Tuesday, December 6, 2011

Hedge Funds Still Raking in the Big Bucks?

It seems like Mass PRIM isn't the only one piling into hedge funds. Underperforming hedge funds still raking in the bucks:
Hedge funds have done a poor job living up to their name in 2011, but they still managed to rake in the big bucks.

Rather than protect their investors against the market's losses, these funds have actually performed worse than the broader equity indexes.

An investor who put money into the S&P 500) at the start of the year would have lost just 0.8% as of Nov. 30. That same investor would have lost 7% if the money was in an actively managed hedge fund with highly compensated advisors, according to the Dow Jones/Credit Suisse Core Hedge Fund Index.

Despite the industry's subpar performance this year, investors continue to add to these funds. Overall a net $8.6 billion flowed into hedge funds by the end of September, according to the Hedge Fund Research Institute.

Why would investors put money into an asset class that charges significantly higher fees (roughly 2% on money managed and 20% on any profits) than all others, which generally charge about 1%? Ask the underfunded pensions.

"Today, boards have this serious pressure to increase their returns," said Yuliya Oryol, a partner and head of the public pension practice at San Francisco, Calif., law firm Nossaman. And hedge funds, while riskier than other investments, offer the promise of market-beating returns, even if they prove to be elusive.

Boards often think they have no other choice because of those returns, said Oryol.

Take John Paulson's hedge funds. The Paulson Advantage LP is down 32% from the start of the year through Sept. 30. But for those who invested in this fund in 2007, it generated returns of nearly 100%.

Public pensions are facing huge gaps between what they've set aside to pay for employees retirement and what they've promised. In 2009, the gap for state and local public pensions was $1.26 trillion, yes trillion, according to the Pew Center of the States.

Low yields on Treasuries, which generally account for 25% to 30% of a pension portfolio, have exacerbated pressure for pensions, which generally forecast annual returns of 7% to 8% to stay current with funding.

According to data from the Federal Reserve, state and local public pensions held $3 trillion in assets, so even a small uptick in their allocation to hedge funds moves the needle for the overall industry.

"Hedge funds offer instant gratification to pensions because they can make the decision and get fully invested in the next month," said Stephen Nesbitt, CEO of Cliffwater, an investment consultant to pensions and endowments.

But investors can just as quickly get burned if those bets don't pay off.

Some of Paulson's funds are down nearly 50%, after he made faulty bets on companies like Bank of America and Chinese forestry company Sino-Forest.

Such staggering losses forced Paulson to turn his third-quarter letter to investors into an apology. "Year to date performance was the worst in the company's 17-year history. We are disappointed and apologize for those results," said the letter, which was obtained by CNNMoney.

Still, fewer than 8% Paulson's investors say they plan to remove their money from the roughly $28 billion under management by year end. A spokesperson for Paulson & Co. declined to comment.

Pensions are still drawn to the promise of stellar returns, which may be what's keeping Paulson's investors in his fund. In his third-quarter letter, he estimates 934% returns for the life of one of his funds, which has been operational since 1994.

Pensions have been increasing their allotment to hedge funds by a few percentage points over the past year, according to Nesbitt.

Unlike private equity funds and real estate investment trusts which have five to 10 year lockup of funds, investors in hedge funds can also remove funds on a quarterly basis.

Oryol said her clients, which include the California State Teachers' Retirement System and the Los Angeles City Employees Retirement System, are using that flexibility to leave underperforming hedge funds and move the same amount or more into other hedge funds. For hedge funds like Paulson's, it appears that a mea culpa might be enough for now to keep investors' money.
When it comes to alternatives, I much prefer the liquidity of hedge funds over private equity and real estate, but still, investors need to know how to properly approach this asset class. Interestingly, the California State Teachers' Retirement System (CalSTRS) just announced the selection of Lyxor Asset Management as its advisor in the development of a new global macro hedge fund strategy:

The selection of Lyxor concludes a 15-month selection process for a consultant to help CalSTRS investment staff initiate, monitor and assess its global macro hedge fund strategy.

The new strategy is part of the CalSTRS Innovation Portfolio and will be implemented on a trial basis for up to a three-year period to determine its value to the larger CalSTRS investment portfolio.

