Tuesday, September 9, 2008

Will Pension Funds Cope With Vanishing Alpha?


A long time ago, I started thinking how massive pension fund flows into alternative investments will affect alpha.

My reasoning was simple: if everyone is blindly shoveling billions of dollars into alternative investments such as private equity, real estate, hedge funds, commodities, timberland, infrastructure, as well as structured products like CDS or whatever is the next "new" thing, then they are collectively contributing to one big massive 'alternative investment bubble'.

For many years, many managers moved to set up their own hedge funds, salivating at the thought of charging 2 percent management fee and 20 percent performance fee to reap large profits. They would often claim of adding "significant alpha" but the reality was that most of them were selling beta as alpha.

At the same time, private equity and real estate titans were collecting huge fees for delivering "significant alpha" to their limited partners, but when you stripped away the leverage they used, weighed the cost of tying up your money for 10+ years and compared their returns to market indices, the performance of most of these private funds was paltry at best.

Take it from me, alternative investments may sound great (who doesn't want to make money in all market conditions?), but the reality is that most funds are just good at marketing themselves to unsuspecting pension funds that are desperate for yields.

Worse still, as pension funds scrambled to invest in all these "absolute return" alternative assets, they contributed to systemic risks that are just now coming home to roost.

Mark my words, in this Ursa Major, there is nowhere to hide. When all is said and done, the path to alpha will be littered with hedge fund, private equity and real estate corpses. What looks ugly now will be a walk in the park compared to what will unfold in the next 18 months.

If you don't believe me, then pay attention to the news that is hitting the wires as this financial crisis deepens.

For example, most hedge funds saw their assets shrivel in the first half of the year. And it isn't just 'average funds' that are hurting. Some of the top funds are losing assets as well:

Renaissance Technologies, which runs one of the world's most successful hedge funds that also charges some of the world's highest fees, saw assets under management shrink by 14.71 percent during the first six months of the year.

The firm, run by former mathematics professor Jim Simons, managed $29 billion (16 billion pounds) at the end of June, according to a survey conducted by magazine Absolute Return.

While total assets may have shrunk, its $8 billion Medallion fund soared 48 percent at the end of July, net of fees, the New York Post reported, citing people familiar with the returns.

Farallon Capital Management's assets declined 8.3 percent to $33 billion, and Goldman Sachs Asset Management saw assets fall 7.9 percent to $26.9 billion.

Overall, 35 percent of the polled hedge funds lost assets in the first six months of the year, the magazine said, adding that funds' added assets at their lowest rate in six years.

The only hedge funds that seem to be profiting from the turbulence in markets right now are volatility hedge funds and short sellers who do nothing but bet on the decline of the markets:

Volatility hedge funds returned 7.3 percent this year through August, according to the Newedge Volatility Trading Index, which started in 2003. Hedge funds overall lost 4.8 percent in the same period, according to Hedge Fund Research Inc. in Chicago.

"Nobody knows the direction of the markets or economy at the moment, and we're profiting from that uncertainty,'' said Trevor Taylor, 35, co-chief investment officer at Miami-based Innovative Options Management LLC. The firm's $90 million hedge fund rose 12.3 percent this year through August, after returning 25 percent in 2007.

...

The best performers this year are short-sellers who do nothing but bet on the decline of the markets. As a group they are up 9.76 percent in the first eight months of the year, even though they slipped 0.31 percent in August. Doug Kass' Seabreeze Partners Management, for example, is up roughly 25 percent amid bets that companies like Fannie Mae (FNM.N: Quote, Profile, Research, Stock Buzz) and Freddie Mac (FRE.N: Quote, Profile, Research, Stock Buzz) would fall more, someone who is familiar with the fund said.

But even volatility hedge funds and short sellers are tied to beta (low risk-adjusted returns), which makes you wonder how long will investors continue paying 2 and 20 to hedge funds?

I quote Dr. Susan Mangiero:

Wall Street Journal reporters describe a trend that some believe was once only urban legend, namely hedge fund managers cutting their fees. In "Hedge Funds' Capital Idea: Fee Cuts" (September 9, 2008), Jenny Strasburg and Craig Karmin describe a new balance of power in which investors are being courted to stay the course rather than pull out their money in search of greener pastures.

Replete with examples, the article suggests that jittery institutions may get a big discount on fees if they agree to lock-up periods or give the fund managers ample time to recover losses or improve on sub-par performance.

This makes sense from the hedge fund managers' perspective, especially those who face unprecedented redemption requests.

From the pension investors' vantage point, things are not so clear. Yes, it's great to be able to pay lower fees but if the price of doing so is the realization of a mediocre risk-adjusted return profile, plan sponsors may be better off rethinking their allocation to that fund.

