Hedge Funds

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Ray Dalio, Principles:  Life and Work  

2019 Family Office Outlook for Hedge Funds

As a multi-family office, Privos and our family office partners are active allocators to global hedge funds.  As a firm, we expect hedge fund growth to slow this year as the world economy slows and the effects of the 2018 fiscal stimulus fade. Family offices investing in hedge funds are bracing for a downtown with global earnings tracking subdued growth outlook. That being said, hedge funds remain an important asset allocation strategy for our firm and our family offices partners this year.

In 2018, the number of funds in the $3 trillion market saw contraction as veterans who survived several business cycles throw in the towel. Money-making opportunities have dwindled with the downturn in stocks, while higher barriers to entry from regulation make it harder for new blood to come in. Hedge fund closures have outnumbered launches for the third year running: 580 funds decided to shut as of Dec. 3, 2018m compared with 552 openings, according to Eurekahedge. Many fund managers shut their doors last years and turned their fund into family offices, a wise move.

The Current Reality

The number of new hedge funds starting in 2019 is set to be at its lowest in about 18 years — if the trend of the first three quarters is repeated in the fourth, according to Bloomberg. Fewer hedge funds are starting; but fewer are also being closed. As the industry has matured and the regulatory environment has become more vigilant, the cost of setting up shop has risen. Only truly outstanding managers with a strong track record can garner enough seed capital to start up in the first place. The economies of scale are acting as gatekeepers to keep out the riffraff.

Meanwhile, despite the recent run of big-name exits like Jabre, the number of firms giving up the ghost is also declining. Liquidations this year are on target to be at their lowest level this decade. This suggests that investors who have allocated capital to hedge funds are becoming more willing to weather periods of lackluster performance. While Hedge Fund Research’s Global Hedge Fund index is down about 6 percent this year — matching the decline in the MSCI World Index — there’s hope that more volatile markets in 2019 will create a trading environment conducive to managers who can generate alpha.

Indeed, there are still some industry names out there who are putting plans in place for the expected improvement in climate. Martin Taylor, who shut his $1.5 billion Nevsky Capital fund almost three years ago, plans to reopen for business next year as Crake Asset Management. After delivering returns of more than 6,400 percent for investors in the two decades through 2015, Taylor got out after saying that the rise of computer-driven trading and geopolitical risks could produce “erroneous” market trends “which could then persist for far longer than we could take the pain,” as Bloomberg reports. In September 2019, though, Taylor announced plans to return. “There are ever fewer active participants to ensure price discovery,” he said. “There will be more opportunities for those active funds that remain.”

Elsewhere, Dharmesh Maniyar is spinning out his macro hedge fund from Tudor Investment Corp., and will start with more than $500 million of assets, Bloomberg News reported this week. The fund returned 3 percent in November, helping boost returns for the year through last week to 16 percent. The catalog of funds closing or becoming family offices this year is striking, as this list compiled by Bloomberg shows a long list of market veterans including Leon Cooperman, T. Boone Pickens and Dmitry Balyasny. However, Privos cautions our family office partners not to rush to write off the industry just yet.

Hedge Fund Closures in 2018

Hedge fund closures have dropped to a level not seen since before the 2008 financial crisis.  A total 125 funds liquidated during the three months through June 2018, down 44 percent from the same period last year. It was the lowest number of hedge fund closures since the third quarter of 2007, according to a Hedge Fund Research. The data tracker said hedge fund assets climbed to a record $3.24 trillion at the end of June 2018, after firms started more new funds than they closed in the first six months of this year. Managers navigated global trade tensions and slowing economic growth outside the U.S. to produce average returns of 1.75 percent during the first eight months of 2018, according to HFR.

Bets in developing countries have struggled in 2018, particularly in Asia, India, and Latin America, the report shows. The HFRI emerging markets index has lost 5.87 percent this year through August, compared to a 19.36 percent gain in all of 2017. 

