THE POINT

December 23, 2019 Tanya Williams, CFA Head of Manager Strategy Research

What’s the Point?

• funds are heterogeneous investments that should not be looked at through a single lens. • should pay close attention to objectives and risk tolerances when selecting hedge funds for portfolio constructions. • Opportunities continue to exist in investing despite several high- profile fund liquidations.

The Long and Winding Road of Hedge Funds

Appaloosa Management and Moore Capital, two titans within the hedge fund industry, made headlines in 2019. Readers might have expected to learn of their exemplary performance, but instead read about their founders’ decisions to return capital to outside investors and convert their respective businesses into family offices.

It’s not uncommon for hedge funds to close, only to be replaced by newly launched funds. In fact, nearly 50% of hedge funds will not survive beyond five years. So, why are these fund closures worthy of newsprint? What makes Appaloosa and Moore remarkable is that they have achieved investment histories of 26 and 30 years, respectively, with commendable track records. Do the closures of two preeminent investors signal the end of hedge funds? Probably not. This isn’t the first time founders of high-profile and successful hedge funds have returned capital and closed their funds. Stanley Druckenmiller’s Duquesne Fund closed in 2010, George Soros’ Quantum Fund closed in 2011, and BlueCrest and Standard Pacific closed in 2016.

Historically, the number of hedge funds in the market has expanded and contracted multiple times. In “A Primer on Hedge Funds” (1999), William Fung and David Hsieh explain that hedge funds were relatively obscure until 1966. However, soon after Fortune magazine wrote about the success of Alfred Winslow Jones’ hedge fund strategy, private wealth investors almost immediately began requesting them. Consequently, the investment industry experienced a proliferation of hedge funds from 1967 to 1968, followed by a decline in the fund count due to the bear markets of 1969 to 1970, and 1973 to 1974. Eventually, hedge funds would regain their appeal, growing exponentially from the late 1980s until the global financial crisis of 2008. The number of active hedge funds grew around 17%, while net asset flows increased 24%, annually. THE POINT

Fund closures are often due to poor performance. Numerous academic studies have documented a correlation between fund flows and fund performance. Inflows reflect positive recent performance, while outflows reflect negative recent performance. However, the relationship is non-linear. Additional factors such as manager , perceptions, market conditions and fund characteristics -- such as managerial incentives, past flows and liquidity -- can also influence flow levels. Chart 1 illustrates the change in number of active hedge funds, launches and liquidations from January 1990 to September 2019, overlaid with hedge fund performance, as represented by Hedge Fund Research, Inc. (HFRI) Fund Weighted Composite Index. The chart shows the number of liquidations rising as the average annual return of hedge funds trended downward from 2004 to 2007.

Lately, investors have been less enamored of hedge funds. Instead, more and more investors have chosen to embrace strategies. And why not? Beta strategies have generated impressive returns as the result of an extended bull market that keeps going up. Since the bottom of the global financial crisis (April 2009), S&P 500 and MSCI World indices returned +15.76% and +12.23% as of September 30, 2019, respectively. Comparatively, hedge funds, represented by HFRI Fund Weighted Composite returned +5.29%. The lag in performance and liquidity concerns have resulted in capital exiting this part of the market. In turn, investors have reallocated capital to cheaper, passive investments, like exchange-traded funds. In addition, institutional and private wealth investors are allocating capital to private investments with the expectation of larger returns. This trend prevails as investors believe the prolonged bull market’s reign is likely to end in the near future and public market returns will contract. In addition, companies are staying private longer. Therefore, investors are drawn into private markets in order to capture capital appreciation gains earned during a company’s early growth stage.

In addition to performance, there are other reasons why a fund manager may decide to close-up shop. As the hedge fund industry has grown in size, it has also evolved. Since institutions have become the dominant hedge fund investors, regulations have intensified, pushing for greater transparency and increasing the cost of compliance; and fees have Page | 2

THE POINT compressed. These changes have challenged the original business practices of hedge funds and forced structural shifts. Also, the industry’s growth has coincided with an investable equity universe that is shrinking, creating overcrowding for some. Lastly, a tough macroeconomic environment has challenged managers’ investment processes. From a hedge fund manager’s perspective, the climate has become more onerous and less profitable. From an investor’s perspective, hedge funds have failed to keep pace with the market, while charging a lot. The result of these two forces has been a decline in number of active hedge funds.

