It’s no secret that the hedge fund industry has changed over the last 20 years, but the changes have happened gradually. The most significant change is access to information, and there’s certainly no going back. But there is much more to the story.
Dominique Mielle, author of Damsel in Distressed, the first hedge fund memoir from a woman, looked back on her time at Canyon Partners, which has made a name for itself in the world of distressed investing.
A new environment
Mielle says in an interview that the most significant changes for hedge funds have been the environment in which they operate. She notes that information and data are more widely available now and very cheap;
Data is now distributed to global investors within a nanosecond, a very different world from the late 1990s. The market is very global, with a much higher correlation of asset classes than in the past. She also noted that there are more regulations.
“Regulations have crept up everywhere, so in that sense, the environment for doing business and having an edge is very different than it was in the 90s. Hedge funds themselves have changed, as every industry does.”
A maturing industry
The hedge fund industry has matured and now is the total opposite of what it was in the 90s.
“It’s the opposite of when I started 20 years ago,” she said. “It was a very small industry, small assets versus the market and opportunities, incredibly lucrative in the sense that there were few of us, and they could charge very high fees. If you think of the business in terms of supply and demand, there were a ton of opportunities, arbitrage, mispricing, a lack of information.”
Few people were able to capitalize on the situation, but it’s reversed now. She noted enormous pools of money going after those few opportunities, and many hedge funds look alike with similar portfolios, a similar make-up, and similar ways of doing business.
Mielle notes how much of an impact Regulation Fair Disclosure has had on the hedge fund industry. When she first joined Canyon, information could be disseminated to investors at different times. There was no internet with every company having their own website and publishing their SEC documents, press releases and earnings releases immediately to everyone.
“So you could get an edge having that information,” she states. “And further, if you’re talking about distressed, restructuring and bankruptcies, there were very few funds who had the legal expertise to understand the process. Just to get the information was very expensive and very difficult. You had one website that produced the documents from bankruptcy court, and you paid by the page, which was astronomically expensive, or you could physically go to the court.”
Reg FD leveled the playing field by requiring that information be released to everyone simultaneously. As a result, hedge funds lost some of their advantage against other investors.
One regulation that benefited hedge funds
Aside from Reg FD, there have also been other regulations over the last 20 years, some of which have been permanent and others that came and went.
One regulation that benefited hedge funds temporarily was Dodd-Frank, which stemmed from the Global Financial Crisis. It imposed capital requirements on banks, stipulating a maximum amount of leverage they could have based on their capital. Dodd-Frank constrained banks in terms of their ability to underwrite deals and lend money to risky companies.
“[Dodd-Frank] has played very well for the shadow banking systems and benefited hedge funds greatly because they took the place of banks,” she opines. “A lot of those regulations have been walked back under the Trump administration, or the banks found a workaround.”
Another important part of Dodd-Frank was the risk retention rules. Mielle believes that the legislation imposed stringent constraints on fund managers and was necessary for the large hedge funds to start doing CLOs (collateralized loan obligations) and eliminate the smaller players.
Things that didn’t change
Although much has changed in the hedge fund industry, not everything has. The process that hedge fund managers follow is still the same despite the new environment.
“What I did, didn’t change much, although everything around us changed, she said. “And I think that’s one of the reasons why it’s become very difficult for hedge funds to outperform because the job has remained by and large the same with the same tools, meaning poring over financials, talking to companies, management, companies’ vendors, other investors. And that was pretty much the same thing 20 years ago.”
What still needs to change
Mielle explains that the hedge fund industry might change through two avenues: pushing and pulling. Pushing is when investors demand something like diversity, and hedge funds follow through. She added that this is already happening to some degree, although diversity is still lacking at hedge funds.
David Swensen, known for his time with the Yale Endowment Fund, put hedge funds on the map by including some in the endowment. Mielle credits him with the enormous sizes of hedge funds today. She added that he wrote a letter before his death telling investment managers that they would be ranked not only on performance but also on diversity in their investment team. Mielle believes many investors will pick up that letter and start demanding more diversity.
On the other hand, the pull comes from inside hedge funds.
“I think as long as the business worked, and it worked tremendously for decades, there was little propensity to change,” Mielle opines. “Inside hedge funds, partners have got to be convinced that it would benefit their firm to have a better make-up of investment teams. Whether it’s reading research or understanding what investors want, they need to believe in hiring and promoting women and minorities.”
Why buy hedge funds if they’ve lost their edge?
In recent years, one question that may be on investors’ minds is why it’s worth investing in hedge funds if they can’t outperform the market any longer: This may be an even more important question when realizing that hedge funds have lost their edge. Warren Buffett once bet $1 million that investment professionals couldn’t put together a portfolio of hedge funds that would outperform the S&P over ten years. But there are still reasons to buy hedge funds, but the issue is not so simple.
“There are good reasons and less good reasons,” she said. “I think diversification is a good reason. Now the question is how much should one pay in terms of fees for diversification and how good the diversification is. This is a very valid reason but a very valid question, and there’s actually a study that came out very recently that looks at a traditional portfolio, 50 stocks [S&P 500] and 50% bonds [VBITX], versus an alternative portfolio that has a hedge fund allocation of 20%.”
The study found no return outperformance when introducing hedge funds. However, it improves the portfolio’s Sharpe ratio and volatility, mainly before 2008, so there is some benefit in the risk area. It’s a matter of how much investors should pay for that improved risk profile.
“I would cite another reason that was very interesting and bought to me by the CIO of a large university endowment. He said, ‘Look, I get paid by outperforming the index, so the sure way to not get a bonus is to buy an index. So it’s worth the risk to buy hedge funds to try and outperform the index because if I do, I get a bonus. Otherwise, I don’t.'”
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