A countless amount of ink has been spilled on the topic of hedge funds in the past 5 years. Critics argue that hedge funds suffer from lax regulatory oversight, opaqueness of information and poorly defined mandates. But this view assumes a hedge fund is simply an unregulated investment entity using a myriad of possible strategies from traditional long-only public equities to quasi-private-equity. As a result, it misses the bigger picture about hedging. For all their real and imagined faults, hedge funds have done one thing very well – they have focused investors on alpha and shone a harsh light on the growing problem of index hugging in active management. It is this unique quality of hedge funds – and the fundamental industry changes it will bring about – that will be the lasting legacy of the recent “explosion” in the hedge fund industry.
Industries change incrementally as business processes are improved over time. For example, money management has become more efficient through scale, operational improvements and marketing acumen over the past 30 years. However, the basic business model has remained the same.
But occasionally, new technologies disrupt this pattern and lay the foundation for a fundamental re-organization of industry value propositions. These “disruptive technologies” often disintermediate existing value chains and enable customers to purchase a la carte, assembling totally customized products.
The Internet is one such technology. It had a profound and irreversible effect on, among other things, the travel industry. The Internet allowed customers to assemble their own vacations online, rather than relying on a travel agent to do so on their proprietary reservation systems. This forced us to ask the fundamental question, Why travel agents?
Hedge Funds and ETFs are another example of a “disruptive” technology. As distinct sources of alpha and beta, they essentially amount to “off-the-shelf” components that allow investors to build their own mutual funds rather than buying what amount to “pre-packaged” alpha/beta combinations. Hedge Funds & ETF (and ETFs’ brethren futures and swaps) force us to ask the fundamental question, Why money managers?
Of course, there are good answers to both of these questions. Why travel agents? For their advice, not for the (commodity) reservation system. Why money managers? For their alpha, not for the (commodity) ETF embedded within their portfolios.
But recent research has shown mutual funds are becoming closet indexers. Like travel agents at the dawn of the Internet, that puts active managers in very risky position. The amount of risk faced by traditional long-only money managers is determined by the proportion of the manager’s volatility explained by a simple ETF. The remaining, unexplainable, volatility is analogous to a market neutral hedge fund. In fact, an active mandate can be effectively parsed into a market ETF and a market neutral hedge fund.
Ergo, for mutual funds to survive, they must begin to think like hedge funds. This does not mean they must take more risks, but they must reduce their benchmark correlation and provide more alpha. If they do not then, like the travel agents, they may be accused of charging boutique prices for a commodity service. The good news is that all funds, from value funds to growth funds and resource funds, are on a level playing field in this new paradigm.
How will this new paradigm have a fundamental impact on the structure of the money management industry in the future? Again, the birth of the Internet provides some valuable clues. During the initial years of the World Wide Web, a plethora of “dot-coms” emerged. These were often just Internet versions of traditional “bricks-and-mortar” business models from toy retailing to golf tee-time booking. They argued that you could do it all online – that the “old-economy” was dead. Old economy firms initially charged that the Internet was a fad that would not catch on.
However, most of these “pure-play” Internet business models lacked customer relationships, operational sophistication, and scale. Over time, many of them failed or were bought out. In their place emerged “clicks-and-mortar” business models that integrated the Internet into traditional off-line business models. These new hybrid business models recognized the fact that the Internet could be an integral part of their overall value proposition – not a distinct industry and competitive threat.
Like the Internet during its early years, hedge funds are often viewed as a new and distinct industry – a competitive threat to traditional money management. Money managers have self-identified with one of two mutually exclusive camps: (pure play) hedge funds or traditional managers. The hedge funds argue that you could put all of your money in their funds – that traditional long-only investing was dead. Traditional long-only managers countered that hedge funds were a fad that would not catch on. (sound familiar so far?)
But sophisticated institutional investors have begun to see that hedge funds are the perfect complement – not a competitive threat – to traditional investing. This has caused leading-edge money managers to either purchase pure play hedge fund managers or to launch their own hedge funds. These hybrid managers have become the “clicks-and mortar” businesses of the investment revolution.
Currently, what’s old is new again. The media’s robber-baron du jour has changed from the “dot-com millionaire” to the “hedge fund millionaire”. Recent MBA graduates fight for hedge fund jobs, not dot-com jobs. The foosball tables have been moved from the dot-com staff lounges across the street to the hedge fund trading floor. Society columnists have relocated from the Bay Area to Manhattan to chronicle the excesses of the young and restless. The old Internet “incubators” have given way to hedge fund seeding operations. Their armies of sleep-deprived eggheads who pumped out computer instructions have been replaced by legions of caffeine-dependent alpha males pumping out trading instructions.
But if history is any guide, all of this will change in the next 5 to 10 years as the hedge fund industry is absorbed into the greater investment industry. The fundamental changes that this will bring about – not the dramatic “blow-ups” and calls for greater transparency – will be the lasting legacy of the hedge fund revolution.