As a fan of Sebastian Malalby’s writings on hedge funds and his biography of Alan Greenspan, I was excited to hear about his upcoming book tackling Venture Capital. In our prior quarterly letter, we discussed the concept of Venture Capital Eating the World and how this has permeated the realm of active public market investing. In anticipation of the book, I listened to a conversation between Mallaby and Tyler Cowen. Of note, Cowen asks Mallaby about hedge fund skill, a topic which the Epsilon team has spent much of our careers analyzing. I found his answer interesting. It isn’t a particularly uncommon view but was germane to our current environment. Mallaby (emphasis added):
“When I published my book in 2010 about hedge funds, the best research at the time said that, net of fees, there was positive offer and it was 3 percent a year between 1995 and the late 2000s. That was a pretty strong positive number. I think since 2010, the positive number has declined to be much, much smaller and maybe even to disappear in some time periods. I think that happened because of quantitative easing.
If you think about hedge funds, what is it that they do? They get paid to assess risk and price it. If risk spreads are being squeezed and compressed and reduced to almost nothing by the central bank through quantitative easing, then hedge funds are going to be paid less for doing their work. I think that’s why supernormal positive returns — to use your language, Tyler — have diminished. I think they may now come back because of the end of quantitative easing and the raising of interest rates in the face of inflation.”
Our empirical research has found quite similar results, although we did not opine directly on the reason why. For those that defend hedge fund returns in the post Financial Crisis period, the idea of distortive monetary policy as the culprit is central. The hypothesis being that in an abnormal monetary policy environment – one defined by quantitative easing, zero interest rate policies, and persistently low inflation – the price of risk is distorted in such a way that renders the expensive active pursuit of alpha in a hedged structure unattractive.
There is some evidence to suggest this is correct, if only circumstantial. Directional long/short fund managers on average have migrated to higher net exposures, greater portfolio concentration, and have expanded the circle of investable assets to include more privates. Viewed in total, this could be seen as a response function to a world where the strength of absolute return from beta makes net returns from a 2 and 20 fee structure less palatable.
It seems to indicate that momentum as a strategy in growth equity and venture has been identified as a font of superior risk-adjusted returns. It may also suggest that downside risks associated with portfolio concentration – especially in pre-earnings companies – are disregarded due to a persistent tailwind of multiple expansion. Finally, it represents capitulation toward the painful pursuit of short alpha.
If the above premise is true, there is evolutionary pressure toward a change in the hedge fund ecosystem. This is due to marginal fund flows. Like rain fall in the jungle, fund flows ultimately drive adaptation. The migration of dollars out of one style and into another puts pressure on those whose core competence falls out of favor. This ultimately impacts the alignment between the principals (dollars searching for superior returns) and agents (those that seek dollars and may veer outside of their traditional risk tolerance or their circle of alpha generative competence).
Out with 40% net, out with 75 longs / 125 short positions, out with DCF and tangibles based underwriting; in with 80% nets, 25% single name positions, significant late-stage/pre IPO marks, embracing capitalizing the income statement. After half a decade of this gradual evolution, which was dealt an adrenaline shot in the aftermath of the initial COVID shock, is the ecosystem poised to reposition itself in a macroeconomic regime shift?
If Mallaby is right and monetary policy is about to make an abrupt U-turn, valuations will become crucial and pricing risk appropriately will be paramount. Simply put: there will be more emphasis on the left tail vs the right tail. This is evinced by the daily deluge in high-multiple growth/tech land, as concept stocks and high performers (through the prism of revenue growth) have been decimated. DCF will replace TAM and NPS. Unprofitable growth will become unpalatable.
Early evidence from the last 12 months (when growth truly began to crack) has been eye-opening. The data suggests that fund managers are digging into their existing playbooks rather than reverting to the old ways of doing things. As we have written in the past, the collective lesson of missing Amazon may be a more powerful meme than reverting to free cash flow. As such, buying the dip has seemingly yet to be exhausted, even though it may be finished as a (near term) profitable practice. This retrenching will severely test the patience of investors.
Ultimately, it may take some time for investors to rewire their investment approaches, and this process may be entirely driven by the trenchant nature of inflation. If monetary policy truly tightens instead of an about-face as we witnessed in 2018, the focus will be less on S-curves and more on short-term profitability. Portfolios will reduce net exposures, reduce concentration and embrace liquidity as optionality. Funds will eschew privates because the opportunity cost and uncertainty associated with them will be less attractive than capitalizing on dislocations in the public markets. What was old will become vogue.
If fund managers are to truly demonstrate skill in an era of quantitative tightening, they will have to navigate The Great Rewiring. That, or investor dollars will ultimately flow to other sources, leading to an entirely different ecosystem.
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