Thursday, December 1, 2011

Time to Rethink Hedge Funds Strategy?

The Economist reports that hedge funds are suffering a terrible year and remain dazed and confused:
Managers of hedge funds like to think of themselves as seers, skilled in predicting where the market will go next. But today they are staring blankly at their liquid crystal screens and wondering where it all went wrong. The average hedge fund has fallen by around 9% this year; the S&P 500 has fallen by just 3.4%.

It is an unwelcome reminder of the past. In 2008, the average fund declined by more than 19%. This year’s euro crisis could be even worse. Managers have diligently researched undervalued stocks, only to see markets plunge after yet more bad news from Brussels. When funds instead position themselves more conservatively and short stocks, the markets promptly rally on the merest whiff of better news.

An unaccustomed timidity has seized many hedge funds. They have reduced their leverage, which enhances returns but aggravates losses, too. They are shrinking positions and trading less. There is a “conviction to do absolutely nothing” among hedge-fund managers today, says Andy Ash of Monument Securities, a brokerage.

Some fund managers privately confess that they wish they could move entirely into cash and sit out the market turmoil. But they feel pressure to continue trading to justify the steep fees they charge for managing investors’ assets.

With turmoil comes temptation. A few managers swear that some assets are cheaper than ever, and that “spreads” (the difference between prices) are astonishingly wide. Basil Williams, the boss of Concordia Advisors, points to the difference in the price of some holding companies and their subsidiaries as a buying opportunity. Another manager cites the wide price gaps at some dual-listed companies, such as Rio Tinto, a mining giant, which is traded in Britain and Australia. But many are too scared to pounce, in case prices diverge even more.

The dilemma of whether to pile in or stay put is perplexing hedge funds. Many remember the sudden rally in 2009 and regret they were not in a position to ride it. “The whole hedge-fund industry is completely terrified of missing a rally now,” says the boss of a London-based fund. But John Paulson, a hedge-fund boss once famed for his prescience, offers a reminder of the risk of premature bullishness. He recently apologised to investors for being “overly optimistic” about the economy earlier this year, leading to the worst performance in his firm’s 17-year history.

One small source of comfort, however, is that most of Mr Paulson’s investors are still with his fund. Perhaps they learned their lesson from the last crisis and don’t want to sell at the bottom. More likely, they can’t think of anywhere better to put their money.

Indeed, TraderMark reports that the big drop in hedge fund exposure to market in Q3 ended up costing them:

I don’t find this data at all surprising as I think about how I would be approaching the current market… with the short term gyrations and huge moves up and down, often on rumors or innuendos it’s an incredibly difficult market to wrap your arms around if your time frame is longer than 1-3 hours days. The fact that correlations are so extreme (“Lemmings on”!) does not help either. Looks like the hedge fund industry is viewing it the same way, as net exposure to the market has dropped significantly between Q2 and Q3.


  • Frustrated by market volatility over the European debt crisis and uncertain U.S. economic outlook, the so-called smart money—hedge funds—has thrown in the towel for 2011 and pulled out of stocks, according to fund managers, SEC filings and exchange data.
  • Hedge funds have slashed their exposure to stocks—both on a long and short basis—to the lowest level since 2008, according to Bank of America Merrill Lynch analysis of SEC disclosures and NYSE and Nasdaq data.
  • Their net long exposure to stocks plummeted by more than a third, the biggest drop since 2009, stated the report by analyst Mary Ann Bartels entitled “Hold ‘em and Fold ‘em.” Hedge funds are clearly as worn out by gyrating markets as everyone else.
  • The uncertainty coming from the Eurozone has created an environment where almost all asset classes have traded in tandem and fundamental analysis has been almost irrelevant,” said Michael Murphy, CEO of hedge fund Rosecliff Capital. (amen brother) “The very analysis that hedge funds rely on has become secondary to the headlines coming out of Europe on a daily basis.”

“The rally in October was a worst case scenario,” added Murphy. “It brought the S&P back to the black for 2011. A lot of funds were extremely hedged or net short due to the global uncertainty.”

This month, stocks have fallen back below breakeven for 2011 as uncertainty over the size of the European bailout grows and a failed bipartisan agreement to cut the U.S. deficit points to more political infighting next year.

Hedge funds have paid the price. The HFRX Global Hedge Fund Index—compiled by industry observer Hedge Fund Research—is down 9.9 percent for 2011 through the end of last week. The S&P 500 is still negative on the year—even with Wednesday’s rally—and the majority of global markets are the same.

Bartels’ research report also showed that hedge funds raised their cash levels to 6.8 percent. They cut their exposure to the financial and industrial sectors by half. These would be among the hardest hit if the Euro falls apart, sparking a financial crisis that grinds global growth to a halt.