Family offices are carefully considering fundamental aspects of fees and liquidity on portfolio performance. During the 2018 second quarter, the average for hedge fund fees remained at the lowest level since 2008, even as fees rose for new hedge funds, according to HFR. Funds created in the three months through June charged average management fees of 1.46 percent, up 27 basis points from the first quarter, the report shows. Their average incentive fee for performance, meanwhile, rose 128 basis points to 18.44 percent. The new funds are more expensive than industry average, a management fee of 1.43 percent for management and 16.98 percent performance fee. HFR said the traditional 2-and-20 structure is no longer widely used, estimating that only about 30 percent of managers charge such fees or higher.

Past Lessons for Family Offices: The Hedge Fund Provide Profound Market Insight and Protection for Family Offices in 2019

Family offices have an unique insight into the hedge fund world that few other investors have in this market.  By way of example, in August 2018, many family offices know that hedge funds are "tightening up their book" in anticipation of a serious market correction that many in the financial services industry believe is on its way.  Family offices report that their best traders see "cracks in market dynamics" and that they are "getting rid of their low conviction positions" to keep their powder dry for upcoming opportunities.  Some traders think the markets are starting to look a whole lot like 2008 and the market is overcooked, with M&A and private equity driving an overheated environment.  Whatever the case, hedge funds are reporting to their family office investors that they are seeing pockets of disconnection in this high volatility financial environment that they are looking to take advantage of for their family office investors.

By way of background, global family office watched Apple breaking the $1T mark recently and demand for global equities is strong.  Total hedge fund industry capital globally increased $4.5 billion to a new record of $3.215 trillion, according to the HFR.  

For hedge funds, 2019 year started strongly, with hedge fund posting positive performance; however, globally many hedge funds were unable to capitalize on growing market volatility as equity markets globally experienced large fluctuations. Geopolitical risk such as the trade conflict between the US and China amid the implementation of President Trump’s tariffs on Chinese goods.  With global equity market volatility increasing, and concerns mounting around a possible market correction, family offices are seeing fewer funds targeting equity strategies brought to market.  Preqin reports seeing more market-neutral strategies, such as relative value strategies, entering the market at the start of 2018.

Overall in 2018, family offices have witnessed hedge funds struggle to navigate challenging market conditions.  One  winner in the industry has been credit strategies that generated positive returns early this year.  On a regional basis, hedge funds with a focus on emerging markets have done well, with the emerging markets benchmark outperforming all other top-levelregional benchmarks, except for Asia-Pacific, over 12 months. Although investor appetite for long/short equity remains strong, family offices are looking to positioning themselves more defensively, with macro strategies particularly highly sought among those investors looking to allocate to hedge funds this year.

Family offices allocating to hedge funds today are looking for broader equity market outperformance and defensive positioning as it pertains to overall equity market valuation.  Global family offices are also looking to their managers to capture quantitative, trend-following macro strategies which will drive industry growth and performance into 2019.  Family offices continue to allocate to equity strategies, with a performance for global exposure over the U.S., developed markets over emerging markets; China focused funds are seeing huge redemptions with Chinese debt-focused strategies being hit hard; and there are outflows of family office money in the long/short equity funds.  

What Happened Last Year: 2018 Performance Numbers:  A Mixed Bag

Hedge fund industry performance wound up in negative territory for 2018 following three straight months of negative returns, data from Hedge Fund Research Inc. show. The HFRI Fund Weighted Composite index returned -4.07% in the 12 months ended Dec. 31, while the HFRI Asset Weighted Composite index returned -0.84%. For the nine months ended Sept. 30, the fund weighted composite index had returned 1.45%, but returns of -3.15%, -0.3% and -1.97%, respectively, for the months of October, November and December brought the year-end numbers down. Still, the HFRI Fund Weighted Composite index did outperform the S&P 500 index (which returned -9.2%) for December, according to P&I.

Overall industry returns were just slightly negative at -0.51 per cent in June, while 2Q 2018 returns were positive at +0.37 per cent and YTD 2018 returns stand at +0.16 per cent.  Among primary strategies, Distressed and Origination & Financing funds are performing well.  Distressed funds returned +1.53 per cent in June, +3.50 per cent and +3.34 per cent YTD. Origination and Financing funds returned +1.02 per cent in June, 2.48 per cent in 2Q and +3.83 per cent YTD.  Commodities funds are among the biggest losers so far in 2018, returning -2.70 per cent in June and -1.30 per cent YTD.  A strong dollar and developing trade wars have been hurting emerging markets funds.

