2021 has been a good year for hedge funds. According to multiple surveys, investors are once again happy with their hedge fund returns and an increasing number have indicated that they intend to increase allocations next year. Few would have argued during the darkest days of March 2020 (though many will now claim that it was obvious) that we would be seeing a never-ending succession of records, but the liquidity spigot was turned on swiftly and with full force - the rest, as they say, is history. 

Generally speaking, markets dominated by unrestrained liquidity, paired with recurring fears triggered by a still ongoing crisis, and periods of what seems like collective amnesia (what pandemic….?), are a tricky beast for hedge fund managers. Macro managers tend to struggle with the distortions created by all this liquidity, the breakdown of correlations and the fact that old dynamics no longer make sense; add to this, the myriad of unintended consequences which baffle even the most seasoned investors. Equity managers, unless they are long biased, extremely adept market timers or momentum traders also have a very hard time keeping up with ever-increasing equity gauges. Systematic strategies tend to get whipsawed from never ending reversals as liquidity and investor sentiment intersect almost daily. Despite all of this, only two of the total 73 HFRI indices, as measured by Hedge Fund Research, are in negative territory this year, though looking at dispersion among managers tells, as always, a more nuanced story with a trailing 12-month top-bottom dispersion of 75.8 per cent, as the top managers delivered an average of +62.7 per cent, while the bottom decile returned an average of -13.1 per cent.

Exhibit 1 HFRI Index Dispersion
Date: December 2020 to November 2021 

Source: HFR

2021 in many ways can be summed up as a year where alpha was in very short supply; lower quality names did better than quality names; fundamentals, for a large part of the year, were not only irrelevant but a hindrance to success; and, generally speaking, it paid not to overthink the markets, to cast reason to the side and to simply follow liquidity…. time will reveal the wisdom of this strategy. 

Many managers that have had consistent returns over successive years and market cycles have found 2021 to be one of the most challenging and frustrating years they have experienced. A well-thought-out, and consistent investment and risk framework was often no match for markets driven by momentum and liquidity rather than by fundamentals. The impact of earnings misses on equity prices has been amongst the lowest since 2000. For example, in the US since the end of the 2020 reporting season, one-day moves following earnings announcements that have seen beats rewarded and beats sanctioned by some of the narrowest margins in history as seen in Exhibit 2. Retail investors fueled by Robinhood and Reddit, created further headwinds for those managers who were willing to engage in crowded shorts pushed to excessive highs by an army of day traders (shouldn’t they have known better…?). 

Exhibit 2 Relative 1-day post-reporting performance versus S&P 500 on EPS and sales surprises
Date: Q1 2000 to Q3 2021 
 
Source: FactSet, BofA US Equity & Quant Strategy

In light of all this, funds’ historical track records therefore often provided little guidance for investors trying to assess performance in 2021. Significant deviations could be seen across strategies, and previously robust managers delivered returns which were significantly different from what investors had come to expect. Perhaps most disappointingly for investors inclined to chase eye-popping performance, managers that had generated returns of over 100 per cent in 2020 often made little to no money this year (though many of these managers have also been unable to articulate clearly how these 2020 returns were achieved and how they managed risk).

Does this mean that previously solid managers suddenly have lost their edge, that the market changed irreversibly in 2021 and that investors should look for a new breed of managers instead that rebuff heretofore sensible ways of investing and managing risk? Perhaps. But if they do, they should proceed with caution. The reality is that today’s market is one that is dominated by an ever-increasing number of risks building up in yet-to-be-identified places (although some risks are already pretty obvious), which some managers are willing to accept, don’t fully understand or the ultimate impact of which they are underestimating. Investors may be wise to remember lessons learnt in the past and not forget that corrections are a normal part of markets. As the saying goes, even if history may not repeat itself, it does tend to rhyme. 

This is not to say that investors should not be alert to managers that have found better ways to navigate markets and that are nimble rather than entrenched in old ways for no good reason. We should all recall the number of macro managers that delivered stellar performance during the 2008 crisis only to go out of business in the ensuing recovery because they were unable to adapt to a new environment and lacked the intellectual flexibility to envisage a new paradigm. Investors should learn their lessons and avoid making the same mistakes again. Being a permabear is seldom a profitable long-term strategy. 

At the same time, investors should heed the lessons of prior crises and be wary when being told that this time is different. The direct lending market is a perfect example of this. The hunt for yield is not new, and post 2008 many ABL funds (as they were called at the time) lost significant amounts of money and saddled investors with illiquid positions of questionable value. In addition to this, the strategy was marred with frauds. This is not to say that the same will happen again, but the parallels with today’s markets are striking and should give investors pause for thought. 

As investors try to navigate these markets, characterized by almost daily factor and style rotations, manager selection will remain key. Relying on a tried and tested research process, backed up by a solid risk management framework, traded by a group of smart individuals with enough confidence not to sway from what they know they are good at, but enough humility to know their weaknesses, a willingness to learn and adapt rather than to arrogantly and rigidly stick to old ways, should continue to produce profitable outcomes in future. Especially in uncertain times, with records being broken almost daily, managers that have tried and tested processes should provide some comfort.

As we close 2021 and look to the year ahead, investors and those advising on manager selection, would be wise to remember that markets can remain irrational longer than most investors can stay liquid, and that reason and fundamentals, for better or worse, tend to have a habit of reasserting themselves now and again.