Cyclical and Secular Overlap: Making sense of the future of hedge funds amid higher interest rates and alpha industrialization
As one of the largest gravitational forces in the market, hedge funds presently account for 28% of US Equity holdings. Amidst a challenging macroeconomic cycle and rising forces of creative destruction, the future of the multi-manager model is under scrutiny, marked by an 80-billion-euro capital outflow in 2023.
In 2024, Hedge funds confront a pivotal question: can they retain and attract clients amidst an environment where investors can secure a near 5% annual return free of risk? In an inflationary environment, achieving such performance becomes challenging, exacerbated by the prevalent "2 and 20" fee structure requiring an even higher actual return. The substantial leverage on which the funds are often dependent faces challenges as rising interest rates increase borrowing costs, potentially diminishing net returns.
Beyond the cyclical constraint of a higher risk-free rate is a secular trend that seems to threaten the long-term prospects of the active investing industry. As clients take note of passive investment innovations such as flexible ETFs and index funds of all kinds, many may see this as an opportunity to bypass the hefty fees associated with the active management of their funds. Further, a key challenge for hedge funds is the evolving perception of value in light of evermore efficient markets.
Historical fee data reveals that portfolio managers traditionally earned 15-20% of profits, with additional expenses covered. Managing a team with a $2 billion portfolio and achieving a 5% annual return can result in a portfolio manager earning over $10 million per year. Citadel, for instance, offered interns in its Hong Kong program a monthly salary of $19,200 during the summer. One might question whether these fees are warranted at a time when ETFs excel at providing consistent returns at a significantly lower cost, and U.S. treasuries approach a 5% yield. To thrive and command their pricing premium, hedge funds need to ascertain their ability to generate consistent alpha. Interestingly, it seems that passive investing is not alone in the face of technological evolution.
In the ever-evolving hedge fund arena, the Trade-Optimized Portfolio System (TOPS) is a disruptive force reshaping the landscape. Born out of an intriguing bet between the founders of Marshall Wace, Paul Marshall, and Ian Wace, TOPS emerged as a system designed to measure the outcomes of sell-side calls by stockbrokers. Initially used to track broker recommendations, this system evolved into something far more powerful. Over time, TOPS proved itself more than just a tracking tool. It morphed into a system that could capture and replicate successful trading strategies.
Increasingly, another aspect of the multi-manager model might raise concerns among investment professionals. The center book strategy maintains a comprehensive overview of all trades conducted by portfolio managers throughout the firm. Armed with additional insights into these managers' strengths, weaknesses, and behavioral tendencies, a subset of these trades can be replicated in a central book. For funds such as Citadel, such strategies can help answer crucial questions of the likes of, “Are our portfolio managers adequately sizing their positions and taking enough risk in their top investment ideas?”
In both cases, the search for improving judgment under uncertainty and diminishing the heuristics and biases that even the finest investors experience has been positive for the firms. However, such systems introduce fundamental questions about portfolio managers’ traditional roles and compensation structures. Currently, fees are enough to compensate them, but their share of the earnings might decrease as their impact is more precisely assessed. This seems reminiscent of the transformation seen on investment bank trading floors, where a greater portion of the value shifted towards the firm rather than individual traders who saw their salaries decrease substantially since the 1990s.