A Hedge Fund Renaissance Is Coming: Here's Why

By Jon Caplis, founder and CEO, PivotalPath

Several important quantitative and qualitative indicators point to a very positive decade ahead for the hedge fund industry

Many believe the golden age of hedge funds has passed. When you look at their overall performance on a simple return basis from 1998 to 2007 (Period 1), you can easily see why – hedge funds generated annualized returns of 13.3% - almost double the annualized returns of 7.4% generated between 2008 and 2021 (Period 2). During much of the last decade, many began to wonder whether overcapacity, among other structural changes, may have limited hedge funds’ ability to meet the needs of investors.

When looking at performance in context, speaking with hundreds of managers and our institutional investor client base, and following the data, we are seeing emerging trends that makes this sentiment very far from the truth. In fact, many signs point to a robust decade ahead.

Here are three reasons we feel so strongly this will be the case, and they are not solely related to returns. There are multiple factors at play that influence the attractiveness of hedge funds, which just as importantly, is also reflected in the changing nature of their investor base.

1. Performance was better than you think and remains strong, even against a surging S&P 500

First, let’s put things into context by considering historical hedge fund returns relative to the risk-free rate, which averaged ~3.6% in Period 1 and ~0.6% in Period 2 respectively. Accordingly, annualized hedge fund returns in excess of the risk-free rate drop to 9.7% in Period 1 and 6.8% in Period 2, a difference of 290bps per annum, (though roughly half of the spread based solely on relative returns). If one were to remove 2008 from the analysis, as a unique outlier attributed to the financial crisis, the spread in excess returns narrows to just 140bps per annum.

No matter how you cut it, 1998-2007 outperformed 2008-2021, however, the difference is far less than conventional wisdom would suggest when viewed in the right context.  

Additionally, hedge funds continued to deliver during the recent pandemic-driven crisis. In 2020, our Composite Index was up 11.3% - its best year since 2013 when it gained 14.6%. In the rolling one-year period ending in March of 2021, the Composite gained ~26%, which was also one of the best one-year performance periods dating back to January of 1998.

Even more impressive, 38 out of 40 strategies and sub-strategies that we track generated positive alpha relative to the S&P over the last year – annualizing at 7.4%, one of the best periods of rolling alpha since 2010. This is especially notable given the S&P 500 returned 41% over the same period and demonstrates that hedge funds once again generated unique return streams that institutional investors covet during market dislocations.  

2. Past performance isn’t everything, diversification matters as a forward-looking indicator too

While a recent boost in performance is important, that alone would not foretell a pending rise – especially one that we think would span the course of an entire decade. However, diversification of hedge fund performance along with the risk factors they trade, supports this case as well.

Our Diversification Indicator – which combines proprietary measurements of both the likeness of institutional quality hedge funds and the underlying risk-factors they trade – rose back to its 10-year average after falling to an all-time low in February. This matters because falling correlations bode well for hedge funds generally as they can capitalize on unique risks, leading to unique return streams – as a complement to any diversified portfolio.

In short, diversification is an important forward-looking indicator and from what we are seeing now, the risks hedge funds face are unique to each individual fund, not the category at large. This is why the fallout from some of the meme stock crazes earlier this year typically did not affect more than a small number of funds in a significant way. Rather, only the unique decisions that a particular manager made were subject to the effects the rapid price fluctuations that we saw.

3. Investor expectations are shifting – in a pragmatic way

Lastly, the expectations of hedge funds among the investors allocating money to them has evolved. Hedge fund allocators now primarily consist of pensions and endowments, among other institutional investors – who both demand and have received additional transparency from hedge funds. 

To put things into context, Funds of Funds (FoF) comprised more than 50% of the $1.5 trillion in total hedge fund assets in 2007. Today, hedge fund assets under management are over $4 trillion and less than 10% of these assets come from FoF. Instead, that gap has been filled by more institutional investors such as pensions and endowments.

These investors are typically more informed, and their general expectations match the reality of the role hedge funds can play within their overall portfolios. No longer do they consider all hedge funds absolute return vehicles that are expected to outperform the S&P on the upside and generate positive returns when the S&P is down.

This has helped realign expectations to be more realistic and consistent with what hedge funds can deliver – downside mitigation and alternative sources of returns.

To summarize, why be so bullish? Performance, in context, is strong and is trending up. Managers are continuing to generate alpha during periods of both weak and strong equity markets, and funds are diversified to the point where broad market trends do not affect the asset class as a whole. Additionally, this is all happening at a time when investor expectations of hedge funds are more realistic and favorable than ever.

Jon Caplis is the founder and CEO of PivotalPath, a leading hedge fund consultancy and analytics firm. Founded in 2013, PivotalPath covers over 2,400 institutional quality hedge funds across 40 strategies comprising ~$2.5tn global hedge fund capital. Leading pensions, endowments, foundations, RIAs, and family offices leverage PivotalPath’s platforms and perspective to supplement their manager research, benchmarks, and allocation process.