Hedge funds posted an aggregate 2.3 percent gain through the first quarter, which marks the strongest start for the industry since 2013. Long/short equity strategies lead the pack with composite returns of 3.2 percent.

Back to Reality

At first blush, this sounds terrific but, realistically, the industry is beating a very low bar—its own performance record. The unvarnished truth is that hedge fund performance continues to compare poorly to the S&P 500 Index, which returned 6.1 percent in the same period, almost three times hedge funds’ aggregate gains. Even the wildly successful long/short strategies posted gains that represent only about one-half the S&P 500 gains.

According to Prequin, the quarter breaks down as follows: January saw gains of 1.46 percent, followed by February gains of 1.01 percent and ending with March gains of 0.68 percent, which totals 3.15 percent, a more generous result than the 2.3 percent reported by eVestment. Regardless of the disparity, one thing is clear, the direction is wrong with gains diminishing each month during the first quarter.

Cause for Concern?

Actively managed funds of all stripes are under pressure. Blackrock’s actively managed equity portfolio lost $42 billion between 2013 and 2016. More broadly, actively managed equities lost $442 billion in the past twelve months as $542 billion flowed into passively managed index funds, representing a nearly trillion-dollar shift.

Hedge funds have seemingly countered by adopting an “if you can’t beat ‘em, join ‘em” strategy. Hedge fund investment in ETFs have surged 77 percent, rising to $43.7 billion while the actual number of hedge funds investing in ETFs have risen by 17 percent, this according to Deutsche Bank’s 2016 Guide to Institutional ETF Ownership.

One can’t help but be concerned about the motives behind hedge fund investment in what is arguably a rival investment vehicle—an investment vehicle that has attracted $1.44 trillion from about 3,500 institutional investors, representing 59 percent of EFT assets.

What Is the Answer?

Hedge funds do not invest in EFTs as a core asset building block. Rather, such investment provides quick, efficient asset class access and to provide liquidity. This liquidity can then be leveraged to provide the fund with the ability to execute large trades without significant market impact. In short, hedge funds use ETFs as completion strategies, as tangible satellite positions, for cash management, for liquidity access, and risk management.

In the hedge fund industry tradition of innovation, hedge funds are using ETFs to their greatest advantage.

What is the Relevance to Hedge Fund Jobs?

The Deutsche Bank report offers palpable evidence that hedge fund investment in EFTs is on the rise. It follows that individuals with a background in ETFs may have just the credentials required by hedge funds exploiting ETFs for the purposes outlined above.

More to the point, it is instructive to learn that the spirit of innovation is an important attribute for anyone that seeks a position in the hedge fund industry. How “outside the box” is a strategy that sees hedge funds investing in a competitor?

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Robots, once the bane of blue-collar workers, may now threaten the livelihoods of hedge fund professionals. Taxi and Uber drivers are menaced by driver-less technology, fast food workers are marginalized by robots capable of making a burger in less than ten seconds, and BlackRock, Inc. is implementing data-driven, artificial intelligence (AI) programs that will ultimately replace as many as seven portfolio managers and dozens of analysts.

BlackRock’s foray into robotic investment represents its latest effort to rescue an actively managed equities business on the decline. BlackRock’s actively managed equity assets, which stood at $317 billion in December 2013, dwindled to $275 billion by December 2016.

Clearly, BlackRock is not the only firm facing this problem. In the last twelve months, $442 billion flowed from actively managed equities, while $542 billion surged into passive index funds—a swing of almost $1 trillion.

What’s Driving This?

It is relatively easy to grasp the cost/benefit of robotic short order cooks but the driving forces behind robotic investment are more complex. The two factors driving this decision are performance and fees. While the jury is still out on the performance metrics of robotic investment, the fee side of the equation is less opaque.

These calculations will make the rationale for robotic investment clear. According to the Investment Company Institute, mutual fund managers earn about $131 in fees per $10,000 invested. Contrast this with the $18 in fees earned on $10,000 invested in passively managed index and exchange traded funds.

Based on BlackRock’s portfolio of $275 billion, robotic portfolio management has the potential to reduce fees from around $3.6 billion to about $49.5 million. Of course, these calculations do not factor in development and implementation costs. In the case of BlackRock, these expenses may be offset by eliminating the salary and bonuses of multiple portfolio managers and dozens of analysts. One thing is certain; the potential fee savings for investors are staggering.

Implications for Hedge Funds

Hedge funds face similar performance and fee challenges. However, hedge funds have succeeded in maintaining asset growth through the majority of the years following 2005 and have recently achieved all time highs in terms of assets under management.

This is not to say that the hedge fund industry is behind the curve in its efforts to incorporate AI, algorithms, and similar robotic investment strategies. One need not look beyond such firms as Renaissance Technology, Bridgewater Associates, and Steve Cohen’s Point 72 Asset Management, which recently set up a vehicle to finance AI startups.

What Does This Mean for Hedge Fund Jobs?

The hedge fund industry has unique relationships with its investors as compared to actively managed U.S. stock funds, which have a significant retail investor component. The relationships between hedge fund investors and portfolio managers are profound and, as such, will be particularly resistant to exclusively robotic portfolio management.

While the hedge fund industry explores and employs the technology, it is unlikely to be something other than a zero-sum game in terms of job opportunities in the industry.

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Hedge Fund Numbers Shrink as Assets Under Management Soar

March 20, 2017

The suggestion that assets under management are soaring is admittedly a bit Trumpian, but the fact is that the number of hedge funds shrank to 9,803 (including funds of funds) while 2016 industry assets under management climbed to just over $3 trillion according to the HFR Market Microstructure Report. What Can Be Inferred From the […]

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Surprisingly Investors Remain Bullish on Hedge Funds

March 5, 2017

After an inglorious 2016, many pundits jawbone about a continued investor exodus from the so-called overpriced and underperforming hedge fund industry. However, the facts are in stark contrast to the rhetoric. January 2017 redemptions total $5.2 billion, about one-quarter of the $19.3 billion outflow the hedge fund industry experienced in January 2016. Furthermore, a substantial […]

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Will Trump’s Core Regulatory Principles Favor Hedge Funds?

February 20, 2017

On February 3, 2017, President Trump signed an executive order that outlined his administration’s core principles for regulating the U.S. financial system. They are: (a) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth; (b) prevent taxpayer-funded bailouts; (c) foster economic growth and vibrant […]

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How Vested Are Hedge Funds in Trump’s Success?

February 7, 2017

Hedge Fund Research and other respected sources suggest that hedge funds, taken together, gained about one-half of one percent in the month of January, far short of the S&P 500’s gain in the same period. With January in the record books and the balance of 2017 stretching out ahead, what does the future hold for […]

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What Was Under Last Year’s Tree for Hedge Fund Professionals?

January 23, 2017

For starters, around three-quarters of hedge fund professionals will not receive their bonuses until the first quarter of 2017, according to the  Hedge Fund Compensation Report, so, if there was nothing under the tree, no worries, it is coming. What Will Bonuses Look Like This Year? Although the financial media has painted a bleak picture […]

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