Tuesday, September 29, 2009

Are Hedge Funds Worth It?


Gregory Zuckerman of the WSJ writes that Pessimism Exacts Price on Skeptics:

Hedge-fund manager Peter Thiel is suffering, not because he lost money in the downturn, but because he missed the rebound.

Mr. Thiel, a billionaire co-founder of online payment company PayPal and an early investor in Facebook, thinks the economy is far from recovered and has bet with the bears amid the relentless rally. His fund has seen double-digit declines as other hedge funds have racked up gains.

"The recovery is not real," he says. "Deep structural problems haven't been solved and it's unclear how we will create jobs and get the economy growing again -- that's long been my thesis and it still is."

The contrarian view puts Mr. Thiel among a group of investors with impressive track records who are holding out, unwilling to buy into the notion of the economy's rebound.

In London, the largest fund of John Horseman's $4 billion hedge-fund firm is down 20% this year; "it is hard to build longer-term confidence when employment prospects and job markets are shrinking," he said in a client letter.

In New York, a large hedge fund run by investing power Renaissance Technologies dropped almost 12% through August by wagering on stocks with promising earnings prospects and betting against those seen as flimsier. And in Chicago, Benjamin Bornstein's smaller Prospero Capital Management lost almost 5% through the second quarter, but he is still shorting the market.

Heavy job losses, weak revenue growth for most companies, full stock-price valuations and an inability of the economy to grow without help from the government are all reasons Mr. Bornstein remains wary of stocks.

"I have rarely been so convinced that the next broader market move is down," says Mr. Bornstein, who avoided most of the market's troubles last year. "The problem is that governments do not create income or wealth, and current stimulus equates to a future tax liability. That will become a major concern in mid-2010 when the stimulus is done."

Mr. Thiel's Clarium Capital Management, which at one point last year had $6 billion in assets, has seen losses of nearly 16% through mid-September, compared with a 14% rise for hedge funds broadly through August, according to Hedge Fund Research Inc. Clarium now manages about $2 billion. In 2008, Clarium lost 4%, even as the Standard & Poor's 500-stock index fell 38%, and the firm has recorded annual gains averaging 22% since inception in 2002, according to investors. Last year, the fund was sitting on gains of more than 40% before the collapse of energy prices caught Mr. Thiel by surprise, making Mr. Thiel's contrarian stance in the face of losses seem more gutsy.

For the skeptics, the stakes are high. The hedge-fund business had its worst year on record last year; another year of disappointing performance could be the death knell for many funds that struggled last year.

Mr. Thiel wouldn't seem like an obvious poster boy for the market's worrywarts. A 41-year-old former nationally ranked scholastic chess player and graduate of Stanford Law School, he was chief executive officer of online-pay service PayPal earlier this decade and scored big in 2002 when eBay Inc. bought the company for $1.5 billion. Mr. Thiel added to his venture-capital successes with early investments in firms like Facebook and Palantir Technologies, a high-tech firm that hunts for terrorists.

In 2002 he launched Clarium and scored impressive gains for several years, largely by buying up energy investments on the view that growing global demand and more limited supplies would boost oil prices.

For much of this year, Mr. Thiel's firm placed a series of bets against the market, in part because valuations on a range of global equity markets have looked rich, he says. As markets have climbed higher, he has been forced to scramble to trim the positions, to avoid deeper losses.

He has bet on the Japanese yen, purchased safe bonds, wagered on the dollar, all in the belief fear will return to the markets. He has taken other conservative steps because "a real, sustainable recovery is not possible without productivity growth."

"The U.S. and much of the developed world are not very competitive globally -- that would require difficult improvements in technology that I'm not seeing enough of," he says.

The most exciting technologies being developed, including robotics, rockets, artificial intelligence and the next wave of biotechnology, are several years down the road, Mr. Thiel argues.

Mr. Thiel says he is sensitive to a challenge to pessimistic investors who prospered during the tough period of the past two years -- becoming overly negative. Some of his investors ask Mr. Thiel if he could lose serious money in the short term, he says, even if he is right over the long haul. He is sticking to his stance.