“In these times of economic volatility and uncertainty, it’s important to diversify the CalSTRS portfolio into areas that protect against downside pressures,” said CalSTRS Chief Investment Officer Christopher J. Ailman. “We believe this strategy can help us accomplish this goal and Lyxor is vital to its inclusion into the CalSTRS portfolio during this trial period.”

Steven Tong, director of the CalSTRS Innovation & Risk unit, said: “During our search, Lyxor emerged as the top contender because of its strong track record in thoroughly vetting and overseeing global macro managers and hedge fund portfolios for large institutional investors such as CalSTRS.”

“We are extremely pleased to be working with CalSTRS, as it underscores our commitment to the U.S. market and illustrates our ability to partner with the largest, most sophisticated institutional investors in the world,” said Lionel Erdely, CEO of Lyxor Asset Management Inc. “Since 1998 Lyxor has been focused on helping institutional investors benefit from hedge funds while mitigating many of the associated risks.”

CalSTRS staff will work with Lyxor to select three to six hedge fund managers. Within three years, the CalSTRS Investment Committee will determine whether to expand the strategy on a permanent basis, continue to monitor it on a temporary basis or terminate it.

Some of Lyxor’s duties will be to assist CalSTRS investment staff to:

  • Develop, review and update investment policies, procedures and program structures for the strategy.
  • Develop a search strategy, identify highly-qualified managers and conduct due diligence on candidates and proposed investments.
  • Conduct regular manager assessments, perform account valuations, identify concerns and prepare quarterly reports to the CalSTRS Investment Committee.
  • Evaluate various investment structures, including managed accounts.
  • Research and analyze issues and topics in the global macro hedge fund space.
  • Provide training and workshops on global macro hedge fund topics for CalSTRS investment staff and the Investment Committee.

In general, a global macro hedge fund strategy uses a variety of financial instruments to achieve gains from price fluctuations in volatile environments, offering diversification and value protection during times of financial distress. The strategy historically has provided absolute returns with a low correlation to equities and offers lower volatility than equities.

CalSTRS is one of the best large US public plans. Its sheer size allows it to commit big tranches into ultra liquid global macro strategies. It chose the Lyxor platform, a well known managed account platform, but I still prefer Innocap's platform.

Nonetheless, the point is CalSTRS is approaching their hedge fund investments a lot more intelligently than most other pension funds, including Mass PRIM who are just piling into hedge funds, paying huge fees. Someone pointed this out to me:

The FoHFs really killed MASS PRIM and they paid over $35mn/year in fees over the last 5 years for lousy results – that is a lot of pensions that could have been paid. Look at the 5 year return column net of fees on page 5 – 1.75%. Now they have hired Cliffwater – a consultant – to help them pick and the Cliffwater guys have never managed a fund in their lives so guess what you will get???
Indeed fund of funds fees really hurt Mass PRIM and we shall see what results Cliffwater delivers.
A lot of consultants never managed a fund and yet the consultants are the gatekeepers in the US where cover-your-ass politics permeates public pension funds.

And just how are global macro funds performing in 2011? According to HFR, not so great but far better than the rest:

Hedge funds extended their losses for the year in November, leaving almost all strategies in the red with just a month left in 2011.

October's turnaround was short-lived for the HFRX Global Hedge Fund Index, which fell 0.87% last month. The benchmark is now down 8.48% on the year; having missed out on most of October's stock-market rally, the index once again underperformed the Standard & Poor's 500 Index, which lost 0.5% last month.

Most of the strategies tracked by Hedge Fund Research for the HFRX suite also lost ground in November—and all but one are in negative territory for the year. Only multi-strategy relative value funds remain in the black in 2011, and barely, at 0.21% after a 1.06% November loss.

Meanwhile, one of November's few winners, fundamental value stock funds, which added 0.15% last month, remain the worst-performing strategy of the year, down 22.73%.

Last month's other positive performers were systematic diversified commodity trading advisers, up 1.42% (down 2.59% year-to-date), and macro funds and CTAs, up 0.3% (down 4.61% YTD). But they were vastly outnumbered by the losers.

No strategy took a bigger hit in November than distressed restructuring, which fell 2.37% (down 7.23% YTD). Fundamental growth stock funds lost 2.13% (down 12.77% YTD), market directional funds 1.38% (down 17.68% YTD), equity hedge funds 1.34% (down 18.38% YTD), relative value arbitrage funds 1.15% (down 4.11%) and convertible arbitrage funds 1.1% (down 3.38%).

