Monday, December 12, 2011

Hedge Funds' Fading Star?

Anuj Gangahar of the WSJ reports, Hedge Funds' Fading Star:
There was a time, not so long ago, when the term "star hedge-fund manager" had a legitimate place in the investment lexicon. Today, however, the sector smacks more of faded grandeur than constellation.

Take John Paulson. At the height of the financial crisis, he and his company, Paulson and Co., amassed returns on a gargantuan scale after correctly calling the U.S. subprime mortgage crisis. By reportedly making $3.5 billion (€2.6 billion) in a year as a result, Mr. Paulson became the benchmark of success in the hedge-fund industry. But as market volatility has wreaked havoc upon the portfolios of even the savviest investors, such star managers have become increasingly rare. Even Mr. Paulson has suffered a series of setbacks of late after two of his largest funds recorded losses earlier in the year.

Stellar performance has proved elusive across the investment world. But unlike the more-run-of-the-mill active funds, hedge funds must justify their hefty fees with strong absolute returns or investors will rapidly lose patience. This is particularly true as the year-end approaches and investors' thoughts turn to redemption.

Investors considering putting money in hedge funds nowadays need to approach their decision with eyes wide open. As a means of diversification, in terms of investor asset allocation, they are still a generally positive proposition. And the fact remains that if a hedge-fund manager has a particularly good year, huge returns are still possible.

But if investors are seeking the outperformance on which the industry earned its hard-driving reputation, they will mostly be disappointed. As institutional money has flowed into hedge funds and rules governing them have been tightened, the market has become less exciting. This move into the mainstream means many are now a relatively safe investment. But investors have to ask themselves whether safety is enough of a selling point, particularly in light of the fees many hedge funds charge.

Questionable Fees

Typically, a hedge fund will charge a management fee of 2% and a performance fee of 20%. These figures vary depending on a manager's track record of success, reputation, longevity or sheer chutzpah. The best-performing–or most self-confident–managers have been known to charge management fees as high as 5% and performance fees approaching 50%. Investors inevitably question fee levels when performance turns out to be no more than mediocre. And in recent times, taken as a whole, the hedge-fund industry's performance has been just that.

According to Chicago-based data provider Hedge Fund Research, the average hedge-fund portfolio across all strategies was down 3.5% between January and November this year. This is in spite of a positive month in October, when HFR's weighted composite hedge-fund index gained 2.43%. This gain followed a third-quarter drop of 6.5% from the previous quarter–the fourth-worst quarterly performance on record. Despite these recent woes, fee levels remain stolidly at, or just below, the 2% mark for management and 20% for performance.

John Bailey, founder and chief executive officer of Spruce Investors, a U.S.-based fund-management company that invests money on behalf of endowments, family offices and wealthy individuals, says finding good hedge-fund managers has become harder in recent years as the barriers to entry have come down. "Now people want alpha generators and managers who have skill at shorting," he says. "It can be a slog to find those managers. It is a global process of networking and involves meeting a lot of frogs. It is usually quite apparent when you find a truly great manager."

As the hedge-fund industry matures and moves further into the fund-management mainstream, investors are re-examining the ways in which they are allocating money to alternative investments. According to Paul Hamill, global head of prime finance at HSBC in London, the hedge-fund investor base has changed. "More money than ever is institutional money, and so the expectations among investors for what hedge funds should deliver have changed," he says. "The money coming into hedge funds now is more sticky, tends to take a longer-term view and is more ready to ride out volatility."

He adds that before 2008 and the worst of the financial crisis, performance was the single most important factor to investors. But this is no longer necessarily the case. "Long-term performance is still important, but other selection factors such as risk and control infrastructure, non-correlated returns, quality of investment team and investment philosophy, liquidity terms, stability and asset manager brand are increasingly critical factors," he says. "Allocations are increasing to the firms with scale, brand and long-term track record far more than was the case pre-crisis."

This isn't surprising, says Emma Sugarman, global head of capital introduction at BNP Paribas in New York. She says there has been a flight to quality since the financial crisis, with big brand-name managers and funds taking in almost all new or reallocated money. All the trends seen since the crisis have helped to move hedge funds further into the mainstream. But the continuing volatility also puts pressure on managers to perform. "It is during times such as these that you see who genuinely generates alpha," Ms. Sugarman says.

The concentration of money with the largest hedge funds, and the tendency of institutional investors to invest with those funds, has led to doubts about the very survival of smaller hedge funds. Mr. Hamill says questions are being asked about where the cut-off is, in terms of assets under management, for a hedge fund to attract institutional money.

At a certain level of assets under management, funds tend to have the long-term track record, infrastructure and the brand to attract institutional money.

"In most cases, in this post-crisis world, a quality brand probably trumps short-term performance."

Mr. Bailey of Spruce Investors disagrees. He argues that size is the enemy of performance, which is why his firm generally favors small to medium-sized managers. He also says wealthy individuals and family offices prefer smaller, more nimble managers and will tend to back those funds. But, Mr. Hamill says, some funds with less than $1 billion in AUM often struggle because they are not big enough to attract institutional money.

