Funds: The state of hedge funds

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on December 25, 2017 - December 31, 2017.
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The most common thing people ask me when I tell them I am a hedge fund manager is, “What are you hedging against?” or “Are you like Leonardo DiCaprio in The Wolf of Wall Street?”

I find this rather funny because the constant misconception people have about hedge funds in general in Malaysia is that they are either extremely risky or that they do not know much else about it. I guess the lack of awareness among investors in this country is due to a dearth of competition for absolute return products in the funds space.

Many of the sophisticated individual investors or institutional investors that are aware of hedge funds or alternative investments tend to transact overseas with our neighbours in Singapore or in Hong Kong.

What a lot of people do not know is that the hedge fund industry has over US$3 trillion in assets under management (AUM) globally and this figure is expected to grow at 10% next year.

Outside Malaysia, it is an industry that has been thriving over the last 

40-odd years and has produced some exceptional money managers such as Ray Dalio, Carl Icahn, James Simons and hedge fund cult hero Warren Buffett.

What many may not realise is that Buffett originally started, practised and mastered one of the many hedge fund strategies in his early days during the Buffett Partnership in the 1960s. Since then, the hedge fund world has evolved tremendously over the last 10 years or so, with competition in this space heated due to the demand from high-net-worth individuals and institutions for highly talented investment managers. It is an industry where only the fittest survive, with a recent survey by one of the top hedge fund research houses showing that only two out of every 10 hedge funds survive past the five-year mark.

Having said that, the industry in the last two years or so has experienced such negative publicity especially at the start of 2016, with many hedge funds hampered by poor performances and miserable returns.

Many investors questioned the sustainability of these funds, considering its high fee structure and poor returns. By the end of 2016, over US$110 billion in AUM was pulled out from hedge funds due to the reasons above. Fast forward to this year, we have seen a sudden resurgence in hedge funds where performance in 2017 has recovered, with many of the managers having met or beaten their own targeted returns for the year.

Much of this outperformance from hedge fund managers of late can be linked to the overall record highs in the global equity markets, although there are certainly a few exceptional managers that have achieved alpha due to their ability to better understand and read the markets.

With net returns of over 15%, I would think that most investors would be very happy. However, the challenge that lies ahead for most hedge fund managers would not be so much when underperformance or poor returns kick in, but the high fee structure that remains.

This has always been the most contentious point within the industry. 

Clients that have not enjoyed the impressive returns produced by top hedge funds will most likely be very frustrated and typically withdraw within a certain timeframe to more cost-efficient products available in the market.

With the recent flood of index funds or exchange traded funds (ETFs) in the market, many investors are resorting to low-cost fee structure funds that may not necessarily produce returns over and above the market. However, because it is cheap, we have seen a big move, especially with the institutional money going from hedge funds to low-cost index funds.

Competition for capital will certainly to be one of the biggest challenges for hedge funds all around if and should their returns be subpar. Next year will certainly be an interesting one for funds in general with equities at an all-time high and with interest rates on the rise across the markets, how a hedge fund performs in this type of environment will make or break it.

Devan Linus Rajadurai is co-founder, CEO and chief investment officer at MTC Asset Management (M) Sdn Bhd