The passing of the JOBS Act by US Congress in 2012 brought all but the smallest US hedge funds under the regulation of the SEC as registered investment advisors (RIAs). For years, hedge funds had been exempt from the vast majority of SEC regulations, but the rapid expansion of the industry made it too big for the regulators to continue to ignore.
While this was widely viewed as a setback for the industry at the time, the changes have actually ended up providing new opportunities for hedge funds, and industry-wide assets under management (AUM) are currently at record levels of $2.7 trillion. Rather than resisting the change, managers have embraced their new-found RIA status, and have launched vehicles that both satisfy the daily pricing and liquidity requirements of mutual funds and employ investment strategies that were traditionally associated with hedge funds. This has raised some concerns, however, that the retail investment-like structure of these vehicles could attract investors who do not fully understand the risks involved.
With the new rules, regulators were hoping to make life more difficult for hedge funds, so the rapid rise in hedge fund assets that followed could be seen as a failure from the SEC’s point of view. However, over 80% of the asset growth since 2008 has come from market price appreciation rather than fresh investment, and in fact far more investor money went out of the industry in 2008/2009 than has come in since, and inflows remain below the pre-crisis peak.
However, beneath this trend of outflows is an underlying shift among investors into direct investments in funds rather than fund of funds. In 2008/9, Fund of funds saw $159bn in outflows, and since then a further $60bn has gone out of the industry. These outflows have meant that fund of hedge funds have yet to recover their pre-crisis peak in terms of assets under management, and at $665bn, the figure is 17% less than the 2007 figure. Historically low investment returns across most asset classes have weighed particularly on the returns of funds of hedge funds, due to their ‘double charging’ structure, in that investors pay management fees directly to the fund of funds manager, and indirectly to the managers of the underlying funds.
Capital flowing into event-driven and equity long/short
As far as hedge fund strategies go, event-driven – including activist investing, credit arbitrage, distressed/restructuring, merger arbitrage and special situations – has seen the biggest inflows over the last year. Equity long/short – the classic hedge fund strategy – came a close second in attracting new money. The bull market for stocks is something that investors are keen to profit from, but most want to do so in a less risky way, and this is why they turn to hedge funds that employ this model.
Although hedge fund investors, as a group, tend to be more sophisticated than retail investors, they still have a tendency towards herd behaviour in that money flows tend to follow past performance. For example, the poor performance of global macro in 2013 caused many investors to take money out of these strategies and into equity long/short, which like activist strategies, has been boosted by the bull run in the stock market.
This herd instinct was also in evidence in the recent move away from small cap and tech stocks towards large cap value plays. However, history has shown that a forward-looking investment approach can produce better results, as it means investors can get in ahead of the deal flow. But although investment consultants often suggest an analytical forward-looking approach, their suggestions are not always followed by clients.
One such forward-looking suggestion has been the move into credit strategies, which have also seen an upsurge in client interest in the last two years in the US, and more recently Europe. This has been driven by higher expected returns, with post crisis regulatory changes creating an unusual opportunity. With banks getting out of certain businesses and selling the related assets to improve their capital ratios, this has created an opportunity for managers following credit strategies to take advantage.
40 Acts make an impact
Because these assets are illiquid and hard to price, they have been invested in solely by hedge funds as these investments would not comply with any other investment vehicle regulations. So, the new ‘retail hedge funds’, known as 40 Act funds would not be able to capitalise on this opportunity, as they require daily pricing and liquidity.
This restriction to the most liquid hedge fund strategies – namely global macro and equity long/short – could cause 40 Act funds to fail to live up to investor expectations. Even with equity long/short, 40 Act funds have to stick to large cap and the larger mid-cap stocks; and the need for liquidity also rules out emerging markets. The smaller fees – 1-2% per year rather than the 2 and 20 charged by most hedge funds – have been a cause for concern among some in the hedge fund industry, but the expected lower returns from 40 Act funds should prevent investors from taking money out of hedge funds and putting it into the cheaper retail versions.
In an effort to revive their fortunes, funds of hedge funds have embraced 40 Act funds, but given the poor performance of these vehicles in recent years anyway, the high underlying costs could eat into profits and leave many 40 Act investors disappointed.
With money flowing into more liquid investments due to the new regulations, there has also been an upswing in investments at the other end of the liquidity scale, with tight capital lockup restrictions and phased capital drawdown arrangements. These types of investments – which are more like private equity than traditional hedge fund investments – have been providing the best returns in the post-crisis years, and an increasing number of high-end investors are willing to live with the lock-ups in exchange for much greater returns.
I am a writer based in London, specialising in finance, trading, investment, and forex. Aside from the articles and content I write for IntelligentHQ, I also write for euroinvestor.com, and I have also written educational trading and investment guides for various websites including tradingquarter.com. Before specialising in finance, I worked as a writer for various digital marketing firms, specialising in online SEO-friendly content. I grew up in Aberdeen, Scotland, and I have an MA in English Literature from the University of Glasgow and I am a lead musician in a band. You can find me on twitter @pmilne100.