The average performance of the hedge fund sector since the Great Recession has lagged the returns of passive investments including broad-based equity index funds tied to the S&P 500 as well as exchange-traded funds. The underperformance of hedge funds, a risky but historically high-flying sector whose managers are compensated on their ability to outperform the markets, has resulted in net capital outflows and lower fees. That, in turn, has led to consolidation within the industry and the return of investors’ money by a number of managers.
The recent increase in market instability and the possibility of these conditions persisting may prove to be another test for hedge funds. Hedge funds are expected to outperform in periods of volatility when markets are hit by bouts of fear and panic. Investors look to hedge funds to demonstrate active management skills characterized by superior asset allocation and stock picking that can weather the storm through periods of market stress. This has not been the case for nearly a decade and recent examples have highlighted how the sector has lost its golden touch.
Consider November to December 2018, when financial markets experienced a period of increased volatility resulting in a widespread sell off across most asset classes. From September 2018 highs, the S&P 500 experienced a drawdown of as much as 20% and closed 14% down by the end of that year. Despite this backdrop of instability in equities markets, hedge funds had one of their worst years.
Hedge fund underperformance has not abated. In May 2019, the effect of trade war tensions began to take a toll on the markets, resulting in another episode of volatility. According to Bloomberg, a recent Hedge Fund Research report showed that hedge funds returned 5.7% on average in the first half of this year; in comparison, the S&P 500 delivered about 17% over the same period.
The lack of excess risk-adjusted returns has resulted in investors challenging the traditional model of 2% management fees and 20% performance fees that used to be the industry standard. Investors have struggled to rationalize allocating capital to hedge funds when more passive strategies through low-cost ETFs have generated better returns than professional money managers. According to a recent study from Eurekahedge, a research firm, as reported by Bloomberg, performance fees for new fund launches have been trending down and are tracking below 15% in 2019.
Source: Eurekahedge, Bloomberg
A volatile environment
On July 31,, the Federal Reserve cut interest rates by 25 basis points for the first time in more than a decade. Markets fell into a state of confusion as Chairman Jerome Powell attempted to play a balancing act, reassuring markets that the Fed would act in the future to protect against downside risk but without guaranteeing the additional cuts that markets were pricing in going into the July 31 Federal Open Market Committee decision.
This sent markets tumbling in the day. The Chicago Board Options Exchange Volatility Index (VIX) jumped to levels not seen since the beginning of June 2019; the Bloomberg U.S. financial conditions index sagged; the Dow dropped by over 400 points in intraday trading; and the short end of the yield curve flattened as short-term yields jumped. The Dow ended down 334 points and other asset classes also went south late in the trading session, with some unexpected correlations observed between risk assets and safe-haven assets.
This market unrest continued in the late session on Aug. 1, following President Trump’s announcement of 10% tariffs on $300 billion of additional Chinese goods. Markets closed at the lowest level since the end of June, with the biggest two-day loss since May.
The July 31 and Aug. 1 events created a risk-averse environment that financial markets have not experienced in a few months and may set the stage for a choppy third quarter. The periods of volatility experienced in November-December 2018 and May 2019 were also fanned by trade and Fed policy uncertainty. Markets may see volatility elevated over the remainder of this quarter or possibly even through the end of this year, if uncertainty mounts.
Should these conditions persist, it will be interesting to see if hedge funds can finally break their losing streak and prove their value by outperforming when it counts the most.