In June, China-focused funds fell most, with China fund losses nearly rivalled by losses at funds focused on India and Brazil, which also saw negative returns. However, India focused funds, at -12.28 per cent for the year, are seeing the largest losses so far in 2018.  Performance, and the fees demanded for this performance, have driven the conversation around hedge funds in recent years.  In 2017, hedge funds built on the strong returns that began at the end of 2016, with annual returns hitting a four-year high of 11.43%.  Family offices has seen investor sentiment improve leading investors to allocate a net $44bn to the hedge fund industry in 2017, according to Preqin.

The North American hedge fund industry grew by US$136.4 billion over 2017, owing to the strong performance of hedge fund managers.  Thanks to the strong equity market performance around the globe, hedge funds with high long exposure to equities enjoyed the benefits of the record breaking equity market rallies. Despite falling behind their peers from Latin America and Asia, North American hedge funds kicked off 2018 with a decent performance.  Long/short equities funds topped the chart among strategic mandates.  

New Managers

Family offices often look to invest in a new managers who financial studies have shown have a greater likelihood of generating alpha than older, more established managers.  Many family offices (so-called "family office seeding platforms") will invest and take of the GP of a new manager with great results.

To understand the new manager universe, there were 74 hedge fund launches in Q1 2018, of which single-manager hedge funds represented the majority.  Nearly two-thirds of new funds launched in Q1 2018 aremanaged by North America-based fund managers.  The proportion of total fund launches accounted for by managers in North America has fallen by four percentage points in comparisonwith Q1 2017.  In contrast, Europe’s share of fund launches has grown over this period, from 16% of launches in Q1 2017 to 27% in Q1 2018.  In comparison with recent quarters, there has been a significantgrowth in the proportion of funds launched pursuing a global investment strategy (84% in Q1 2018, Fig. 10). This indicates that with volatility increasing across many markets globally, hedge fund managers are launching new funds to exploit opportunities on a macro scale.

This year we will see fewer new manager launches as markets in 2019 are more dangerous than years past, according to Privos CEO.

The proportion of hedge funds launched in Q1 2018 that employ an equity strategy fell for a second consecutive quarter.  This may indicate that fund managers’ outlook for equity strategies aligns with the views of many investors: Preqin’s recentsurvey of investors revealed that 45% believe we are at the peak of the equity cycle. There has been a significant uptick in the proportion of launches represented by event driven strategies and relative value strategies vehicles in Q1 2018, the proportion (21%) of all funds launched that pursue an event driven strategy is at its highest level since Q3 2016.

Cryptocurrencies and Blockchain

This year is likely to surpass the previous year in terms of the number of crypto fund launches, according to HedgeCo.net

Through July 31, Crypto Fund Research writes that there were 96 new crypto hedge funds and venture capital funds, an annual pace of 165. This would surpass the record 156 crypto funds launched in 2017. More than half of all crypto funds currently in existence have launched in just the last 18 months.  There are now 466 crypto funds across the globe.  If 2017 was ‘the year of Bitcoin’, 2018 is shaping up to be the year of the crypto fund.  Crypto Fund Research writes that while investors await decisions from various regulators on new investment vehicles, such as the bitcoin ETF proposed by Van Eck and SolidX, crypto fund managers are setting up new funds and hoping to take advantage of what they perceive as unmet investor demand for crypto investments.
The pace of fund launches doesn’t represent the whole story, however. Though crypto funds are the fastest growing hedge fund strategy by number, overall assets are still quite meagre. Crypto funds collectively manage just USD7.1 billion – far less than many of the top traditional hedge funds. Most institutional investors remain on the sidelines, something many crypto fund managers hope will change in the coming months.
Top cities for crypto funds launches, 2018 are: San Francisco (9); New York (6); Singapore (5) and London (4), while in addition to the above, Austin, Dallas, Hong Kong, Philadelphia, San Diego, Tokyo, and Zug have all seen multiple fund launches this year, Crypto Fund Research says.