For most funds, attracting funds and having billions of capital to deploy is the goal. Yet some hedge funds have become so successful and so large that they have become a victim of their own success. This is the case at Moore, where Louis Bacon just announced he would return about a quarter of his flagship fund back to investors, an amount worth $2 billion USD. Having been down overall last year, and up just 1.6% this year, the fund was in need of a shake-up.
Yet Moore’s struggles are symptomatic of a trend seen in 2011 in Bloomberg’s list of top performing hedge funds. Out of the top 100 large funds (with assets greater than $1 billion), the 50th placed fund earned 4.9% and the 100th fund returned just 0.8% on the year. As reference, the S&P 500 returned 1.3% over the same time, meaning the last 6 firms failed to beat the index and were still among the best performers in the world. Contrast this with the list of medium funds (defined as with assets of $250 million to $1 billion), where the 50th fund returned 7.9%, a whole 3% (or 1.6x) more than its “large” counterpart. While the medium-sized list would have had many more candidates and therefore was prone to include more one-year wonders, keep in mind that the large funds only have that much capital for a reason; they are the best of the best, and have made outsized returns for years. In other words, any advantage the middle-sized firms (which are far from tiny) had in having a lucky year would have been countered by the fact that they were compared to an all-star team of hedge fund managers.
So what could be hindering large-sized firms to the point that even a hedge fund manager would give back his hard-earned cash?
1. Liquidity: To return 10% on a fund of $500 million, you need to make $50 million. With a $5 billion fund, the required profit leaps to $500 million. The problem is that in today’s markets, the liquidity that allows for large enough trades to make $500 million in a year is proving harder to find. It is no coincidence that the largest funds are dominated by macro and multi-strategy funds; there are simply no other markets large enough to absorb their flows.
2. Correlation: Asset classes have become increasingly correlated with each other which have lead to broader “risk-on” or “risk-off” moves across the market based on overall macro themes. The Pragmatic Capitalist summed it up nicely in a recent post here, stating that equity investing has become based more on macroeconomic news than on microeconomic fundamentals. In other words, being a multi-strategy fund doesn’t help when all your markets are trading the same way.
3. Alpha: With liquidity drying up and asset classes around the world trading together, funds have struggled to beat benchmarks as seen in the Bloomberg list. It also does not help that rates around the world are at all time lows, with carry trades difficult to find. Large funds are also unable to pursue opportunities in smaller markets with large returns, ironically limiting the scope of many “global” macro and multi-strategy firms.
So how does this affect those who focus on the Investment Frontier?
Frontier markets offer a solution to points #2 and #3. Due in part to their size and the composition of investors (local vs foreign), frontier markets may be one of the last places to find decorrelated assets to invest in. Given that they are all in the early part of growth cycles, outsized returns are also possible for those pursuing alpha.
While the Moore’s and Bridgewater’s of the world are unlikely to pile into frontier markets anytime soon, there are a host of small to medium sized funds in the world who could be benefitting from their absence. Rather than competing with the bigger funds in increasingly algorithmic-driven developed markets, frontier markets represent a place where fundamentals can still matter, and where equities have always represented both an investment in the macro and micro aspects of the country and company.
Due to the dearth of frontier market funds currently operating, we anticipate an increasing amount of funds transitioning to this space. Given the lack of institutional investors in these types of markets currently, this represents an important step for frontier markets to eventually join their emerging brethren. Even the big players are taking notice; in a recent interview with CNN, Mark Mobius of Templeton said as much.