Two months ago, when looking at the monthly Evestment hedge fund fund flow report, we reported that investors had redeemed a net $14.2 billion from the industry in October, the fourth consecutive month of redemptions, bringing Year-to-date HF outflows to a net $77 billion removed from the industry. The breadth of redemption pressure in October was the industry’s largest in 2016 with 61% of reporting funds estimated to have net outflow during the month. Two months later it has only gotten worse, but before we get into the details, here is a quick summary of just why, courtesy of JPMorgan.
As JPM's equity strategist explains in a note summarizing active manager performance, 2016 was one of the most challenging years for active equity managers with only 32% of fundamental and quantitative funds outperforming their benchmarks. JPM estimates that large cap U.S. fundamental managers underperformed by a median 33 bp before fees, with Value managers outperforming (+0.77 bp vs. benchmark) and Growth managers underperforming (-79 bp vs. benchmark).
In more bad news for the buyside, JPM notes that even though (or perhaps because) the market finished up more than 9%, US equity funds saw net ~$50 billion outflows in 2016 and a record rotation from Active to Passive. Investors pulled ~$200 billion from active US equity funds. This is the single largest annual rotation out of active management. Meanwhile, passive equity funds (including ETFs) captured ~$150 billion of inflows.
- Bond funds saw $118 billion inflows in 2016 as equity funds saw $43 billion in outflows (driven by redemptions from active equity funds).
- Active equity funds lost a cumulative $198 billion in 2016 outflows as passive equity funds received $153 billion of inflows.
Meanwhile, as the chart on the left shows, gund flows highlight significant post-election rotation. The global search for yield in 2016 drove large bond fund inflows funded by equity outflows, though this trend reversed after the U.S. election. Since the election, equity funds have seen $52 billion in inflows, and bond funds $10 billion in outflows. Reflation-linked sectors saw the largest inflows while Healthcare and Discretionary experienced the largest outflows.
Still, this "rotaton" has failed to help active managers, as ETFs continue to gain market share. ETFs as a percent of US market cap grew 14% in 2016, with domestic equity ETFs currently at $1.5 trillion AUM. Within the ETF space, Smart Beta products continue to gain strong market share. Smart Beta ETFs currently represent ~$440 billion in AUM, up from ~$300 billion a year ago
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So what about just hedge funds? For the answer we go back to the latest reported by Evestment, in which we find that if the above mentioned October was bad, December was, in their own words, "a fitting end to a difficult year for the industry. While the level of outflows during the month was on par with prior years (an average of $18 billion removed over the last five Decembers) it marked the sixth month of outflows in the last seven, and resulted in Q4 not only being the fifth consecutive quarter of redemptions, but also the largest quarterly outflow from the industry since Q1 2009, and the height of the financial crisis.
Here are the highlights:
- Investors redeemed an estimated $23.7 billion in December, and $43.2 billion in Q4 2016.
- For the full year 2016, investors removed a net $106.0 billion from the hedge fund industry.
- Redemptions from managed futures accelerated in December as the strategy disappointed investors in 2016.
- Investors’ allocations decisions in 2015 and 2016 proved to be unfortunate as winning strategies faced the largest redemptions and vice versa.
And the "flow" details by product group and asset class:
- Throughout 2016, investors clearly reacted to widespread underperformance from 2015, but at the same time showed a willingness to allocate to products which performed well. Nearly $180 billion was removed from underperforming products through 2016, while over $70 billion was allocated to those who were able to post gains.
- The biggest asset gainers of the year were managed futures products. Unfortunately, they also produced the worst average returns of any major strategy and December/Q4 redemptions reflect investors’ dissatisfaction. In the first nine months, investors added $20.0 billion into the strategy, but outflows emerged in October, and accelerated through December. After receiving the second largest allocations in 2015, and the largest in 2016, managed futures performance will likely be seen as the industry’s biggest disappointment of 2016.
- On the opposite side, event driven strategies lost more investor money than any other universe in 2016, and in 2015, but produced some of the industry’s best returns this year. If nothing else, the period of 2015/2016 may go down as one of the worst for investor allocation decisions on record.
- There was one fortunate decision investors made in 2016, which was to, in the face of a significant drawdown, allocate to commodity strategies. The allocation process began in mid-2015 when commodity funds were at the tail-end of a nineteen month drawdown. Commodity funds returned more than 6% in 2016.
- Distressed was another segment of the industry from which investors withdrew assets in both 2015 and 2016. All distressed funds did in 2016 in return were to be the best performing primary strategy of the year. Investors, however have indicated a strong interest in private debt products, which may either compete with distressed hedge funds for assets, or often be offered by the same managers in place of a hedge fund structure. In fairness, this is not an investor issue, but rather an issue of what the most appropriate approach to the best opportunities in the current market.
- After three years of being the most attractive universe in the hedge fund industry, multi-strategy funds’ large December outflows act as a question mark at the end of their first annual redemptions since 2012. The group endured poor performance at the turn of 20015/16, endured high profile fund closures due to elevated losses, and litigation against one of its largest constituents. Unlike event driven managers who produced some excellent returns in 2016, the multistrategy space has left investors facing a difficult allocation landscape. Historical track records, and transparency into internal strategy allocation process will likely be high on investors’ lists of demands before allocating back into this space.
- Macro funds may have also left investors scratching their heads, perhaps even more so had it not been for a fairly good Q4 by some larger products. In the end, the ten macro funds which lost the most investor money in 2016 gained an average of 6.5%, while those who gained the most new assets returned an average of 3.0%. For the three largest asset gainers, an average return of 11% in Q4 perhaps saved more than just their year.
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To summarize, redemptions in 2016 were the industry’s largest since 2009, and the third year on record where investors removed more than they allocated.
And while the industry is not going to disappear any time soon, with hedge fund assets ending 2016 at $3.042 trillion, or an increase of $13.9 billion, the performance gains of $119.9 billion offset investor outflows which surpassed $100 billion.
The report's conclusion will only add to the sleepless night for active managers and hedge fund CIOs, dreading the next redemption notice:
Investor flows for 2016 resembled an industry in crisis. They were similar to mid-2011 and 2012 in persistence, but dwarfed outflows seen during the European sovereign crisis in magnitude. They were below the levels seen during the aftermath of the great financial crisis, but have been much more persistent. It’s clear a swath of investors are uncertain how to best utilize the industry’s available talent. It’s also clear there are pockets within the industry, even at its seemingly most saturated point, where those talented at finding and realizing valuation anomalies, and those able to create sophisticated systematic processes, are still able to shine. The quandary for the largest investors is to find a role for this industry within portfolios. Does one treat it as a group that as whole is able to produce steady aggregate return streams with relatively low volatility, or should individual managers who excel in specific asset classes find a place alongside traditional managers, as a holistic approach to specific markets? What 2016 has shown us is there is talent in this industry, what 2017 will show us is how investors decide to take advantage of it.
And so, to all the smartest guys in the room, good luck.
Photo credit Bloomberg