"The government has helped stabilize the banking system, but I'm not sure we have a path toward sustainable growth," partly because consumers are dealing with debt and other issues, even as an energy crisis looms, he says. "It always feels unpatriotic to be negative. But too few people are focused on the real problems."

While I respect the arguments put forth by Mr. Thiel and Mr. Bornstein, they risk getting crushed in the next market melt-up. What's that? Market melt-up? Huh? The MSCI Global Index is up 66% since March lows and as I write this comment, Australian and Japanese stock futures fell after prices for oil and U.S. equities retreated ahead of a U.S. employment report.

I have a feeling that the U.S. employment report will surprise to the upside (it could even be a monster report with upward revisions to the previous report) and the Dow will smash through the psychologically important 10,000 level in the days that follow. Remember, there is a lot of performance anxiety out there and all the "experts" are predicting a major market pullback in October. These experts are typically wrong.

The fact is the U.S. economy is slowly turning the corner. Yes, consumer confidence unexpectedly fell today, but confidence is fickle and driven mainly by gloomy job prospects. As the labor market slowly recovers, confidence will recover too. Moreover, even though U.S. durable goods orders dropped in August, it was mainly due to nondefense and defense aircraft orders. There were gains in primary metals, fabricated metals, machinery and communications equipment, all of which point to a cyclical recovery. When investment picks up, employment gains usually follow.

Now, back to hedge funds. A lot of them are hurting but most are doing well because they're riding the Beta Express up while charging alpha fees to their investors. Bloomberg reports that Geneva’s funds of hedge funds saw client inflows for the first time in 11 months in August, halting a slump that accelerated after losses related to Bernard Madoff’s Ponzi scheme.

Then you got China's $200 billion sovereign fund - China Investment Corp (CIC) - that just plopped a cool $200 million into Capula Investment Management and is set to pour a total of $2 billion into three U.S. distressed asset-focused funds, including one managed by Goldman Sachs.

[Note to CIC: Be very careful about how you deploy those billions. If I were you, I'd talk to Ron Mock at Ontario Teachers' Pension Plan (OTPP) and Leo de Bever at Alberta's Investment Management Corporation (AIMCo). They're two of the sharpest guys in Canada's pension fund industry and well worth speaking to.]

Finally, reporting for OnWallStreet, Elizabeth Wine asks Hedge Funds: Are They Worth It?:

Hedge funds, those opaque alternative investments designed to post positive returns regardless of how the overall market performs, created headlines for falling into the red alongside traditional investments in last year's brutal crash. The fall from grace was so sharp that many smaller funds have shuttered, and observers expect more to follow.

Not surprisingly, investors headed for the exits. Some analysts and financial advisors now say that hedge funds overcharge for the service they deliver. They say that last year's mauling showed that this emperor had no clothes.

Still, some investors are considering going back to the surviving funds. Strategists in the wirehouses and elsewhere say hedge funds were wrongly maligned, and that the good funds can still serve the purpose of diversifying a portfolio and reducing risk. Better still, they say hedge funds are positioned to do well in the coming months and years.

Indeed, a few hardy souls are dipping their toes back in the alternative waters. The combined intake of $41.4 billion for May, June and July was the first net inflow for a three-month period since December 2007, according to HedgeFund.net. This fresh cash comes after a drop of 37% from the peak of $2.94 trillion in April 2008.

Despite the recent inflows, the amounts are small enough that some analysts are loath to call it a trend. "Investors are taking a wait-and-see attitude; they are going to wait to see what happens to the money they put in," said Peter Laurelli, head of hedge fund industry research at Channel Capital Group, which runs HedgeFund.net. "Once you go through a difficult situation it's tough to come back with the same intensity," he said. He expects August to post another modest inflow.

It's easy to see the new allure of the funds. HedgeFund.net's aggregate index for all the strategies it tracks shows an increase of 12% for the year through July. The benchmark dropped 15.8% last year.

Many in the industry warn against trying to glean too much from one overall performance statistic because these funds track various investment strategies that are designed to perform differently in different scenarios. (One old saw has it that hedge funds are a billing class rather than an asset class, referring to the 2% management fees and 20% performance fees that most have in common.)

