Hedge funds in the 1990s and 2000s were touted as the darlings of Wall Street, attracting trillions of dollars in assets under management. Then, from 2018 to 2019, evidence mounted that hedge fund managers might be the captains of a sinking ship, one that had already struck an iceberg and couldn't take on much more water.
Fast forward to 2021, and hedge funds weathered the recent volatility of 2020 remarkably well, particularly considering the 2020 financial crisis. Thus, hedge funds are, once again, making their mark on Wall Street. These ups and downs lead us to ask: will hedge funds still be around in 10 years?
- Once high-flying alternative investments, hedge funds lagged behind much of the market over the past several years.
- More recently, however, hedge funds have proved resilient throughout the volatility caused by the 2020 crisis and are attracting significant investor attention.
- Overall, the consensus is that hedge funds will continue to grow but will adapt to lower fees, greater use of technology, and increased access to retail investors.
Understanding Hedge Funds
It isn't easy to claim hedge funds are dying out or thriving because hedge funds don't really have a set definition. The Securities and Exchange Commission (SEC) says the term "hedge fund" first popped up in 1949 but that the term "is not statutorily defined." The SEC gives "selected definitions of a hedge fund," but no universally accepted meaning. The International Monetary Fund (IMF) argues hedge fund-style instruments have been around 2,500 years and tries to define them with four attributes: a focus on absolute (rather than relative) returns plus the uses of hedging, arbitrage, and leverage.
This general strategy of hedge funds, so defined, is clearly not dying out. Plenty of successful investment vehicles use hedging, arbitrage, and leverage. Plenty of successful fund managers are compensated based on performance, not on a fixed percentage of assets.
For simplicity and clarity, today's hedge funds can be grouped by a few characteristics: they are privately organized as investment partnerships or offshore companies; they are subject to less regulation; and they build their investor bases with high-net-worth individuals (HNWIs) and institutional investors.
Hedges are not likely to go away, and it seems increasingly likely that the 1980s- and 1990s-style hedge fund management will adapt to survive more volatile times.
How Hedge Funds Have Weathered Recent Volatility
According to Hedgeweek, investor allocations to hedge funds fell for the third consecutive year in 2020. EY reported in its annual "Global Alternative Fund Survey" that in 2018, hedge funds made up 40% of allocations. That figure dropped to 33% in 2019, and to 23% in 2020. Why was there such a steep decline?
For several years, according to EY, other investments have shown better performance than hedge funds, such as private equity (e.g., venture capital), real estate and, credit. Nevertheless, although hedge fund strategies have shrunk as a proportion of investor portfolios, they exhibited impressive outperformance during the crisis in 2020. Painting an even more rosy picture for hedge funds, Preqin’s "Future of Alternatives 2025" study predicts that hedge funds will surge over the next few years as actively-managed hedge fund strategies perform well in a volatile environment.
The Effect of the Coronavirus Epidemic
The coronavirus epidemic changed the work practices of fund managers. Portfolio construction, investor engagement, due diligence, and talent acquisition were all curtailed as business waned and more people worked from home or not at all. The result was that alternative investment managers relied on technology, automation, digitalization, and outsourcing to serve clients. According to EY, “the strength in operations during this uncertain period has shined a light on future possibilities via enhanced investment and leveraging of data, technology, and remote working capabilities, resulting in many managers re-imagining the future work environment.
This factor is encouraging the optimistic outlook for alternative investments and hedge funds. Particularly, EY reports that investments in environment, social, and governance almost doubled over the past year. This is a growing area for investment that is gaining visibility partly due to the social problems that have come increasingly to light during the epidemic—for example, inequality and racial bias. However, EY’s survey also found that although diversity appears to be a priority of corporations, less than 25% of hedge fund managers consider improving ethnic and gender diversity one of their top three priorities.
Besides ESG, another cultural phenomenon that gained steam during the pandemic is the democratization of investing online. That is how meme stocks and meme crypto tokens emerged to invest contrary to what hedge funds shorted. GameStop and AMC are two high profile stories about hedge fund bets gone wrong and their losses experiences at the expense of the crowd.
The Next Decade for Hedge Funds
What does the next 10 years look like for hedge funds? The recent technology disruption and global pandemic have shown the hedge fund industry to be highly adaptable and resilient. Tom Kehoe, Global Head of Research and Communications for the Alternative Investment Management Association (AIMA), sees two trends emerging regarding hedge funds over the next few years.
The first is that hedge funds will respond to the demand from investors and policymakers to incorporate sustainability, climate change, and social concerns into their investment products. The second trend is that hedge fund firms will increasingly use technology, such as machine learning, big data, and ultra-high frequent trading (HFT). Technologies like these may lower costs because technology is more efficient and less expensive than human employees.
Another possibility is that there may be a loosening of restrictions concerning who is allowed to invest in hedge funds. To date, most funds require large (often six figures or more) initial investments and are only able to accredited investors and HNWIs. However, lower barriers to entry are already on the horizon with publicly traded hedge funds and retail-oriented funds that have far smaller minimums.
In quantitative terms, Preqin predicts that global alternative assets will remain the second-largest alternative asset class after private equity and will reach $4.3 trillion by 2025. A senior research associate at Prequin stated, “Hedge funds proved their risk mitigation strategies through the pandemic-induced market crash this year, reminding investors why hedging is valuable.”
The CFA Society of New York, which cohosted an event with the AIMA in October 2020 called "The Future of Hedge Funds,” concluded the following: "Hedge funds offered a unique and valuable way for investors to access strategies, returns, and alpha that are not typically accessible through more traditional structures, such as long only, and are highly accretive to more traditional portfolios. Though incentives are currently aligned, there is still room for greater alignment between general and limited partners, and the hedge fund industry continues to move in that direction.