SHOULD I STAY OR SHOULD I GO?

Investors expect hedge funds to deliver competitive performance under all market conditions. The expectations are based on investment managers’ latitude to employ dynamic trading strategies and leverage. In contrast, traditional portfolios rely on static buy-and-hold strategies and rarely if at all apply leverage. Perhaps, instead of focusing solely on beating the market, it would be prudent to pay closer attention to whether or not a hedge fund delivers what its manager initially promised. Investors should expect to receive different benefits depending on the strategy type employed. Some are return enhancers, while others are diversifiers. Therefore, investors should avoid looking at long/ equity, , relative value, credit, etc. through a single lens, and instead consider their behavioral differences. It’s important to know investor’s objectives and risk preferences when building a portfolio. For instance, are occasional losses acceptable? What is the target volatility? Are uncorrelated investments optimal? How correlated are the existing investments? Chart 2 shows the correlations between the HFRI Fund Weighted Composite, HFRI Equity Hedged, HFRI Macro and the S&P 500. The correlations vary based on strategy type and market environment. Understanding the differences adds value to the portfolio construction process.

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THE POINT

Hedge funds behave like most other industries in an open market environment. First, there is product innovation based on an unfulfilled need; second, growing demand creates extraordinary profits; third, new market entrants eventually compete away the profits; and fourth, low profitability drives away high-cost producers or underperformers. The process repeats itself in another part of the market where opportunities arise. Andrew Lo, finance professor at MIT Sloan School of Management, refers to the hedge fund industry as the Galapagos Islands of the financial sector. There is innovation, adaptation, competition and natural selection.

In truth, although a roster of superstar fund managers has decided to return capital, they haven’t completely left the field. They have chosen to migrate to a structure that mitigates SEC regulations and gives the managers all the flexibility they could possibly want to earn profits. Furthermore, the void created by their departure will soon be filled by many zealous, emerging managers. Further proof that opportunities still exist in hedge fund investing.

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FIELDPOINT PRIVATE INVESTMENT OUTLOOK

• The yield curve (10yr Treasury yield minus 1yr Treasury yield) is no longer inverted following three rate cuts in 2019 by the FOMC. The 1.75% federal funds target is in-line with 2020 consensus estimates for U.S. real GDP growth of 1.80%, inferring policy rates are neutral. Inverted yield curves transitioning to a positive slope historically have signaled recessions. • Global financial conditions are the easiest they have been since 2014. Global money supply is accelerating 2.0% on a six-month rate of change. U.S. M2 is expanding at 5.6% y/y. The FOMC re-introduced QE and the Fed’s balance sheet is once again above $4 trillion. The Eurodollar futures curve is steepening, but remains inverted, implying the market expects one more policy rate cut is ahead. • 2020 U.S. nominal GDP growth is projected to be 4.3%, consisting of real GDP growth of 2.3% y/y plus core inflation of 2.0% y/y. Fieldpoint Private’s 2.3% real GDP growth estimate is above consensus forecast of 1.8% and reflects favorable impacts from (i) a weaker dollar, (ii) recovery of the global manufacturing sector, and (iii) a decline in global economic policy uncertainty. • Fieldpoint Private estimates 2020 S&P 500 earnings of $173/share versus Wall Street’s consensus estimate of $182/share. The current S&P 500 Index level infers 10% y/y EPS growth, which is unlikely in an economy growing at only 2.3% y/y. • Our fair value trading range for the S&P 500 Index is 2725-3250. • Our fair value trading range for the 10-year Treasury note yield is 1.65%-2.30%. • Credit markets will likely signal the end of the business and market cycle before the . There are few signs of market stress as credit spreads remain tight for investment grade and high-yield (except energy). Our capital market expectations (CME) are forward-looking asset return expectations (seven-year compounded rates of returns) that are updated annually. CME estimates

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THE POINT

About Fieldpoint Private

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