Favorite positions among hedge funds were gold, Treasurys and sectors with inelastic earnings streams such as pharmaceuticals and staples , according to Bank of America Merrill Lynch. (i.e. very conservative)

Volatility plus correlation equals no liquidity,” said Alec Levine, an equity derivatives strategist with Newedge Group SA. “It is very hard to find an economically viable hedge—they become too expensive and eat up too much of your potential return. Welcome to the ‘live to fight another day’ market.

The weak performance of hedge funds doesn't surprise me. The majority of hedge funds are mediocre, overblown marketing machines, selling beta as alpha. They stink! And I'd shoot any hedge fund manager who was charging me 2 &20 to hold cash! These charlatans are no better than their long-only counterparts who are closet indexers. Period. Fund of funds are even worse, charging an extra layer of fees on top of this leveraged beta exposure! No wonder institutions are ditching them.

Having been burned before, most hedge fund investors are focusing only on "brand names," and getting raked on fees. However, sophisticated institutional investors are beginning to recognize some of the advantages of getting in early and seeding emerging managers. Investment & Pensions Europe commented on this, reporting once bitten..twice shy:

The year 2011 has been a good one for emerging hedge fund talent. However, prospective candidates are being put through their paces by cautious investors, finds Lynn Strongin Dodds

Spotters of new hedge fund managers enjoyed a bumper first half of 2011, reflecting the overall recovery in the industry and the wave of proprietary traders spinning out from investment banks in the run up to implementation of the Dodd-Frank Act and Volcker Rule.

But it was still nothing to the halcyon period between 2002 and 2007 when 1,200-1,400 funds were making their debut each year. Back then, the barriers to entry were not only low but the regulatory oversight was weak. Investors are much more circumspect these days – the screws have been tightened in the wake of the Madoff scandal and prospective candidates are put through their paces thoroughly. No one is in a rush to make a decision despite the glut of new talent on the market.

“The bar is considerably higher than in 2008 because operational processes and procedures must be watertight,” says Tim Gascoigne, global head of portfolio management at HSBC Alternative Investments.

“Today, there is no sense of urgency,” says Dick Del Bello, senior partner at the Conifer Group, a hedge fund administrator and securities services firm. “In 2008, when a $100m (€72.8m) hedge fund was launched investors rushed in because they did not want to miss out. Now they want to see the fund’s performance figures before diving in. However, I do think that those that have made it through this current period of market volatility will attract money.”

Lisa Fridman, head of European Research at PAAMCO, a fund of funds with a deliberate emerging-manager bias, says that the large number of launches over the past 18 months or so belies the difficulty new managers face raising the same level of assets as pre-2008. “Figures from Hedge Fund Research (HFR) show that the majority of the total assets raised in the industry this year went to managers with assets in excess of $5bn,” she notes. “However, interest in smaller managers with less than $1bn in assets has started increasing as well in 2011 versus 2010.”

According to the HFR global hedge funds industry report for Q3 2011, less than 20% of net asset flows went to hedge fund firms with less than $1bn in assets for the year to date, while more than 60% went to firms managing over $5bn. This has been a year in which the industry, as a whole, has rebounded sharply, surpassing the previous record level of total capital under management at $2.04trn. There were 578 new fund launches in the first half of 2011 (298 in Q1 and 280 in Q2), with two-thirds of the $30bn raised going to new macro and relative value strategies.

But that activity ground to a halt in Q3 as the prospect of an unravelling euro-zone and sluggish global growth unnerved markets and caused the hedge funds to post their fourth-worst performance quarter in history. Anecdotal evidence suggests that conversations have been put on hold and new launches – ranging from $5m-250m – have been delayed until conditions stabilise.

Over the long term, many agree that institutional investors will need to consider hedge funds as part of their broader alternatives portfolio if they want to close their deficits without taking a punt on equity risk – and one major attraction of start-ups or smaller hedge funds is the existing evidence showing that they tend to outperform their larger brethren.

Numerous academic and industry studies underscore their stellar results. One of the more recent reports, from HFR, shows that in the three years ending in March 2011, newer managers – with under two years of experience – delivered annualised net returns of 9.3%, compared with 4.5% for established managers. Over a longer period – 1995 to March 2011 – those in the emerging camp produced annualised returns of 16.5% against 10.7% for their more mature peers.

There are several reasons for this, according to Jeff Majit, head of European investments and event driven and relative value research at Neuberger Berman. “Smaller hedge funds have the size advantage in that they are more nimble and can adjust portfolio exposures quickly,” he argues.

