The Frenchman Jean-Baptiste Alphonse Karr must have been thinking about something besides finance when he mused that "the more things change, the more they stay the same.'' Financially, the more things change, the more things really change. Just a few years ago, we thought diversified portfolios would protect investors. We thought markets were efficient. We assumed consumers behaved rationally.
The 2008 crisis led to lots of rethinking about finance and investing, including rethinking hedge funds and the role they can play in both institutional and individual portfolios. To wit, and contrary to their reputation, we now look to hedge funds to provide sophisticated risk management for institutions. At the other end of the scale, we see the marketing of hedge funds moving to a new level, making them more accessible to retail clients. Thanks to the introduction of "liquid alternatives,'' a hybrid of mutual funds and hedge funds, and to less restrictive rules under the JOBS Act, investment advisors no longer have to buy expensive databases or hire consultants just to ferret out the names of hedge funds.
As they have undergone this transformation, hedge funds have left their gunslinger image behind. Increasingly, they offer transparency so their investors can monitor positions. They take governance seriously, appointing outside directors who represent the interests of investors. Their operations are evolving to meet the demands for higher-quality reporting and infrastructure. What these changes mean is that hedge funds can now play an important part in portfolio construction. It's an opportunity that investment advisors should consider.
Hedge funds were originally boutique investments for the very rich—secretive pools whose managers swung for the fences with abandon and turbo-charged their long-short portfolios with leverage. Even when they were adopted in the 1980s by college and university endowments, it was for their skill in beating the market benchmarks, what the industry calls "alpha.'' Once the news got out about Yale and Harvard's success with hedge funds, pension funds jumped on board, with big institutional investors like California Public Employee Retirement System leading the way in the early 2000s. Money poured in through 2007 as institutions tried to match those outsized returns.
Then 2008 hit and there was nowhere to hide. U.S. private pension funds, to pick a proxy for the damage done to portfolios, suffered real losses of 26.2%. While the 2008 crisis will supply topics for Ph.D. dissertations for years to come, not all of them will be gloomy; 2008 provided valuable lessons.
"Out of the ashes emerges a new phoenix of financial innovation. That's really the nature of progress," as Andrew Lo, professor of finance at MIT Sloan School of Management, put it in a recent CFA Institute magazine interview.
Today, hedge funds' assets under management total $2.3 trillion, an amount that surpasses their pre-2008 record of $1.9 trillion. It's still only a fraction of the $64.2 trillion of AUM worldwide, but more important than their AUM is the way hedge funds are now regarded. Once small tributaries to the river of finance, hedge funds are now a major source of innovation and solutions.
It makes sense. From the beginning, hedge funds have attracted some of the brightest minds in the investment business, lured by the chance to make millions or billions, thanks to their compensation model. Only Silicon Valley start-ups can match the opportunity to create fortunes as fast. But a bifurcation is taking place between small and large hedge funds. Because smaller hedge funds can be more nimble and their managers are perhaps hungrier, they tend to pique investor interest.
But one surprise is that a certain kind of innovation is coming from larger hedge funds. These are the $1 billion-plus funds that have developed some of the most sophisticated risk management tools in finance today. For these hedge funds, it's not about individual "genius'' managers anymore—it's about avoiding losses. Of course, there's irony in viewing hedge funds as risk control experts, but if necessity is the mother of invention, credit the cascade of institutional money for driving the risk management process. It's one thing to strive for absolute returns in a classic long-short equities hedge fund with $200 million in assets. It's quite another to handle $81.9 billion at Bridgewater Associates or $43.2 billion at Man Group or $39.7 billion at Brevan Howard Capital Management, to pick the world's three largest.