But a deeper look into HedgeFund.net's overall numbers shows that nearly every strategy practiced by the 7,100 funds and funds-of-funds in its database gained ground. Thanks to the rally in equities and commodities, the only losing strategy is practiced by short-based funds, which saw its index drop 12.4% through the end of July. The best performing index so far this year tracks the funds investing is India, which notched gains of 34.7%.

ABSOLUTE RETURNS

The increase in performance this year is a welcome change for investors, but why was last year so bad? Hedge funds certainly did better than the broader market, but whatever happened to the notion that these investments were supposed to be "absolute return vehicles?"

Nadia Papagiannis, hedge fund analyst at Morningstar put it most succinctly: "It's a fallacy. No such strategy makes money in every single market. Theoretically, it's possible... if you can hedge out all market risk in your portfolio and always have positive alpha, then you can have an absolute return strategy," she says. "It's a good theory, but it doesn't work in practice. I've never seen a manager who always profits from stock picking and market timing. And a lot of funds that say their strategy is absolute return aren't [portraying it accurately] because a lot of strategies work well in some environments and not in others. To say that's absolute return is lying," Papagiannis says.

This issue was the subject of a January research report, "Why My 'Absolute Return' Hedge Fund Lost Money 'Absolutely' in 2008" by Gregory Dowling of the Fund Evaluation Group, a consultancy catering to institutional clients.

[Note: Also read 7 questions for Greg Dowling.]

He pointed out that hedge funds did their job of returning absolutely in the bear market of March 2000 to March 2003. They protected capital and managed to profit as well. And investors expected them to do it again in the next downturn.

But the funds didn't deliver on that expectation, and his report explained what went wrong, cataloguing the firestorm of problems hedge funds encountered last year: an uncertain regulatory environment, deleveraging and an over reliance on the investment banking system. "Given the higher fees and lower transparency, many investors are questioning the hedge fund model and its place within a portfolio," he wrote.

Nonetheless, he concluded that the hedge funds that survived the shakeout were positioned to do well in the future. Summing up what has become a widely held opinion in the industry, he wrote that fewer hedge funds, and less trading by investment banks, means less money chasing the same trades. And that means more profit for the survivors. Moreover, since most of the funds got rid of their extra leverage and appear to have kept it off, they won't run the risks they used to.

Indeed, Dowling agreed with alternatives experts at Merrill Lynch, Wells Fargo, UBS and Raymond James, writing that hedge funds provide value despite their hefty price tags.

Now, heading into the fourth quarter, his colleague Susan Mahan Fasig, director of alternative investments at Fund Evaluation Group, reiterates that early assessment. "It's a great time to be in strategies like long/short equity because things are starting to turn on fundamentals, rather than broad market factors like liquidity risk," she says. "And because the volatility in the market is good for anybody running a hedge fund, exposure to volatility gives you the opportunity for return." She notes that volatility doesn't usually come into play with long-only equity strategies, like those used by the vast majority of equity mutual funds. Fasig also notes that there is opportunity for hedge funds that take advantage of mispricing. The markets are littered with "displaced securities," stocks dumped during the meltdown at fire sale prices by banks and hedge funds racing to lower their leverage or meet redemption requests.

THE ADVOCATES

Experts in the wirehouses take to heart the numbers that show recent hedge fund inflows. David Bailin, president of alternative investment asset management at Merrill Lynch Wealth Management says, "We think the bottom of the hedge fund market has been reached," noting that net redemptions had stopped by mid-May. He says that Merrill's research backs up the notion that many of the funds are seeing cash inflows.

He also says that hedge funds are more institutional than many critics have charged. Last year, commentators projected that about one-third of hedge funds would go out of business. He countered that by saying of the top 100 managers, the actual casualties are only about 5% and he believes fewer than 10% will close by the end of 2010.

Further, he vigorously defends hedge funds' performance in last year's meltdown. "It's a misnomer that they weren't good." He did a back-of-the-envelope calculation and concluded that once leverage is taken out of the equation, hedge funds had a "pre-leverage loss" of only 6.1%, compared with a plunge of 36% for the S&P 500.

