New standards dampen hedge fund performance

Regulation and institutionalisation of hedge funds has contributed to mediocre returns, but investors prepared to deviate from the crowd should be able to find strong performers, says Hugh Forward, managing director of New York-based Cross Border Alternatives.

Hedge fund investors “want the latest and greatest and hottest thing in Asia”, notes Forward. Inevitably this leads them to the region’s billion-dollar funds, which are not always the best-performing strategies.

Few investors are interested in Asian managers that have been around for seven or eight years, have invested through several market cycles and have good returns but are only running a few hundred million in AUM. "They think there must be something wrong with them," says Forward.

An industry veteran who co-founded US fund of hedge fund Cadogan Management, he set up Cross Border Alternatives three years ago as an advisory firm for high-net-worth families.

While hedge funds are “not a risk-free business, people are trying to turn it into a formulaic business”, he notes. The due diligence process has become standardised, leading to a standard performance by managers that have, on average, underperformed benchmarks.

“If they tick enough boxes, [it’s assumed] the manager has to be good,” says Forward. “That’s why performance is so bad.”

As a result, investors seek the “comfort level” that comes from managers who have spun out of proprietary desks at large investment banks, or large global hedge funds. While they are often billed as star managers, the performance of such funds in Asia has so far been less than stellar.

They are also different to the sector’s pioneering managers. “At the start of the hedge fund industry, the funds were run by very special people,” says Forward.  “The average hedge fund manager [now] is smart, but not really special.”

He adds: “You need to kiss one million frogs” before finding one that’s special.

The talented managers of yesteryear are now managing their own money as they “don’t want to deal with all the regulations that have been put in place to protect investors”, notes Forward.

He cites George Soros, who closed down his hedge fund last year and returned money to external investors.

Forward believes there are allowances that both investors and managers can make that would spur more allocations to hedge funds and better performance.  

“I wish [investors] would tolerate longer lock-ups,” particularly in strategies specialising in distressed or smaller mid-cap equities, where assets are less liquid. You’ve got to give the manager more flexibility to enable him to operate more efficiently."

Most funds nowadays offer redemptions with 30 days’ notice, although a few of the more experienced managers in Asia are asking investors to commit to 1-3 year lock-ups.

Managers in the region have offered lenient liquidity terms, usually to attract investors. However, this backfired during the financial crisis, when some large hedge fund managers, particularly in the US, gated their funds from redemptions. Many counterparts in Hong Kong did not and as a result “it became the world’s ATM”.

Investors that are seeking highly liquid and long-biased vehicles “should be in mutual funds, which are a good option”, suggests Forward.

Instead of offering lenient liquidity terms, managers should be more flexible in their fee structure, which has an industry standard of 2% for management and 20% for performance.  

“How do managers feel justified charging two and 20 when returns have been bad? That’s a basic failure of economics,” says Forward. “How about deferring the [incentive] fee until the client leaves the fund?

“Managers have to come up with more innovative fee structures,” says Forward, adding that family office interest in hedge funds “would be huge” if they did.

The client base of Cross Border Alternatives largely comprises US family offices, and those who want exposure to Asian hedge funds tend to prefer those with managers based in New York, he says. “Investors want to pop in and see how their money is doing.”

Proximity is just one issue, with US family offices generally lacking a “cultural understanding on how the market works” in Asia, he notes.

“More American family offices need to find people who have local knowledge or business relationships to take them on overseas trips – not only to meet the managers, but to understand the culture,” says Forward. “It makes for a better relationship between the managers and the family offices.”

The hedge fund industry is going through a turning phase where investors and managers will need to better align their interests. “The industry will have to struggle before it can grow,” says Forward, “but it will be for the best in the long term."