Goliath is a David

We’ve all heard the David vs Goliath story. The biblical character, Goliath, a giant, was famously defeated by David, a young, a human sized warrior. The story often comes up while describing situations where a smaller competitor is facing a much larger and powerful opponent. Our love for the underdog in a contest probably has linkages to this famous story. (Malcolm Gladwell also wrote a famous book around the topic)

It sprung up again in my thoughts during a random discussion with my friend Sam, while talking about Hedge funds and the decline in their relative importance in the markets. I (like many others) have held a long standing appreciation for Hedge funds and what they do, including their ability to take on risk in a cut-throat competitive environment. The storied careers of hedge fund managers and their swashbuckling style of making money by going long and short on different kinds of securities and asset classes has been well admired by many too. So for me, Hedge funds were always the Goliaths in this jungle. They had billions to invest, and had the ability to move markets with their positions and cult-like following. But…

The tide is turning

Over the last decade or so, the tide has been turning in waves of underperformance and the Goliaths have started to look more like Davids. This year, long-short funds have returned -12% on average with some of the big names like Coatue, Maverick, Light Street down more than 40%. Some of the funds have lost more than what they gained during the entirety of their operating lifetime.

This is not a one-off by any means. As a basket, Hedge funds have underperformed the markets badly over the past decade. There might be a few outlier funds raking in decent gains net of fees, but on average its been tough out there. Given the consistent lackluster performance and availability of cheaper and better alternatives, their place in institutional portfolios has been on the decline.

Annual performance of the weighted HF index, Source: Financial Times

The discussion led me thinking about why it has come to this, which I tried doing via this simple framework.

A simple fraework to structure this train of thought

What did an institutional investor aim for when allocating towards a hedge fund? -Better risk adjusted returns (net of costs of allocating i.e fees paid). The shrinking role that hedge funds play today in investor portfolios shouldn’t come as a surprise given the track record over the decade gone by. Flows follow performance, and negative performance in absolute or relative basis can compound the movement of flows in the other direction.

Overall AUM has been flat since 2017, with inflows into a tiny segment of the HF universe offsetting the bleeding major HFs have witnessed. AUM was $3.58tn in 2017, touched $4tn in 2021 and now after a down year is back to the same levels as 5 years ago.

The edge has increasingly withered away

In the early 2000’s, Hedge funds were amongst a handful of players having access to propreitary data, sophisticated systems and algos that they could let loose to have an edge over the rest of the market. Today, these tools have become a commodity and most market participants have them with a click of a button, from institutional investors to the most unsophisticated of retail traders losing it all from his uncle’s basement. This edge, that hedge funds had is no longer theirs and has slowly withered away to better and cheaper access to tech for the rest of the players.

The market structure has evolved

The market today is much more efficient with more players involved and tighter spreads. Passive investing is mainstream with cheap ETFs putting a downward pressure on fees across the industry. It was the perfect storm as they say. Ultra loose monetary policy and proliferation of passive products turned the market into a different kind of beast. Hedge funds fell face first into it. First during the 2008 crash where a lot of them went bust and then getting caught unawares by the passive storm heading their way. I strongly believe they failed to adapt their playbooks with these ever adapting markets.

Passive vs active flows, Source: Financial Times

Uncorrelated returns can now be found elsewhere

Investor went to Hedge funds seeking uncorrelated returns for their portfolios to improve their return profile. These funds, in a bid to survive the outflows due to underperformance updated their playbook by adding sector and stock exposure (mainly tech) that had massive tailwinds in various forms like loose monetary policy, easy fundraising, and ever increasing valuations. The performance started looking increasingly like the rest of the market and their leveraged bets on tech went bust this year during the large drawdowns.

These sought after uncorrelated returns were instead found in private markets. (one of the opportunity costs) Both Private equity and Venture are much more developed now than two decades ago with larger funds, institutional backing and an acceptance as an important asset class in investor portfolios. They provided LPs with some exposure to sectors and businesses not available in the public markets with lower volatility (at least on paper) lower correlation to their public portion of the portfolios.

Private markets have performed exceptionally well, some of which can be attributed to the same tailwinds discussed above. Unfortunately for Hedge funds, increasing allocation to PE and VC has come at the expense of HFs and other active public equity funds. For example, Washington University decided to cut its HF allocation from 20% to 5% and allocate it to privates. This trend has only been accelerating.

In addition, for their public portfolios institutions are happy to stick to cheaper passive alternatives and pick managers for their private allocations. There is also a prevalence of belief that PE is better than HF due to the operational control PEs have with their portfolio companies, allowing them to weather the storm and ride the cycle in tough environments like the current one.

They failed one of their biggest tests

Some proponents argue that Hedge funds have a place in portfolios due to the environment we are in currently. We’re in a volatile phase of the cycle and these funds can use volatility in their favour to put on some short term bets. They also argue that the era of easy money that drove one of the strongest bull markets in both public and private markets is now over, making it a ideal environement for active managers to outperform

Instead, recent history highlights how bad hedge funds have fared , with some of the largest funds losing more than 50%. during this year’s drawdown. During the last decade, they blamed the Fed for the unfavourable macro conditions. This time around they blamed inflation! They failed to live up to expectations in the very environment in which you need them the most. A whole bunch of them got obliterated, failing to adapt their playbooks again. What worked in the past decade stopped working for half a year and down they went. Of course, you cannot generalise here and there are categories (like Macro) which performed well. But on the whole, its been dismal in the first half of 2022.

It is the cycles like these which allow you to build a track record and attract flows. Net flows this year were flat at $440mn with almost $9bn in outflows. The outlook for flows has not improved given what we’ve seen so far, either.

Investing in hedge funds is far from easy, especially when the Goliath looks more like David. Plus, momentum is a powerful force in the market. Cheering for the underdog in this case might not be enough to plug this outflow and underperformance feeding into each other.

All these arguments are not aimed to take sides, and in no case to generalise for the entire industry. There are some funds that have been able to deliver in their niche keeping their size just big enough to not let it go against you (the larger your fund is, the harder it gets to outperform).

Maybe this is the way to allocate to these funds going forward. Finding the niche in which they’ve delivered over multiple cycles, have kept fees low and are small enough to still fly under the radar.

Today passive products are Goliaths, tomorrow something else might take place. But it always pays to know who’s who to get your game right.

Until next time,

The Atomic Investor

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