And what about the idea of absolute returns? "I think that's an education misnomer," Bailin says. "If I had to criticize our industry, it's that we allowed that phrase to be discussed. Hedge funds are a risk-taking enterprise like any other risk-taking strategy, and the idea that we would not suffer losses in a year like 2008 or in a normal bad year is a mistake. As an industry we need to change that perception of absolute return. That's not the purpose of investing in hedge funds. The purpose is diversification and obtaining sources of profit and risk from different sources in the market."

The Fund Evaluation Group agrees, saying in the January report: "What will change is the very way hedge funds market themselves and the use of terms such as 'absolute' returns. Hedge funds are not magic, but merely unconstrained active management."

Regardless of how hedge funds sold themselves, alternatives experts say that it's the job of advisors to make sure clients understand that there's really no such thing as absolute return all the time. Overcoming the myth surrounding hedge fund managers' market-defying skill comes back to a fundamental part of the advisor's job-regardless of the type of investment. "It's all about setting realistic expectations for the client," says Tim Froehlich, director of Alternative Investments at Wells Fargo Advisors. "What 2008 did was show you that what could happen, would happen," he says.

Froehlich's overall recommendation to clients-using a diversified portfolio of hedge fund strategies-has not changed since the crisis. He says what's new isn't really new at all: a strong reiteration of the importance of setting client expectations early.

Education in the beginning is critical, says Chris Butler, a vice president in Raymond James' alternative assets group. "We work with advisors and clients on what we expect of a fund." That includes fees and liquidity, or the lack thereof, whether redemptions are only allowed quarterly, or even annually. "It's critical that the client understands how the manager is creating value, and the risk that goes along with creating that value," he adds.

Others have noticed the same educational need. September saw the launch of website getalts.com, from investment management firm Rydex/SGI, to help teach investors about alternatives and how they can help a portfolio.

There is one piece of information Butler says clients are asking for now, often before the advisor can bring it up: the due diligence on the managers. In the wake of the collapse of the $65 billion Ponzi scheme run by disgraced financier Bernard Madoff, clients are realizing the importance of having someone vet a manager, and working with an advisor in assessing a particular strategy or manager.

The other form of due diligence is a fund-of-funds, in which a manager creates a portfolio of hedge fund managers. They relatively well last year, Froehlich says. The criticism that they're too expensive-adding an extra layer of fees, usually 1% to 1.5% atop the hedge funds' already high costs-is misguided, he says. "The funds- of-funds proved their worth last year by exiting some of the funds you saw in the paper [for poor performance]. They justified their fees with their expertise."

THE NAYSAYERS

Even in the good days, high fees were a big problem with hedge funds. But those may decline now thanks to pressure from investors disgruntled at the losses from last year, says Fasig of Fund Evaluation Group.

But it may be too little too late to sway others. Morningstar's Papagiannis says that for advisors, the best bet is to use mutual funds that follow the same strategies as hedge funds, minus the high performance fees. Plus, because mutual funds are more closely regulated, they can't use the same amount of leverage or hold as many illiquid assets, making their portfolios less risky. She acknowledges that hedge funds are good diversifiers, especially those using strategies with low correlations to stock and bond markets. But even some of those strategies, including arbitrage and market neutral, can be replicated by mutual funds. Some mutual funds she likes include The Arbitrage Fund, which is up 6.4% through the end of July, and shed just 0.63% last year. That compares to the merger arbitrage hedge fund category, which fell 4.34% last year.

She also likes the Highbridge Statistical Market Neutral Fund, which rose 9.79% last year, compared with a loss of 4.67% for its hedge fund peer group, Morningstar's equity arbitrage hedge fund category. (She said that not many mutual funds use this strategy, so there are not enough funds to have an appropriate peer group comparison.)

Although she generally disapproves of funds-of-funds because of the extra layer of fees, she does like a new entry to the mutual fund-of-funds arena: Aston/Lake Partners LASSO Alternative. The portfolio of alternative hedge-like mutual funds opened as a mutual fund recently, but has an institutional track record dating to 1998. The expense ratio is high for mutual funds, 2.58%, but that covers all the underlying funds, and the fund does not carry performance fees. Since it opened in May until the end of July, it gained 6.4%. Over the same time period, Morningstar's fund-of-funds category gained 7.5%.