As with everything else, it's seldom so simple. Unwinding a position may be expensive in terms of transaction costs alone. Then there is the issue of what should replace the hedge fund, if jettisoned from the pension portfolio.

What will be interesting to watch is whether other hedge funds feel pressured to follow suit in terms of dropping fees.

And what about private equity funds? Investors need to remember that private equity funds need strong public markets to eventually exit positions and realize on their investments. So what do you think happens to private equity returns when public markets plunge? You guessed correctly: the returns head south.

I found it amusing that Blackstone's Chief Operating Officer, Tony James, came out on Tuesday to defend the private equity industry:

“We had the dubious distinction of being like a public punching bag for a year — by politicians, by press, by just about everyone,” James said at a Lehman Brothers financial services conference. “And for better, for worse, I think people sometimes lose sight of what private equity actually does.”

Showing a slide titled “Private Equity is Good for Society,” James said private equity played a necessary role in modern capital markets and in creating jobs. In Blackstone’s case, that’s 42,000 new jobs in the last five years.

James said that public markets were great for companies with robust growth prospects and ones that meet their targets, but they can be “brutal” for those that fall behind.

Private equity, he said, can take companies whose stocks are “bashed down, bring them private, bring in a new management team — which is usually necessary — re-engineer the company, get it growing again, and when it emerges back in the public markets it will be a faster-growing company, fitting more comfortably into the public markets.”

That’s particularly important in tumultuous times such as now, he said, when people are casting about for big pockets, rescue financing and investors willing to take risks when no one else will.

“That’s when we shine,” James said.

(For James’ other remarks about the buyout industry click here.)

Blackstone also shined for going public at the top of the buyout market, effectively screwing their investors as their shares plunged nearly 50% since that famous IPO. But their principals cashed out big, making a fortune in the process (that was how I knew it was the top of the market!!!).

It now looks like investors are fed up with private equity firms eating their lunch:

"Long-only investors have had enough," Cowdery said. "They are fed up with passive investment in financial institutions and fed up with private equity firms eating their lunch."

In the past, passive fund managers, watching as companies in which they have stakes have slumped in value, have been all but powerless to intervene as private equity firms have picked up the companies on the cheap.

Cowdery's latest plan - to set up a public company to act as a consolidator of banks, insurers and asset managers - was born out of that frustration. The plan is simple. Resolution - an investment vehicle - will be floated in a £1bn IPO in November. The City's leading fund managers will be invited to invest in a company that will in turn acquire and consolidate financial services groups in which the fund managers already have stakes.

Mr. Cowdery might just be onto something and his gamble might pay off big, but he will face serious headwinds as this crisis continues to wreak havoc on financial institutions.

And what about real estate? Oh real estate, that asset class that every pension fund simply adores because it offers the best "risk-adjusted" returns. Yeah right! That adoration is about to get seriously tested as commercial real estate woes continue to mount in the United States and elsewhere:

Since the market's peak in 2007, the availability of debt - the lifeblood of commercial real estate - has dried up and choked off sales. Borrowers have resisted selling because of falling prices. Banks have not sold off their troubled loans, fearing a huge write-down of all commercial real estate loans. But it looks as if the clock is running down.

"We're going to see a whole lot more trouble going forward," said Peter Steier, vice president of Inland Mortgage Capital in New York.

Steier was speaking at the Distressed Commercial Real Estate Summit East, where about 200 investors, lenders and buyers recently gathered to discuss how to capitalize on the distress of the commercial real estate sector, as signaled by the growing number of foreclosures, sick banks and distressed loans.

From their peak last year, office prices in the second quarter were down 11.2 percent, according to the real estate research firm Reis Inc.; prices for retail spaces fell 4 percent; and warehouse and distribution center prices were off 6.7 percent. (Apartment prices, by comparison, were down 13.8 percent from their peak in late 2005.)

Commercial real estate sales in the United States are expected to fall 66 percent this year from $467 billion to an estimated $159 billion. This is because debt, especially securitized debt in the form of commercial mortgage-backed securities, or CMBS, is either unavailable or prices are too high and the terms too strict for borrowers, Reis said.

So how are pension funds going to cope with vanishing alpha? That ladies and gentlemen is the trillion dollar question that global pension funds are asking themselves these days.

My advice to pension fund managers is to go back and read John Maynard Keynes. You need to understand that capital markets remain a "beauty contest" and that "markets can stay irrational longer than you can stay solvent."

That last quote from Keynes is my favorite one and the one that most investors, including pension funds, seem to forget at the worst possible time.

Unlike the Great Houdini, I fear that most pension funds are not prepared to escape the wrath of this financial crisis.

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