This article originally appeared here in Institutional Investor on January 31, 2019
Hedge funds are expensive. Would you buy them if they weren’t? If the answer is no — here’s why you might want to reconsider.
When Tim Cook announced slowing iPhone sales at Apple last quarter, analysts ascribed the shortfall to saturated demand at a price over $1,000. Debate turned to how much demand would increase at a lower price and whether higher volumes would offset lower prices and create revenue growth. None of the analysts even considered whether the iPhone had lost its value as a product.
Long-short equity hedge funds, by contrast, are deeply out of favor. During our podcast conversation last year, Adam Blitz, the chief executive and chief investment officer of fund-of-hedge-funds firm Evanston Capital, suggested that the next period of difficult performance for equity markets would prove an important litmus test for long-short equity managers. We saw a bear market in Q4, and the early report card has been mixed.
Almost every CIO I have interviewed on my Capital Allocators podcast has proclaimed they “don’t like long-short in general,” but they do like their managers. That refrain is starting to get old, even for the most long-term oriented stalwarts in the business. When “our managers” have a difficult stretch, or when “ours” retire and return capital, allocators reconsider staying the course.
The distaste for long-short equity is even more pronounced at the board level. The further the degrees of separation between board members and the underlying portfolio of a manager, the more the board leans on outcomes over process in making decisions. Adding a long-short equity manager to a portfolio today is frequently taboo in the board room.
Sentiment around long-short equity funds is so bad that allocators have largely dismissed the product independent of its price. I’ve begun asking allocators a question to reframe how they are thinking about long-short equity funds: Would you significantly increase your allocation if you did not have to pay to your managers? That is, would you invest more if a long-short equity fund cost less than a Vanguard index fund? Almost every allocator thinks before responding; some show interest, but none have leapt out of their chairs to seize the cost-effective proposition.
So would CIOs ramp up their allocation to long-short equity funds if they were paid 5 per cent to invest, instead of paying managers 1.5 per cent & 20 per cent? What about getting paid 10 per cent?
These follow-up questions are often dismissed as unrealistic hypothetical situations. In fact, one CIO contended that if he brought a hedge fund that paid him to invest to his board, the board would dismiss it without consideration — simply because it’s called a hedge fund, and hedge funds are bad.
These answers are monumentally different than they would have been 10 or 15 years ago. Allocators woke up craving the next rising hedge fund star and couldn’t invest enough at high and increasing management fees after the widespread success of long-short funds in the weak equity markets of 2000-2002. Board rooms back then castigated CIOs for not having long-short equity hedge funds in their portfolios.
Both of these extreme views result from faulty thought processes. Evaluating investments is a function of both asset value and price. At a sufficiently low price, every opportunity offers a compelling mix of risk and reward. At a high enough price, almost no asset becomes a worthy investment.
Separating the value of long-short equity funds from their price moves the discussion away from the ubiquitous critique of high fees and towards the merits of the underlying product. Allocators turn to analyzing first principles — the potential for alpha on the long side and short side, the structure of the portfolio, and the transaction costs and borrowing costs to play the game.
Many allocators still disparage the strategy. Fast moving computers, portfolio management around volatility, and a highly competitive market all contributed to recent performance woes and offer reasons to be skeptical even before fees get paid. On the other hand, volatility is increasing, interest rates are normalizing, and large players are cashing in their chips and retiring, mitigating the common critiques.
Still, evaluating the demand for hedge funds necessarily includes fees — and there’s a twist at the end of the story. Stated fees are improving for all investors. Whales like Raff Arndt’s Australia Future Fund can dictate terms to managers, and relative minnows like managing director Donna Snider at the Kresge Foundation see many more fee structures available even from their most desired managers.
More interestingly, the theoretical proposition of getting paid to invest in long-short equity managers is not just a theory.
In higher interest rate environments, long-short equity strategies make money on their short rebate just for showing up. For example, in a 5 per cent interest rate environment like the one we saw throughout the 1990s and 2000s, short rebates pay a manager 4 per cent on their short book. A Vanguard Index Fund may still cost next to nothing, but a long-short equity fund can cost even less when the rebate is factored into returns.
Rates are still low, and the optimal environment for long-short equity is not yet upon us. Those who are positive on the strategy, or just on “our managers,” might want to prepare their constituents for the possibility of better times ahead.
No one questions whether demand would soar for the iPhone at a lower price point. The investment community doesn’t think the same way about long-short equity funds — but maybe it should.