Is it time for portfolio managers to hedge?

A Wall Street sign. (VladLazarenko/Creative Commons)

By Lucy Ren

Shirley Luo, 29 years old, has been with Goldman Sachs since 2007. A vice president in the distressed-debt trading group, Luo recently quit the prestigious company this year, to join a start-up hedge fund.

Luo’s career change is not unique in the investment banking industry. She said six or seven in her group have quit the New York-based company recently. The main reason? Tighter regulations on the industry, Luo said.

It’s the feared Volcker Rule, finally kicking in.

The Volcker Rule is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed after the 2008-2009 financial crisis. It bars banks from proprietary trading, or trading securities for their own account, deemed a practice that does not facilitate the liquidity of banks or provide any benefit to their customers. The law also requires banks to maintain a much higher capital ratio, the measure of a bank’s capital to its risk exposure.

The rule will take full effect on July 21. Banks have been transitioning into a business model adjusted for the tight control of the Volcker Rule. In the past year, big investment firms like Citigroup and Morgan Stanley have experienced a lot more limitation in their retail departments as regulators strive to prevent them from affecting the banks’ depository function, Luo said.

“Overall, the business model is changed,” Luo said. “And it also changed how you are incentivized to do business.”

But there’s more than just the Volcker Rule that’s inducing investment bankers to leave for hedge funds, even brand-new ones that have no track record and thus no job stability. 

The “Human Alpha”

To Brian Shapiro, CEO of Simplify LLC, a New York-based firm that specializes in financial services for such “alternative funds” as hedge funds, the “human alpha” is what investors are really after. “No one cares about the fund,” Shapiro said.

He opined that the “turnarounds and redemptions” in the investment world are just “a recycling of cash,” meaning that although certain strategies may fade in and out over time, investors always want a certain level of exposure to risk. Therefore, he explained, managers shift their strategies from equities to fixed income, or emerging markets to emerging Europe, “and that’s all cyclical—performance goes up and down every day, but smart investors know how to track the best managers and retain the talents.”

Market timing

Another factor seen to be favoring hedge funds is market timing. That’s crucial for Luo’s recent career decision. Based on a seven-year economic cycle in the U.S. and a particularly bullish equity market last year, Luo anticipates higher levels of volatility and fluctuation in the coming year, the seventh year after the financial crisis. Believing that history repeats itself, Luo sees greater opportunities in hedge funds, even new ones, which can go short as well as long.

“Startup takes time. If you are optimistic about the volatility next year, you’d want to be ready for it early,” Luo said.

Fed-watching and correlations

Another reason for investment professionals’ favoring hedge funds: Picking promising categories of investment assets has changed since the Great Recession, according to Nicholas Colas, chief market strategist at the New York-based brokerage ConvergEx Group LLC. Returns of different classes used to vary, but now, he said, “correlations have been driven much higher because the market is so focused on the Fed—everything moves around the Fed psychology now.”

The shift in market correlation after the financial crisis has pushed asset owners and managers to seek alternative investments to improve performance, in other words, to lower the correlations among different classes of investment assets, Colas said. Hedge funds, of course, are free to explore those alternatives.

This desire to break away from Fed-induced correlations helps explain the current fixation on the Fed’s next move. After six years of near-zero short-term interest rates, market watchers are paying especially close attention to what the Federal Reserve has to say. Among economists and central bankers as well as asset managers, debates about when to raise the federal funds rate, the interest rate at which banks charge each other overnight, have never been so heated.

Hawkish members of the Federal Open Market Committee like St. Louis Fed President James Bullard are losing patience. “A risk of remaining at the zero lower bound too long is that a significant asset-market bubble will develop,” he said in prepared remarks in Washington on Wednesday.

Hedge fund launches

As a result of these various factors, the number of hedge fund startups may be turning upward.

The spread between hedge fund launches and liquidations has been steady since 2011. (Hedge Fund Research Inc.)
The spread between hedge fund launches and liquidations has been steady since 2011. (Hedge Fund Research Inc.)

Hedge fund launches totaled 1,040 for 2014, a decline of 20 funds from the previous year, according to a report of Hedge Fund Research Inc. But hedge fund liquidations also declined last year, to 864. The number of launches peaked at 2,073 in 2005 and troughed at 659 in 2008.

Hedge Fund Research, based in Chicago, reported that hedge funds outperformed the market by almost 1.5 times in the first quarter of 2015, as measured by the HFRI Fund Weighted Composite Index, a series of benchmarks designed to reflect hedge fund industry performance.

The report showed that hedge funds rose only 3 percent in 2014, lacking momentum when compared with the bullish market represented by the Standard & Poor’s 500 Index’s 14 percent gain, and the average mutual fund’s return of 4.7 percent, according to an analysis by the Chicago-based investment research firm Morningstar Inc.

Hedge funds and mutual funds have mostly underperformed the market since the Great Recession. (Morningstar Inc, HFR Inc, Lucy Ren/Medill)

The outlook

So, if investment professionals are being drawn to hedge funds, what’s their outlook for 2015?

Both Shapiro and Kenneth Heinz, the president of Hedge Fund Research, see an improving environment for hedge funds.

“People are now more willing to invest in small to mid-sized hedge funds instead of only large hedge funds,” Heinz said. This trend shows him an increase in investors’ risk tolerance, which is favorable to hedge funds new launches.

Similarly, Shapiro said investors now have a “healthy amount of appetite for uncorrelated products like hedge funds.”

Still, big institutions have most of their assets in fixed income and equities. “Hedge funds are just another slice of their portfolio pie.” Hedge funds as a percentage of the overall growing U.S. assets stagnated at 8 percent to 10 percent after the financial crisis in 2008.

Looking back at 2014, Heinz said the hedge fund industry has benefited from rising opportunities outside the U.S., especially in China and Europe, and the exposure to the currency and commodity markets. “But returns have been more pedestrian,” he said, urging investors to be more selective.

These commentators see opportunity in recent market volatility. Speaking Wall Street-ese, Heinz, said, “The equity market beta has become the dominating strategy in the past three years.” Beta is a measure of volatility in prices or trading. Heinz said the high volatility last year has made it “normal for the S&P 500 to gain 2 percent in a day and decline the day after.”

The percentage of trading days with high volatility more than doubled in the last quarter of 2014. (Forbes, Lucy Ren/Medill)

The ability of hedge fund managers to capitalize on such market swings can be advantageous. “Hedge funds thrive on volatility,” Simplify’s Shapiro said. Over an economic cycle, he declared, hedge funds prosper more on the downside.

Photo at top: Some of Wall Street’s biggest investment banks are losing talent to hedge fund startups. (VladLazarenko/Creative Commons)