Give Hedge Funds A Break - The Sector's On A Roll, Says Citigroup

Tom Burroughes

30 May 2014

While some recent figures have pointed to a difficult time for the world’s hedge fund industry, the sector is “thriving” with new inflows and a more varied range of products, according to Citigroup.

The total pool of capital being advised by hedge fund managers will double from $2.9 trillion in 2013 to $5.8 trillion in 2018, according to Citi Investor Services’ 5th annual Industry Evolution survey.

"The hedge fund industry is entering its next evolutionary phase - one of optimization - a term we use to describe how firms are expanding, customizing and focusing their overall businesses," Sandy Kaul, US head of business advisory services at Citigroup, said in a statement.

"Investors are increasingly looking at hedge fund firms more as consultative partners to construct customized portfolios and capture new avenues of uncorrelated returns. In addition, the industry as a whole is beginning to fulfill some of the roles that banks used to traditionally own,” the report said.

The report adds to the debate on whether the industry – the size of which is not always exactly known – justifies its fees that typically remain near the 2 per cent annual charge and 20 per cent performance haircut structure that has been in place for decades. One regular difficulty in assessing returns compared with market indicators is that returns need to take into account the closure or failure of funds over time – the “survivorship bias” issue.

Hedge funds were hit in the 2008 market selloff – although not in general terms as badly as long-only holders of global equities, and there have been mixed periods of performance since that time. The spike in volatility amid fears about eurozone debt hit the sector. According to Hedge Fund Research, the Chicago-based firm that tracks performance and assets, the fourth quarter of last year saw the largest quarterly closures of hedge funds since the crisis-bruised first quarter of 2009, with 296 and 376 respectively. Still far off the record of 1,471 hedge fund closures in 2008 and 1,023 in 2009, 904 hedge funds closed over the course of 2013, a total of 31 more than the previous year.

The Alternative Investment Management Association, which represents many of the players in the hedge fund business, said the sector has come in for unfair attacks. In a report issued in late April this year, it said comparing performance with an index such as the S&P 500 Index of stocks is misguided.

The paper - Apples and apples: How to better understand hedge fund performance - says investors should examine risk-adjusted returns, which illustrate hedge funds have consistently outperformed the S&P 500, MSCI World and global bonds on a risk-adjusted basis. The AIMA paper said hedge funds, for example, had a Sharpe Ratio of 1.28 for the five years leading to the end of 2013, while the S&P 500 was at 0.95 despite the recent equity market rally. The MSCI World stood at 0.68 while the Barclays Global Aggregate ex-USD, which measures bonds, had a Sharpe Ratio of 0.38 over the same time period.

“Put simply, many investors value getting steadier returns with lower volatility over higher returns with much greater volatility. Hedge funds actually have lower volatility not only than equities but also bonds. What that means is that in terms of the risk taken, such as in risk-adjusted terms, the industry continues to outperform,” Jack Inglis, chief executive at AIMA in London, has said.

Isolating risks, playing role of banks

Citigroup said the industry's largest allocators are blurring the lines between investors and hedge funds. Many of the leading institutions that invest in hedge funds have built out their own asset management organizations to complement their specific exposures from hedge funds, it said.

“This is allowing some investors to co-invest into securities and to directly invest into markets alongside their hedge fund counterparts. These participants are also helping to fill a market-making and lending gap that has emerged from sell-side banks that are pulling back, and increased sensitivity to balance sheet impacts from the traditional dealer community,” the report said.