Hedge funds had their best start to a calendar year since before the financial crisis. But, behind the strong figures in the headline, managers are struggling to cope with puzzling movements in the markets.
According to data group HFR, funds rose 6% in the first quarter, on the back of rising equity markets and a strong rebound in the beaten “value” sectors of the equity and credit markets that some funds favor.
Some of the feedback has been mind-blowing. Senvest, helped by a well-timed position in GameStop, gained 67 percent. Crispin Odey’s European Odey Fund, one of the most volatile funds in the industry, is up 56%, and Lee Ainslie’s Maverick Capital, which has hung on to the recovery in value, is up more by 40%.
But other than these numbers, most hedge fund investors haven’t enjoyed such big gains, and many managers’ returns have been much more mundane. For example, equity hedge funds gained 7.1% in the first quarter, based on average performance per number of funds. But that figure is skewed by the large gains from smaller funds. When performance is more asset-weighted, funds grew on average 2.8% more modestly.
And for every manager at the top of the charts, there is a fund that is languishing deep in the red. HFR data shows that the gap between the best performing and the worst performing funds is higher than at any time in the two years leading up to the coronavirus crisis.
“The performance of hedge funds in the first quarter was like [equity] market – indices are very good, but some underlying strategies, or some sectors, have underperformed, ”said Cedric Vuignier, head of liquid alternative managed funds and research at Syz Capital.
A major problem for many managers is that the markets don’t really perform as they normally would expect. Billions of dollars in central bank stimulus, along with the surge in retail investor activity during the pandemic, severed some of the proven relationship between news and price movements that managers have based their systems on.
Take the example of London-based Sandbar Asset Management, which lost 3.9% in its $ 2.4 billion Global Equity Market Neutral fund this year. It highlights the relationship between stock prices and changes in earnings expectations. Normally, and intuitively, an improvement in a company’s earnings expectations should mean that its stock price rises, while greater pessimism should cause stocks to fall.
Instead, that correlation has fallen sharply in recent months “to levels not seen in the past decade,” Sandbar said in an investor presentation. And in industries like aerospace, it turned negative, meaning improving earnings expectations actually pushed stock prices down.
Swedish hedge fund firm IPM has been another victim of a shift in market relations. Once regarded as one of Europe’s top computerized macro-managers trading currencies, bonds and stocks, it has fallen victim to a shift in the market correlations it relies on. Its assets have grown from $ 8 billion to $ 1 billion and the company, owned by financial group Catella, is shutting down, noting that the investment environment has been difficult “for strategies focused on economic fundamentals ”.
All of this adds up to a loss of what industry insiders refer to as “alpha” – jargon for the industry’s “secret sauce”, or the much-coveted extra value managers are supposed to add by betting on them. ‘they take on stocks and other securities.
Alpha is important because it is the main justification that hedge funds use to charge clients their high fees. Beating the markets is difficult, and therefore alpha is rare and valuable. If a hedge fund’s returns come solely from market earnings, rather than the skills of a manager, then why not just buy a cheap index tracker instead?
Sandbar, who admitted his own alpha has been “poor,” cites Morgan Stanley data showing significant negative alpha among his long-short global equity hedge fund clients this year. In other words, making those highly desirable bets made them lose money.
The data also shows that Q1 fund alpha was well below the average generated over the past decade, and well below tough years for hedge fund betting like 2016 and 2018.
Hedge funds have performed well in the market chaos of the 2020s and are still on average in the dark this year. But some managers will nonetheless be worried. If they cannot convincingly show that their well researched and carefully placed bets add value, then clients will wonder why they need to be invested with them.