(03/20/20) 7 Ways Coronavirus Will Impact Hedge Funds

The impact of Coronavirus and the resultant market reaction will create changes in the hedge fund industry, reports Donald A. Steinbrugge.

The changing landscape caused by the Coronavirus will lead to the largest shake out in the hedge fund industry since the 2008 market crash. Below are some of the ways we believe the Coronavirus will impact the hedge fund industry.

Change how people communicate: The Coronavirus will radically change how people communicate and interact within the hedge fund industry. There has been a significant increase in people telecommuting from home and an almost complete stoppage of in person meetings. The hedge fund industry will quickly embrace video technology, which minimally requires a computer and telephone. We will be coming out shortly with a more in depth, separate paper on this subject.
Performance satisfaction: Most investors will be satisfied with how their hedge fund portfolio performed. Through mid-March, the HFRX hedge fund index was down 4.26%, which is in line with expectations as compared to a 60/40 balanced portfolio down 8.79% through March 15 (though this is a moving target and investors expect more from the higher fee hedge funds). Larger price movements provide more opportunities for skilled hedge fund managers. It creates an environment in which managers can add value through security selection in strategies that capture greater price distortions in the market. It can also accelerate performance as security prices more quickly reach targets.
Temporary contraction: Despite most investors being satisfied with performance, we expect the hedge fund industry assets under management to temporarily decline 10% to 15% based on a combination of negative performance and redemptions. We expect most of the assets from redemptions to be invested in money market funds by cautious investors and reinvested back into the hedge fund industry once the markets stabilize.
Significant increase in redemptions based on relative performance: During periods of low volatility there is typically little performance dispersion among managers with similar strategies. With no clear signal for relative performance, hedge fund redemptions are muted. However, during periods of high volatility, dispersion across managers significantly increases. We expect managers who underperform relative to their peers, will experience heavy withdrawals. Unfortunately, for illiquid strategies, this could lead to an increase in gating or suspended redemptions. We expect most of these assets to stay within the hedge fund industry. Some will be reinvested with better performing managers in the same strategy. Most will flow into other strategies as investors re-position their portfolios based on where they think active managers have the best opportunity to add value.
Major rotation of assets across strategies: One trend we identified earlier this year was an increase in demand for hedge fund strategies with low correlation to the capital markets. We expect this trend to increase over the next six to nine months. Some strategies that will see increased demand include managed futures (commodity trading advisors), arbitrage oriented and market neutral strategies, specialty lending and reinsurance.
More hedge funds shutting down: The hedge fund industry remains over saturated with an estimated 15,000 funds. We believe approximately 90% of all hedge funds do not justify their fees, as evidenced by the mediocre returns of hedge fund indices. Fed-up with poor performance, investors are increasingly more likely to redeem from underperforming managers leading to an increase in fund closures. This will impact both large established managers as well as emerging managers. The hedge fund industry is Darwinian and constantly evolving. Some prominent managers’ strategies may no longer offer the alpha generating opportunities that historically drove performance. Some large managers are simply too large to maintain an edge. Managers with less than $100 million in assets, who represent a majority of hedge funds, are being squeezed from both the expense and revenue sides of their businesses. No matter the size or tenure of the fund, poor performance will accelerate the outflows of capital and in some cases result in fund closures.
Greater opportunity to add value: We expect the capital markets to be turbulent for quite some time with the potential for major disruptions in liquidity. The selloff in the capital markets we are experiencing are both fundamental and emotional. This combination causes correlations to rise and creates large inefficiencies in securities pricing. Active managers should be able to capitalize on these inefficiencies. Once the dust settles, we expect the best buying opportunities since 2009 and a rotation back into higher beta/riskier strategies.