A distinguished panel gathered on October 10, 2019 at the Standard Club to discuss the current environment for hedge fund investments. Kenneth Heinz, president of Hedge Fund Research, Inc. served as the moderator.
The panelists included:
- Kevin Doonan, Executive Director, Hedge Fund Strategies, GCM Grosvenor
- Joseph Scoby – Head of Systematic Investing, Magnetar Capital
- Tristan L. Thomas, CFA – Director of Portfolio Strategy, 50 South Capital
HFR’s Ken Heinz began with some opening remarks, which he dubbed “Whistling Past the Graveyard”. After a rough couple of years, investing in hedge funds in the next 2-3 years will be better, he said. One reason is that hedge funds are currently preparing for macro risks for which many mainstream investors might not be ready. A couple warning signs Heinz noted include a recent huge jump in overnight repo rates, and negative interest rates on a wide swath of global debt. Also, IPO markets are showing weakness, with the large We Work IPO having been pulled recently at the last minute. Impeachment proceedings and a possible Warren presidency (with her populist, anti-corporate message) also suggest more risk on the horizon.
Tristan Thomas started by talking about bond returns. A return of about 8% YTD for the Barclays Aggregate index indicates that a lot of bond returns have been pulled forward. That leaves little return potential ahead for bond investors unless yields go negative. The minuscule amount of yield available leaves bond investors in a quandary. They still need income and cash flow, but aren’t entirely comfortable taking on more risk. With that backdrop, hedge funds can play a role in the portfolio. One symptom of this trend, Thomas noted, is that he has recently been talking more to clients’ fixed income departments, who need help generating yield, instead of the alternative groups he typically speaks with. Another challenge is that the costs of running a hedge fund have gone up.
Heinz asked the panel if they are seeing reduced liquidity in the market. Thomas answered yes. Doonan added that markets are now faster to gap down because of weaker hands and banks are less involved than before. Some securities have better liquidity than before, particularly securities held inside ETFs, but securities outside of ETFs have fared worse with respect to liquidity.
The conversation then shifted to ESG, a fast-growing area of investing that the hedge fund world has been slow to embrace. Thomas opined that the ESG trend is real and here to stay and represents a big opportunity for hedge fund managers to win additional mandates. One challenge managers face is defining exactly what ESG is. Investors each have their own answer on what ESG constitutes, and managers need to be flexible and offer customization in order to capitalize on the opportunity. As for returns, Heinz asked the panel if ESG has an impact. Thomas said that there isn’t quite enough data in the hedge fund space to definitively answer that question. Doonan also said that he believes the implications of focusing on ESG will be huge and may have an even bigger environmental impact than government policy.
The group spoke at length about the growing influence of tech on their investment process. Scoby said that at Magnetar, they often debate whether they are a technology firm or an investment firm (Answer: they aren’t mutually exclusive, so both). To remain competitive, firms must constantly appraise external technology to ensure they are using the best tools available. Doonan said that many asset owners and funds-of-funds use advanced analytical tools to decompose returns to ensure that they aren’t overpaying for beta. Regarding some other more nascent technologies such as blockchain, Doonan said that they have generally stayed away.
Heinz asked how the panel’s investment processes have changed over the past five years. Doonan said that the average hedge fund has not delivered enough return to justify its fee, which has made focusing on specialization and co-investment recurring themes. As far as identifying an attractive strategy for the current market (or alternatively, which should be avoided), Thomas said that in a perfect world, it would be macro, but there are few good macro managers out there. He likes credit-oriented managers and strategies with short books that are delivering alpha. He sees relative value strategies as less interesting right now. Doonan said that his firm generally tries to avoid generalist managers in favor of more niche, specialist strategies, while rates trading strategies look problematic to him.
A lot of the appeal of hedge funds comes when equity markets are challenged, so if the equity beta continues to deliver returns around 10% with lower than norm volatility, hedge funds will be somewhat unattractive. It is very hard to find true alpha, and also difficult to separate skill and luck, which makes advanced analytical tools, careful due diligence, and experienced managers with niche strategies all the more attractive in today’s low rate world.