Volatility has continued to make investing with conviction a challenge. Ms. Sugarman points out the deeply conservative nature of today's investors, particularly with year-end approaching. "Lots of funds are essentially gearing up for 2012 at the moment," she says."

According to hedge-fund administrator GlobeOp, money flowing into hedge funds, as measured by the GlobeOp Capital Movement index, increased 2.05% in November, with outflows at 0.7%, a low for November since records began in 2006, reflecting low rates of redemption ahead of the year-end, when investors typically redeem their funds.

Capital Allocation

"There has also been a tectonic shift in where assets are going," Ms. Sugarman says. "Now lots of institutions are going direct to hedge funds. Some of the very largest, blue-chip funds of hedge funds are still gaining assets, but we are seeing large amounts of money going directly to hedge funds and I think this is generally positive for the industry."

Nicholas Colas, group chief market strategist at ConvergEx, a technology provider to asset managers and financial institutions, says that money managers, "whether they be hyperactive hedge funds or slow and steady mutual-fund investors, do not want to be left behind in any year-end rally. If the market ends the year +5%, for example, there is no shame for most managers in being +4%. But +1% in that market is too easy to paint as manager failure."

Managers slipping too far behind the market like this soon hear about it from their backers. "Investors these days are short on patience and so the window for performance is much smaller than it used to be. For a hedge fund even one year of poor performance can lead to survival pressure" Mr. Bailey says.

Any dummy paying 5% management fee and 50% performance fee to any hedge fund manager (don't care who it is) should have their head examined. This article tells me nothing new. Most hedge funds are selling beta as alpha, which is why they're delivering mediocre results. In fact, most funds aren't even keeping up with markets, and yet pensions funds and other institutional investors keep piling into them, getting raped on fees.

Francois Magny at RDA Capital here in Montreal shared this insight on hedge fund underperformance, which is worth noting:

Concerning your leverage Beta comments; I believe a return factor greatly affecting hedge funds is the small minus big effect. This year the Russell 2000 has underperformed the Dow by 12%! It goes a long way to explain the underperformance of hedge funds this year. We have analysed the returns of hedge fund indices and found that this small minus big plus a net long beta explains 80% of the hedge fund returns. Indeed most hedge fund managers are equity long/short, picking small stocks and shorting much bigger caps, keeping a net long bias.

Rolf Norfolk, Principal at Broad Oak Financial Services, shared this with me:

... and the beauty of the hedge fund scam is when the manager can't see any other killings to be made, he closes the fund and "returns investors' money". That is, only if you keep your eyes tightly shut about the fees. How many hedgies have walked away with more money than all their investors put together? I think we should be told.

And John Bailey, founder and chief executive officer of Spruce Investors, is absolutely right, size is an enemy at most hedge funds. Sure, there are exceptions like Bridgewater and others, but most hedge funds who garner assets fast, typically after a stellar year, all end up dwindling as they become large asset gatherers.

Importantly, any hedge fund that has more "marketing and client relationship" staff than investment staff should sound the alarm bells with institutional investors. And to all those pension fund clowns that are piling into "brand name" hedge funds, wake up and look at where the real smart money is going. Goldman and Blackstone aren't seeding hedge funds because they think the world is coming to an end or because they see no future in hedge funds. They see opportunity and aren't afraid to take risks -- risks that institutional investors should be taking in their own hedge fund portfolios. That's why it's time to rethink your hedge funds strategy.

"Oh but Leo, we love flying first class all around the world, going to silly conferences, meeting up with 'impressive' hedge fund and private equity managers. We know they're raping us on fees but we don't care, it's not our money. They wine and dine us at fancy restaurants and they have the cutest women on their sales staff. And some of them are so swell, they bribe us into investing with them. The whole experience is so sexy, you should know, you used to allocate to hedge funds and private equity funds."

I know all about it and can tell you from firsthand experience that it's all nonsense, both on the hedge funds side and private equity side. If I was a government auditor, instead of producing sham reports, I'd rip into the travel expenses of senior public pension fund managers and analysts claiming that they need to travel all around the world. Give me a break, most of these trips are a total waste of money. There are smarter ways to perform due diligence on managers without inuring all these travel expenses.

I'm glad institutions are starting to wake up on hedge funds and other alternative asset managers. Unfortunately, too many institutions are getting hoodwinked, and they'll end up paying the price for their stupidity. In this environment, top institutions are focusing on seeding performance driven emerging hedge funds using managed account platforms, not doling out billions to large asset gatherers who are delivering leveraged beta. Again, if you are a seeder fund or an institution looking to seed alpha talent in Canada, please contact me at LKolivakis@gmail.com and let me introduce you to sharp, humble and hungry emerging alpha talent. All liquid, transparent and scalable true alpha strategies and no problem being on a managed account platform.

Below, Ingrid Pierce, a partner at Walkers, talks with Deirdre Bolton on Bloomberg Television about regulation of the hedge fund industry. This is a hot area in the hedge fund world. Listen to her say how busy they are and what investors are demanding in terms of liquidity.

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