Event-driven funds fell an average of 0.96% last month (down 4.36% YTD), special situations funds 0.76% (down 3.03% YTD), merger arbitrage funds 0.28% (down 2.16%) and equity market neutral funds 0.19% (down 3.1% YTD).

You might be looking at the figures above and asking yourself why would any institution in its right mind pay 2 & 20 for such poor results? Good question. The bulk of hedge funds deliver mediocre results and the amount of pension monies going to pay fees on hedge funds and fund of funds is downright scandalous.

I can repeat the above often enough but institutions are doing whatever their brainless pension consultants are telling them to do. I've been telling pensions to start thinking outside the box, focus more on beta and start seeding new emerging alpha managers using a managed account platform.

CalSTRS will be investing in global macro funds using Lyxor's platform but I know others who invest in all sorts of strategies including L/S Equity, CTAs, commodity relative value funds, equity market neutral and convertible arbitrage funds using other platforms.

And still, very few sophisticated institutions are seeding any emerging funds. The smart ones are looking into seeding funds, but most just invest in brand names and getting raped on fees. If you want to know what the smart money is doing, look at Goldman Sachs, they are seeding hedge funds:

Goldman plans to use the new fund for providing start-up money to hedge-fund managers varying from 8 to 10 new hedge funds. Moreover, in each hedge fund Goldman would invest $75 million to $150 million from the new fund created, which in turn, is expected to raise approximately $1 billion in total.

Hedge fund is a portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns. Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a initial minimum investment. Investments in hedge funds are illiquid as they often require investors to keep their money in the fund for at least one year.

Overall, this new venture would be beneficial for the bank. It would earn fees on the total amount managed by the fund coupled with fees generated from hedge funds’ business conducted through bank’s trading unit. On the other side, investors will gain due to the hedge funds’ profits, excluding a percentage of the hedge-fund managers’ fees.

According to the Journal, Goldman fund has already started working. In September, the fund invested approximately $100 million in a New York-based hedge fund called Palestra Capital Management LLC.

Previously, Goldman and a number of its peers, such as Morgan Stanley (NYSE:MS) and J.P. Morgan Chase & Co. (NYSE:JPM), bought hedge funds in expectation of high returns. But unfortunately, at the peak of 2008 financial crisis, they incurred huge losses.

On the regulatory front, the new fund has no limit on investment or trading as Goldman is using only clients’ money for the venture rather than its own money. Moreover, the existing goodwill of Goldman in the market and its association with hedge funds will facilitate new hedge-fund managers to raise more cash from other investors and from brokers.

In spite of volatile returns in the recent years, the hedge fund industry has bounced back sharply. The assets have outpaced the height reached in 2008 and currently amounted to more than $2 trillion, according to Chicago-based Hedge Fund Research.

Additionally, seeders are raising more cash. According to the results of a survey of about 40 global hedge fund seeders generated by New York-based firm-the Acceleration Capital Group, the total capital projected to be invested with emerging managers in the first half of 2011 was expected to be around $2.5 billion, double the amount expected in comparable survey showed in 2009.

Further, the business of seeding hedge funds is expanding as large number of money managers is interested in raising new funds and investments from large financial institutions.

I can't emphasize how important it is for large and small pension funds to start thinking about seeding hedge funds, especially in this tough environment. CalPERS took a small step in this direction, seeding a Canadian hedge fund, but a lot more funds need to come to Canada and start rethinking their entire hedge fund strategy.

Again, if you are an institution looking to seed liquid strategies such as global macro, CTAs, commodity relative value strategies, L/S Equity, please contact me and let me introduce you to a handful of managers with strong track records worth seeding. My email is LKolivakis@gmail.com and trust me, I won't waste your time or my time peddling any manager that I wouldn't invest in myself.

I'm the toughest, most cynical investor on earth. As far as I'm concerned, most hedge funds are full of crap, selling beta as alpha! Nonetheless, they manage to consistently pull the wool over investors' eyes and are still raking in the big bucks and the big fees that come along with these pension monies. Below, an example of marketing nonsense from the Hedge Fund Association.

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