“There is also a psychological element: they are much more dependent on returns for the success of their business, whereas a larger manager can generate average returns and live comfortably on the management fee. There is, though, a high level of dispersion across managers and investors need to be aware of this.”

Investors are also advised to evaluate the next generation of hedge fund managers from a wider perspective than in the past. “We have seen a significant number of spin-outs of prop traders from investment banks,” acknowledges Stefan Zellmer of Revere Capital Advisors. “However, just because someone is a good trader does not necessarily mean that they will be good at running a business over the long term or have the right risk-management skills, which is very important in today’s markets.”

Dan Mannix, head of business development at RWC Partners, an independent investment management firm, echoes these sentiments. “It is important for investors to realise that not all smaller hedge funds outperform,” he says. “There is an element of survivorship bias in the performance figures but I would say that the good funds do persist over the longer term, with the best performance in the early years. This is because start-up managers have a different mind-set. About 90% of a young fund’s success is defined by performance, whereas high returns may not be the primary driver of a more mature fund. Wealth preservation often becomes one of their main concerns.”

Jeroen Tielman, chief executive and founder of IMQ, the hedge fund seeding platform backed by Dutch pension manager APG, says: “Talent has many dimensions. It is not just about the technical skills but also the investment, risk and the operational management systems in place. Equally as important are the behavioural aspects of the managers, as well as team dynamics. We look closely at their drive and motivation, as well as the maturity level of the members.”

Once managers are identified, according to the HFR research, the preferred route to gain exposure is via a single-manager vehicle as opposed to commingled fund of funds. Although pension funds will look at early stage funds, seeding has traditionally been the domain of high net-worth individuals, private investors, and friends and family of the manager. Institutions have typically preferred to get on the ground floor at a slightly later date – with so-called ‘accelerator capital’.

“Pure seeding is at the more complex and riskier end of the spectrum because it involves more unknown variables than accelerator capital,” says Matteo Dante Perruccio, CEO and founding partner of Hermes BPK Partners, the alternative advisory boutique and fund of hedge funds established as a partnership with Hermes Fund Managers.

“Some institutional investors prefer acceleration capital since there are fewer unknowns and the teams have had the opportunity to demonstrate they can perform and work together well, representing what we believe to be a more attractive risk-reward proposition,” Perruccio says.

Hermes BKP, along with private equity firm Northern Lights, has joined a number of other players in launching an acceleration fund. Their Accelerator limited partnership is a commingled vehicle that will invest in and receive an economic stake in the growth of early-stage hedge fund managers.

Hermes BPK Partners will handle manager selection and due diligence, while Northern Lights will negotiate investment terms, work with managers to institutionalise their business processes, and provide marketing and distribution services.

So while it might be some time before the hedge fund industry sees the same infusion of new blood as it did before the financial crisis, there is plenty of evidence that sophisticated institutional investors are beginning to recognise some of the advantages of getting in early – which, together with the tighter capital and regulatory conditions, should ensure longer-lived and more robust outcomes all round.

Smart investors know the advantages of seeding talented emerging alpha managers, especially in this environment where most large funds charge 2 & 20 for leveraged beta.

So why aren't more sophisticated Canadian pension funds engaging in seeding activity? To be sure, there is risk in seeding hedge funds in any environment, but if it's done properly investing in liquid strategies using a solid managed account platform -- providing investors with transparency, liquidity, full control, eliminating operational risk -- it can pay off in droves. Unfortunately, there is a lot of politics involved in seeding hedge funds, especially in Canada where start-ups are starving for seed capital.

I would love if Hermes BKP, PAAMCO, APG, ABP, sovereign wealth funds and large multi-strategy hedge funds or global macro funds came to Montreal, met with me so I can introduce them to three or four emerging managers in this city and Toronto that can easily manage billions, offering high risk-adjusted returns in liquid strategies.

The managers I know are experienced, have a proven track record investing in currencies, fixed income, commodities, stocks and can compete with the best of the best. No bullshit, no leveraged beta, no huge hedge fund egos, just smart managers who need seed capital and are getting shunned by stupid Canadian pension fund managers who prefer flying all around the world to get wined and dined by slick salespeople and hedge fund managers charging them outrageous fees!

If I sound frustrated and utterly disgusted with the current strategy for hedge funds at large Canadian and global funds it's because I am. So tired of watching the pension herd acting on terrible advice from their overpaid and clueless pension consultants or from equally overpaid pension fund managers with huge egos investing in "brand names" because that's what everyone else is doing. Feel like telling them to wake up already and start seeding emerging alpha talent, especially here in Canada! Glad I got that off my chest. -:)

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