At two recent Morgan Stanley investor conferences, the question of poor hedge fund performance surfaced repeatedly. We surveyed a group of long/short fundamental equity hedge fund managers at one of the conferences as to what they thought was the primary reason for poor performance in their industry. Of all the answers received, 54% said ‘crowding’, 23% said ‘factor exposures’, 8% blamed ‘macro headwinds’ and 8% said ‘poor liquidity’. The remaining group (also 8%) said ‘poor stock selection’.
In other words, when performance is bad, it is beta (the market), when performance is good, it is alpha (returns above the market). The truth is that 100%, at some level, should have said ‘poor stock selection’, and what this data reveals is that 92% of respondents are blaming something other than their stock selection methodology for the current underperformance. Our portfolio has outperformed for five straight years, and is lagging this year. It is 100% stock selection.
The alpha from the Hedge Fund Research Inc (HFRI) long-short index was close to 14% per annum in the early 1990s, and has been slightly below zero for the past few years. Why is this? We don’t claim to have some systematic rank ordering of explanations for the decay in performance, but there are many possible reasons.
Ten possible explanations
First, there has been a sharp rise in the number of funds, with HFR estimating that there are 3,400 equity-focused hedge funds today (about as many as stocks under global coverage by the Morgan Stanley research department).
Second, low interest rates have removed the rebate hedge funds received, a non-trivial driver of historical returns when rates were materially higher.
Third, hedge fund CIOs are increasingly cautious. Since 2003, US regulation FAS123R has made it illegal for hedge funds (and everyone) to know anything material and non-public in the US, at least, and frequent, high-profile hedge fund investigations have curtailed information-seeking at some level.
Fourth, the more rapid availability of information has materially shortened the time arbitrage that previously existed. The days when you ran to a pay phone to call a large portfolio manager in Boston when you learned something you thought mattered have been over for years. You have to publish something first that passes the smell test from nine different editors, compliance officers, control groups and stock selection committees.
Fifth, there increasingly appears to be a ‘group think’, as going to Omaha to hear what Warren Buffett says has transitioned to systematically tracking billionaire holdings and riding out the last bit of momentum from their ideas. Everyone attends or hears about the pitches made by successful hedge fund owners at industry conferences, dinners, charity events and presentations, raising questions about ‘crowding’ (that is, good opportunities are arbitraged away).
Sixth, the quants have stolen some of the alpha. Everyone knows the quants are onto something, so they are hiring junior quants to analyse their ‘factor exposures’, even though they don’t know what to do with the information once they get it. The HFRI equity market neutral index has beaten the HFRI long-short by about 3% per year for the past 10 years, so the ‘quant thing’ isn’t new. In addition, liquidity quant trading, baskets and ETFs have potentially been ‘sucking’ alpha out of the traditional long-short industry.
Seventh, limited partnerships don’t invest in hedge funds for as long as they used to, as their manager selection gets analysed and evaluated, creating more fear of redemption today versus yesteryear, and exacerbating short-termism among the hedge funds. We don’t remember anyone saying in 1995 that they were bullish on the market because hedge fund performance has been so bad that there may be redemptions and a ‘you might as well go for it’ melt-up. We hear that regularly now.
Eighth, macro factors account for a higher percentage of total returns today than in the past, and most hedge funds are set up for bottom-up security selection. This may have been prudent in a 1995 world where 80% of the average stock’s performance was idiosyncratic, but with macro now explaining well over half of the average stock’s returns, many classic hedge funds may be sub-optimally staffed for the current opportunity set. This has, in turn, affected dispersion (which became low) and correlation (which became high), and the dollar, rates and oil exposures, among others, are material on many books.
Ninth, while all active management has suffered, long-only firms began to realise they could replicate some of the more successful hedge fund approaches, shifting some of the alpha away from the hedge fund industry over time.
Tenth, the capital markets have been less supportive, meaning, the ‘free money’ associated with IPOs in the 1990s has clearly slowed. Very few high-profile deals have been monster stocks this cycle.
When can we expect excess performance to return?
While this surely isn’t a comprehensive or rank-ordered list of reasons for weak alpha generation, it hopefully touches on some of the issues. When will excess performance be likely again? Our suspicion is that much wider dispersion is required, and this isn’t likely until long-dated rates back up meaningfully or economic volatility grows materially. That said, dispersion is clearly wider than it was a year ago, and active management has yet to enjoy an improvement in performance. Here’s hoping that later this year we won’t need any excuses due to good stock selection.
Adam Parker is a Chief US Equity Strategist at Morgan Stanley.
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