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Why analysts are seeing a new market for hedge funds

Samuel Madden, CFA of Interactive Buyside

Interactive Buyside Weekly Thoughts for Market Realist

On July 10, 2013, the Securities and Exchange Commission (or SEC) voted 4–1 to lift a decade-old ban that prevents hedge funds and private equity firms from marketing their investments to the general public. The change is expected to take effect in about 60 days. This move opens up a new $55+ trillion market of potential customers to help hedge funds grow capital.

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New market size

Individuals who are legally allowed to invest with hedge funds and private equity firms must be deemed “accredited investors.” According to the Securities Act of 1933, an accredited investor is defined as either:

  1. An individual (or married couple) whose (joint) net worth exceeds $1 million, excluding the value of the primary residence
  2. An individual with income exceeding $200,000 in each of the two most recent years, or a married couple with joint income exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year

The SEC estimates that approximately 8.7 million U.S. households (or 7.4% of all U.S. households) fall under the accredited investor category. This new and untapped market is now open to recruit capital in an attempt to raise new funds to help hedge funds grow their assets.

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Why is the SEC’s move good for retail investors?

Hedge fund performance (on the whole) over the past few years has underperformed the broader market, mainly because the S&P 500 index has only been going up, and most hedge funds are by nature “hedged,” maintaining short positions as downside protection.

However, if you take a more long-term view on hedge fund performance, Hedge Fund Research’s HFRI Composite index has posted an annualized return (net of fees) of 8.24% over the past 16 years, compared to 6.24% for bonds and 6.08% for the S&P 500 index, over the same period.

Retail investors now have the ability to invest in a new asset class (so to speak) that has superior long-term performance.

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Why is the SEC’s move good for hedge funds?

Traditionally, newly formed hedge funds need to generate excess returns for three to five years before they can reach out to fund-of-funds and/or wealthy individuals in the hopes of growing their assets. The difficulty in getting a fund from $5 million of assets up to $100 million is extraordinary, and the ability to attract institutional capital as a small firm can be problematic. Not to mention, competition for said capital has been heating up as the upfront costs of setting up a fund is quite low, thus thousands of small/mid-sized hedge funds have been popping up over the past decade. The WSJ just recently reported that industry players have even started going away from the “2 and 20” model as competition for institutional money heats up.

Smaller funds now have a new and alternative source of potential capital they can go after, thanks to the SEC ban lift. This is over $55 trillion of household net worth (according to the SEC) that is essentially untapped fresh capital. With bigger funds focused on larger institutional clients, smaller hedge funds can now focus on marketing towards this niche, yet large, new market of individuals.

The question now becomes: how can funds attract retail capital in an efficient and effective manner?

How to efficiently tap this market?

To effectively match up funds and investors, both markets must be served:

For funds

  1. As smaller firms are cost conscious by nature, smaller funds will want a marketing strategy that was as low-cost (or free) as possible. Managers will not want to outlay meaningful capital by paying a public relations company or even a third-party marketer to chase down new capital.
  2. As a tangent to point 1 above, smaller funds are also lean and focused on investing, and not set up to add more manpower to have a separate marketing department. An easy and efficient way of getting their ideas, strategies and track records out to the masses is ideal for a smaller fund.
  3. Fund managers also will want to get their names out to as many eyeballs as possible. With 8.7 million households as potential customers, it will be imperative to cast a wide net to ensure all potential investors are aware of the new asset class available to them.

For individuals

  1. Just like any type of investor (i.e., institutional, retail, etc.), individuals will want to know the track record of the fund as well as the pedigree of the fund manager(s). How long the fund has been in existence, return performance of the fund to date, résumé of the fund manager(s), etc.
  2. Another crucial detail is the strategy and focus of each fund. What asset class (e.g., equities, credit, real estate, etc.) does the manager specialize in? What industries are the focus of investments? Is there a hedging strategy in place (e.g., short, options, etc.)? Investors like to know these details so they know how to manage the rest of their personal portfolio from a diversification perspective. Also, from a psychological perspective, they simply like to know where their money is.
  3. Investors also like to know how managers think about and analyze investment ideas. Funds that share their investment analysis and research with potential investors have the upper hand in attracting new capital from said investors. Individuals will get a chance to see what exactly determines a good investment for these fund managers and how they go about evaluating companies and industries.

Early innings

This drastic shift in marketing regulation has just occurred, so it is still in its infantile stages. I will not be surprised if in the coming years, there will be numerous third-party marketing firms that develop tools to help hedge funds raise capital from this new and large market of capital. The winning strategy, however, will be platforms that fulfil the needs of both funds and individuals (as discussed above) in an efficient and powerful manner. Funds want capital, and individuals want information—time to take advantage of this $55 trillion opportunity.

The Market Realist Take

Although the hedge fund industry hasn’t given stellar returns in the last few years, it has added value during periods when risk assets haven’t performed well. So investors who are looking at long-term gains may not necessarily back out because of lacklustre performance in the last few years. The lifting of the ban, which aims to encourage new business development and raise capital, has invited criticism from consumer advocates, who feel there isn’t enough protection for gullible investors. So the SEC needs to make the proper safeguards to protect these investors from risky bets. The regulation can help funds like DE Shaw and Blackstone but also new start-ups that need funding and brand awareness.

Investors who want a higher Sharpe ratio than holding just stocks can combine SPDR S&P 500 ETF Trust (SPY) with the high yield ETF iShares iBoxx $ High Yield Corporate bond ETF (HYG) or the SPDR Barclays Capital High Yield Bnd ETF (JNK) in a 60–40 split to get lower volatility returns with a current income component. Hedge fund ETFs like  IQ Hedge Multi-Strategy Tracker ETF (QAI), WisdomTree Managed Futures Strategy ETF (WDTI), and SPDR Multi-Asset Real Return ETF (RLY), have been successful in attracting maximum assets. AlphaClone Hedge Fund Long/Short Index (ALFA), Credit Suisse Merger Arbitrage Index Leveraged Exchange Traded Notes (CSMB), and AdvisorShares QAM Equity Hedge ETF (QEH) have provided the highest year-to-date returns.

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