-advisors, investors now more than ever are abandoning active managers such as hedge funds (“HF”s) and fleeing to passive strategies such as index-funds. Why? In 2017, the S&P 500 (“SPX”) returned nearly 19.42%1. Before that, the SPX has generated positive returns since the financial crisis. Moreover, these strategies promote the idea of diversification, a notion that is highly appealing to any finance newbie. Investing in an open-end mutual fund or an index fund has minimal management fee, a transparent strategy, and is very easy to use; an app with a touch of a finger. Even Bill Miller of Legg Mason, one of the greatest money managers of all time, could not continuously beat the market. With such little knowledge of investing among this demographic, it just seems simpler to join the market instead of beating it.
There are also arguments to be made against HFs too. The exorbitant management fees, capital gains fees, and the relatively meek returns compared to the market. In 2017, HF managers achieved an 10.45% return2. With only an 10.45% return, you also take into consideration the infamous “2/20” fees for the fund, as well as the high potential for illiquidity due to extended lock-up periods. Moreover, there is a good chance that as a beginner investor, you have no idea how the HF’s investment strategy operates.
Even former alpha-hungry gurus have left their active ways and moved towards indexing. So, is there an argument to be made for HFs?
There are inherent benefits to active strategies. Hedge funds are less sensitive to systematic fluctuations, especially in the cases of funds operating a long/short portfolio. They can hedge their portfolios to mitigate downside risk. Though costs are higher, these funds main objective is return no matter a bull or bear market without the fluctuations inherent in an economic cycle. Moreover, these funds can have shorter investment horizons, allowing for maximum returns in the short-run as opposed to the cyclicality of firms with a 6+ year holding period.
Also, the market has produced only positive returns since the financial crisis. The last time we saw such a positive streak was from FYE 1991 up until the dot-com bust in 2000. PE ratios are also the highest they’ve ever been, and they seem to continue to rise. It is remarkable how many companies are beating current analyst estimates this earnings season, let alone this past year.
So, is this run sustainable? Are firms rallying thanks to President Trump’s Tax Law, or are we truly in a period of economic success?
The short answer is: It’s tough to say. However, the real question worth asking is, “Are you protected against the possibility of an economic downturn?”
If you are long the market in a passive strategy, chances are, you aren’t. However, if you invest with a HF that has a long/short focus, you can get a hedged portfolio with the benefits of diversification.
Investing in a passive strategy also precludes the investor from profitable investment opportunities. Recall Bill Ackman’s, CEO of Pershing Square Capital Management, investment in Wachovia before Wells Fargo’s bid back in 2008. Within four hours, Ackman’s team conducted the necessary due diligence to deem this a profitable opportunity3. As a result, they made a handsome return. This is unobtainable by simply throwing your money in an index fund.
So, if these arguments resonated with you and you are a high-net-worth individual looking to choose an active strategy, here are my thoughts:
Spend a lot of time researching your manager. What is her strategy, and how has her historical performance played out? If she is an activist, has her intervention led to capital appreciation in the company? Is she a specialist in some niche method (e.g. arbitrage, emerging markets, etc.)? Do you understand how she is helping your money grow? Is the manager investing her own money in this fund?
If she trusts the strategy will make you wealthier, then she will obviously utilize the strategy as well (depending on their investor profile).
Transparency is key. If your manager makes it difficult to understand how she is investing your money, there’s probably a reason why.
You should also know your risk appetite and liquidity preferences. Are you willing to risk a lot for high returns, or would you rather a stable growth over a longer investment horizon? Do you need immediate access to your funds, or are you willing to wait out a lock-up period? These are things to consider.
This is not to say passive strategies aren’t successful. I am aware of several former active managers who have abandoned the alpha-seeking lifestyle for a more passive approach, and I commend them for their transition. That is perfectly fine, and clearly, there are returns in a passive strategy too.
All-in-all, it depends on the type of investor you are. But I strongly believe HF managers can retain client relationships by reducing their management fees in times where they fail to produce alpha. In the long-run, you would rather lower your fees than maintain them. Investment management is a client-focused business, and therefore, client retention and satisfaction should be the utmost priority.