Here’s the harsh reality: If a financial advisor had their clients’ assets invested in the top percentile of hedge funds last year—ranked by assets under management—they were probably a big winner. And if they didn’t—or couldn’t access these investments for their high-net-worth clientele—the opportunity cost of choosing smaller or emerging hedge funds was potential alpha for their clients in 2022.
While bigger doesn’t always mean better, as seen by the general outperformance of smaller hedge funds over the last several years, the coupling of endogenous and exogenous market forces reversed this trend in 2022 as established players shined.
Don’t Underestimate Large Players
Advisors would be wise to pay attention to large and established players: they are armed with deep institutional memory in navigating market cycles, are equipped with robust and nimble strategies overlayed with systematic trading infrastructures, and have incredibly deep teams capturing vast amounts of data across many time zones. They also have rigorous risk management guidelines in place.
Last year, with the changing economic environment, the resourced firms were able to nimbly navigate murky markets and produce impressive results. Larger funds pursuing quant trading generally saw strong gains last year, according to a report from The Wall Street Journal. For example, D.E. Shaw’s Composite Fund, which has about $60 billion in assets under management, rose 24.7%, while D.E. Shaw’s Oculus Fund gained 20%. Citadel, the hedge fund operation that manages about $54.5 billion, saw its flagship fund, Wellington, return 38.1% for investors, while the firm’s Citadel Equities Fund rose 21.4%. Quant pioneer Renaissance Technologies LLC’s well-known Medallion hedge fund rose about 19% in 2022. Industry-wide, the HFRI Fund Weighted Composite Index, which gives equal weight to funds of all sizes, fell 4.25% in 2022, while the HFRI Asset Weighted Composite Index, which gives more weight to the larger funds, rose 0.97% during the same period.
While there’s no guarantee of future performance or whether this trend could continue in 2023, according to a Reuters report in January, the biggest hedge funds—the top 5%—are set to take 80-90% of investor inflows in 2023. Investors may be recognizing that larger, established funds are more likely than smaller funds to focus on quantitative, arbitrage, and other strategies that don’t rely on rising markets to generate profits.
Instead of betting on the market’s direction, some of the larger funds seek to take advantage of momentary pricing discrepancies in stock and bond prices. This happened to be an advantage in 2022, a year when both stocks and bonds tumbled, and larger funds on average managed to outperform smaller funds, for the first time in several years.
Institutional Access Possible For Non-Institutional Investors
Prevailing uncertainty and volatile markets may fuel high-net-worth investor demand for alternative investments that go beyond cookie-cutter solutions. However, many of these larger and established hedge funds require high minimum investments that may not be within the reach of smaller or individual investors directly. This can also create an avalanche of administrative burdens, given that most clients don’t invest in just one alternative fund. The optimal solution is to provide clients with a diversified portfolio of multiple funds. Such an offering, however, can require a tremendous amount of work to successfully manage subscriptions, redemptions, rebalancing, liquidity, capital calls, distributions, statements, K-1s, and other key operational requirements through time. The solution is an outsourced alternative investment platform that can take the burden of repeatable processes and systems off the shoulders of advisors.
While the tradeoff for access may require an additional layer of fees, RIAs and independent broker-dealers can connect with an outsourced alternative investment platform to simplify this intricate process. This complex environment implies advisors must think quickly and focus on client needs first—something that’s within reach with the right platform. For advisors seeking growth, the power of reduced investment minimums, objective manager selection, a streamlined subscription process, consolidated reporting and other platform features could be the key to next-level business development.
Steven Brod is CEO and CIO of Crystal Capital Partners, LLC, a leading turnkey alternative investment platform for financial advisors.