"Imagine that in order to have a great life you have to cross a dangerous jungle. You can stay safe where you are and have an ordinary life, or you can risk crossing the jungle to have a terrific life. How would you approach that choice? Take a moment to think about it because it is the sort of choice that, in one form or another, we all have to make.”
Ray Dalio, Principles: Life and Work
As a multi-family office, Privos and our family office partners are active allocators to global hedge funds.
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. Hedge fund capital increased in the first quarter of this year, rising to a seventh consecutive record as investors reduced equity market beta in favor of M&A-focused event-driven (ED) exposures and fixed income-based relative value arbitrage (RVA) strategies. Total hedge fund industry capital globally increased $4.5 billion to a new record of $3.215 trillion, according to the HFR. Following inflows of nearly $10 billion for 2017, 1Q18 net inflows totaled $1.1 billion, with the gain moderated by a concentrated capital outflow within equity hedge strategies.
For hedge funds, this 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.
2018 Performance Numbers: A Mixed Bag
Halfway through 2018, hedge funds are producing very mixed results with just over half reporting strategies positive for the year. Those funds that are positive are up an average of 5.3 per cent, while those in the red are down an average of 5.3 per cent.
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.
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.
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.
Family Office View
On the ground, many family offices view the hedge fund universe as often nothing more than vast armies of slick hedge fund IR professionals and third party marketers pitching sub par hedge funds to unfocused global family offices, blasting out blind or cold emails, following up on sending pitch books, decks and collateral, racking up T&E Amex bills and other related marketing and travel expenses to raise money for their funds. Family offices gossip between ourselves that hedge fund IR folks contact family offices, drag in their arrogant, unappreciative hedge fund manager for a meeting, do cursory follow up after their pitch, update their tailored Salesforce CRM, and then send the same follow up tickler email when their CRM system reminds them. That is how hedge funds market to global family offices, to use perhaps an overly broad and unfair generalization. Hedge funds are then surprised the family office does not allocate to their hedge fund, and managers then go on to their Cambridge, Wilshire, Mercer consultant meetings wishing things in the family office world were not the nightmare it is in the person fund, endowment, sovereign wealth institutional world. Thus, hedge funds miss the opportunity to engage with smart, global family office investors who actually need and want good hedge fund managers. It does not have to be that way. For hedge funds looking to raise considerable assets, global family offices are overall extremely good potential investors. The key is knowing how to engage with a family office effectively, over time, to win their trust as a long term capital partner and provider.