By Antoine Bernheim, Publisher.
As we look back at the decade’s investment performance, the explosion in hedge funds stands out. Over the last ten years, hedge fund assets grew from an estimated $400 billion to over $1.5 trillion. In the early part of the decade, hedge funds demonstrated their ability to preserve capital during the bursting of the tech bubble and the ensuing decline of equities. Institutions began to roll into an investment product they had largely stayed away from in the 80s and 90s and today, they represent the major source of funding for the asset class. Hedge funds provided positive returns in a decade where equities did not. Yet, the recent financial crisis has brought to light a number of questionable practices which ought to be eliminated through a combination of regulatory guidelines, pressure from investors and enlightened industry leadership.
Unlike the S&P500’s exceptional performance in the 90s, with an annual compound return around 18%, U.S. equities delivered a negative 1% annual return in the just-ended decade. Hedge fund performance followed a parallel pattern, yet delivered far superior results: a sample of leading funds of funds in the 90s averaged an annual compound rate of 15% net of funds of funds fees and expenses (which typically add up to over 200 basis points annually); in the 2000s, again an average of a sample of leading funds of hedge funds over the last decade shows an annual return of 5%, net of all fees and expenses. As an asset class, hedge funds have continued to provide investors with a suitable alternative to equity portfolios and returns competitive with equities in rising markets and significantly better in poor markets; hedge funds have also generally delivered their returns with much lower volatility. However, while hedge funds handily outperformed U.S. equities during the last decade, their returns did pale in comparison to the oldest and simplest form of storing value (gold) and only matched the returns from bonds over the period.
Hedge funds are the most expensive, complex and idiosyncratic investment products and the financial crisis has revealed certain shortcomings in the way they have been managed. Those include the liquidity mismatch between hedge fund assets and liabilities, side-pocket policies, performance representation, disclosure of the actual cost of incentive compensation and how to resolve conflicts of interest between managers and investors under appropriate ethical standards.
The liquidity mismatch was a big shock for many hedge fund investors when the credit markets froze and they were unable to withdraw capital according to anticipated redemption terms. This affected primarily the multi-strategy funds, a number of which still remain gated or keep investors stuck with involuntary and illiquid side-pockets more than a year after the effective date of their redemption requests. Going forward, funds that engage in potentially illiquid investments are beginning to adopt the best practice of more carefully differentiating between liquid and potentially illiquid instruments at the time an investment is made and giving investors the option to participate, or not, in voluntary side-pockets. For long/short equity or global macro funds which in most cases honored their liquidity obligations, market pressure has caused many of them to reduce lock-ups and relax redemption provisions.
Secondly, the widespread use of side-pockets, including assets tied to Lehman Brothers’ bankruptcy, resulted in multiple approaches to performance disclosures. Some managers adopted the best practice of reporting their performance both including and excluding side-pockets, and bringing in third-party experts to provide independent valuations of side-pockets. However, too many managers report side-pocket performance separately and to their investors only, while reporting the performance of the liquid portion of their portfolio in their marketing material with a simple disclosure that it excludes side-pockets. This practice is simply unacceptable and should be deemed deceptive and manipulative by the SEC, if a material amount of capital is side-pocketed and the performance of the side-pocket deviates significantly from the balance of the portfolio. The argument that investors’ individual participation in side-pockets makes it impractical to fairly present a fund’s performance inclusive of side-pockets has been abused, and has occasionally resulted in a gross misrepresentation of performance. Unfortunately, there is not enough focus on the impact of side-pockets on performance disclosure, nor would it be addressed by the requirement for hedge fund managers to register as investment advisers currently contemplated by Congress.
Thirdly, the disclosure of the actual cost of incentive compensation by hedge funds is inadequate, specifically during long periods below the high water mark, such as today with roughly 50% of hedge funds below their 2008 high water marks. I recently invested in a fund with a nine year history, positive returns seven out of nine years and a compounded annual return of 15% since inception. With this fund’s history, an original investor would have paid no incentive compensation over the last one year, two year or three year periods, but would have paid incentive compensation over the last four years while incurring a loss, and over the last five years, the investor would have paid 21% of the profits. This is the result of an industry practice with no claw-back provisions except in very rare instances. Clearly, the 1.5%/20% formula is not a fair representation of the relationship between incentive compensation and profits and, in particular, institutional investors need to assess whether the lack of claw-back provisions creates scenarios that are inconsistent with their fiduciary obligations. Regulations should require funds to disclose these percentages over various time periods.
But most importantly, the industry overall failed the test of ethical behavior. There were too many instances where the lack of a mechanism to address conflicts of interest led managers to overreach in favoring their interests over that of their investors. What irked investors was the gating, side-pocketing, side-agreements and selective or insufficient disclosures and communications which marked investor relations during the financial crisis. While many managers took certain such steps with the stated purpose of “acting in the best interest of all investors” and theirs was often the right course of action from an investment standpoint, most managers failed to properly address the inherent conflict of interest which arises when locking up investors’ capital and continuing to charge management fees. Communications with investors were often insufficient and selective. Information to redeeming investors who faced deferrals or in-kind distributions was too often not shared with non-redeeming investors with the stated rationale that “it does not concern them and it could hurt the fund”. While many managers did find the right balance between investors’ interest and their own, the shortcomings of an investment product with no requirement for independent oversight were glaring. Managers would be well advised to set up formal or informal investors’ councils or boards to consult with, and address some of these conflict issues. Transparency is difficult to establish, it does involve risks and many factors sometimes ought to be carefully weighted by independent third parties. Finally, investors should demand that gate and involuntary side-pocket provisions be tied to deferral, reduction or elimination of management fees, until such time as funds revert to their ordinary liquidity provisions.
Over the last decade, hedge funds have come from the periphery to the center of financial markets. They have certainly played a positive role in bringing liquidity to the markets and provided investors with an attractive investment product. However, with the massive outpouring of institutional capital into the hedge fund sphere, the stakes have become too high to ignore certain objectionable practices. While hedge funds were among the financial players’ least responsible for the financial crisis and certainly suffered from it, the pendulum is now swinging back to give investors more influence and regulators the political leverage to correct some of the deficiencies that have been highlighted. Managers who demonstrated an ability to properly balance their investors’ interests with their own have an opportunity to take a leading role in promoting needed standards and regulations that will benefit the long term health of the industry.