But not everyone thinks mutual funds automatically win the argument on price alone. Bailin of Merrill notes that the track records of some of the hedge fund imitators are short. "It'll be interesting to see how those strategies do in 2009 and 2010 versus the top half of hedge funds." He adds that hedge fund managers' storied compensation puts them more in line with investors' interests than their cheaper mutual fund counterparts. "Hedge funds pay a manager when they make profits and pay them to avoid sustained losses, but that doesn't mean the returns they generate will always be positive."

Still, those losses mean at least one good thing for beleaguered investors who still have money invested with a hedge fund. Managers won't be pocketing the 20% performance fees for some time. The fees are charged once the manager has hit a certain benchmark-albeit a sometimes fairly low bar, such as Treasuries. But the practice is not allowed after losses until the manager has made back an investor's money from its so-called "high-water mark."

Papagiannis calculated that in the maximum drawdown from peak to trough, investors lost 25.2% between the beginning of November 2007 and the end of February 2009. Between March and July, the hedge funds in Morningstar's database gained 14%, so one might think investors only have 11% to go to get back to square one. But really they have 17% to go to break even.

Funds-of-funds have an even bigger hurdle to make investors whole again. They lost 24.7% in the same period, and between March and July climbed 9%, leaving a gain of 21.7% to go before investors get back to their original investment. That's before the funds can charge a performance fee again.

Still, critics say some of the shuttering hedge funds with an even worse sin than failure: gamesmanship.

They suggest that some of the fund managers are simply closing down temporarily so they do not have to spend months, if not years, working to regain investors' money without being able to charge that 20% performance fee. If they open a new fund later, they can charge 20% performance fees again as soon as that first benchmark is surpassed.

Dominick Vetrano, a certified financial planner and a certified public accountant with Clune & Associates in Chicago, says, "They closed down because they can get rid of the high-water mark. Then wait a while-a year or two until memory fades-hide for a bit, then come back out and say, 'We have a new strategy.' I'll say I have a proprietary model nobody understands, and I could be doing the same thing. The market goes up, and I get carried up with the rest of the market and I make 20%. It's a beautiful thing. They say they don't get paid unless they're making you money, and that's true-unless they close the fund and start over. Nobody thinks about that."

Vetrano has heard many sales pitches from hedge funds to his clients, who have an average net worth of $3 million to $4 million, and generally declines. He'll occasionally recommend a managed futures strategy—one he notes has been around for 40 years—for diversification and low correlation to other assets. But only to substantially wealthy clients who will not need the liquidity. In any case, his clientele has almost no appetite for hedge funds these days. "Since the crash and Madoff, people only want things that are public. Anything fairly convoluted, people back away—even private structured notes. Anything illiquid is really hard to present to anybody now. Before they would entertain it," he says. "I don't see that at all now."

The big change in his clients from before the crash is they've lost their snobbery, Vetrano says. Many wanted entire portfolios of hedge fund managers—up to 70% in alternatives, "because anything else they saw as stupid, for the masses," he says. "They wanted to be better than that. It was like going to a nightclub or a special restaurant that was invitation only. Did they understand it? No, they thought it was a privileged investment, and that they'd get better performance. Not that zero correlation stuff that you hear from advisors, or adding alpha. None of that stuff was thought of."

If the fund flows are indicative, they're thinking hard about it now.

They'd better be thinking hard about it, because take from it from someone who has conducted many due diligence exercises and invested with some of the best hedge funds in the world, these 'absolute return' funds are no panacea. And in many cases, they are pure con artists peddling snake oil.

I am glad the SEC is finally moving to beef up reporting from U.S. hedge funds, but I fear that this won't be enough. As I stated before, I prefer liquid hedge fund strategies in managed accounts, which allows investors to pull the plug if they feel a manager is severely underperforming.

But I warn all of you, liquid risk strategies are highly correlated, so don't be fooled into thinking that just because you have liquidity and transparency, you are not at risk of a severe downturn. In these markets, things can go awfully wrong very quickly. Always be prepared for the unexpected.

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