Can Factor Investing kill off the Hedge Fund?
This was the subject of The Big Read in the Financial Times on 22nd July and it sparked my interest. However it is not a new story. Over the last decade we have been explaining to our clients how the industry has become increasingly commoditised over the last 30 years – what used to be expensive and complex is quickly becoming cheap and simple.
I recommend reading a recent Financial Times article which can be accessed by clicking here. (However, a FT subscription may be necessary to open.)
The commoditisation of the traditional long only equity strategy
When my father was a boy the main way to gain exposure to the financial markets was via a stockbroker who would buy and sell securities and charge a fee.
The active fund management industry as we know it today, grew out of changes to the market structure following the Financial Services Act of 1986 and the privatisation of former publicly owned industries. This attracted a wider audience to the financial markets and the prospect of returns which professional money managers sought to deliver either directly or via a mutual fund. These managers earned respect for their perceived ability to navigate market conditions and deliver market beating performance for their clients.
During this time academics also began researching a relatively new academic field now called Financial Economics. These academics sought to understand the sources of investment returns.
During the 80s and 90s, Vanguard, DFA and others created funds that employed systematic strategies leveraging off the same academic research. These fund companies pioneered the concept of low cost index funds enabling investors to purchase baskets of securities based on different financial metrics. Vanguard bet heavily on market cap weighted index replication (S&P 500) and others such as DFA created factor strategies (Value, Small Cap etc..).
A decade ago, the ‘active management’ industry spent considerable sums of money taking swipes at the birth of the low-cost index fund. However, slowly but surely, the market shifted and the naysayers debating the ‘active versus passive’ debate went quiet.
The majority of the traditional active equity manager’s return can now generally be achieved using a combination of low cost index funds and strategies that systematically explore additional return premia that are empirically proven and academically supported, such as value or small cap. Remember, all investment carries some risk.
The commoditisation of the Hedge Fund strategy
So, we now turn our attention to the commoditisation of the hedge fund strategy and the meat and potatoes of this blog. The way we see it is that hedge funds are encountering exactly the same process as the active managers a decade ago. The hedge fund industry had their day in the early 2000s where they charged a 2% management fee and 20% of profits to generate returns that were not supposed to be correlated to traditional equities and bonds. That was the holy grail of finance – to generate return streams that delivered strong risk adjusted returns that were not correlated to traditional assets – why wouldn’t you pay 2% and 20% for that?
Many investors were unaware of how these hedge funds were generating their returns – were they the smartest guys in the room and hence deserved every penny they earnt? There was (and still is) a mythical god-like appreciation for a hedge fund manager and his ability to ‘spin’ his/her crystal ball. But the question we ask ourselves is whether this is the same mythical appreciation my father had for his stockbroker a generation ago and which we had for the active investment management industry twenty years ago?
In the knowledge that past performance is not an indicator of future performance, over the last decade the academics have begun to understand where the returns of the hedge fund managers have come from and market practitioners have begun to create lower cost fund vehicles to capture these returns. In the same way that Vanguard and DFA have created systematic strategies to obtain exposures to parts of the equity markets, the likes of AQR have done the same within the hedge fund arena.
I recently came across a research piece* written in September 2007 which predicted the emergence of the low-cost hedge fund index fund:
….the notion of “hedge-fund beta”…… is now a reality. The fact that the entire class of long/short equity strategies moved together so tightly during August 2007 implies the existence of certain common factors within that class. Although more research is needed to identify those factors (e.g., liquidity, volatility, cashflow/price, etc.), there should now be little doubt about their existence. This is reminiscent of the evolution of the long-only index-fund industry, which emerged organically through the realization by most institutional investors that they were all invested in very similar portfolios, and that a significant fraction of the expected returns of such portfolios could be achieved passively and, consequently, more cheaply. Of course, hedge-fund beta replication technology is still in its infancy and largely untested, but the intellectual framework is well-developed and a few prominent broker/dealers and asset management firms are now offering the first generation of these products. To the extent that the demand for long/short equity strategies continues to grow, the increasing size of assets devoted to such endeavors will create its own common factors that can be measured, benchmarked, managed, and, ultimately, passively replicated.
*What Happened To The Quants In August 2007? Amir E. Khandani and Andrew W. Lo
At MASECO we don’t often make predictions but in our opinion we predict that systematically replicated hedge fund strategies will become more mainstream and cost should drop, putting pressure on the hedge fund industry. These strategies are not new; they should have their time in and out of the sun but will become standard components even of private client portfolios, just as hedge funds promised to be twenty years ago.
Risk Warnings and Important Information
The value of investments can fall as well as rise. You may not get back what you invest. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
The above article does not take into account the specific goals or requirements of individual users. You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy.
MASECO LLP is authorised and regulated by the Financial Conduct Authority for the conduct of investment business in the UK and is an SEC Registered Investment Adviser in the USA. MASECO LLP trades as MASECO Private Wealth. It is a partnership registered in England and Wales and has its registered office at Burleigh House, 357 Strand, London, WC2R 0HS. MASECO Private Wealth is not a tax specialist. We strongly recommend that every client seeks their own tax advice prior to acting on any of the strategies described in this document. This document does not constitute and should not be construed as investment or any other advice. The information contained herein is subject to copyright with all rights reserved.