Monday, January 30, 2012

"Eaten Alive" by Hedge Fund Fees?

A follow-up to my earlier comment on Bain or blessing discussing private equity. This time I'll focus on hedge funds. David Mildenberg of Bloomberg reports, Texas School Fund Weighs In-House Managers to Curb Fees:
Texas's Permanent School Fund may hire in-house money managers to oversee its $25 billion in assets because returns are being “eaten alive” by hedge-fund fees, according to Chief Investment Officer Holland Timmins.

Returns were less than 1 percent for the 44 months through November on assets managed by the five companies that bundle multiple hedge funds into single investment vehicles, Timmins said Jan. 25 at a State Education Board meeting. After fees, the return was negative, he said.

“The sector that should have enhanced our funding for schools actually detracted from it,” Timmins said. “We had a positive return in the asset class, modestly, but it got eaten alive by the fees.”

Hedge-fund expenses have reached about $72.7 million since 2008, according to a document Timmins distributed among board members. The reserve backs school-district debt and distributes $1 billion annually to support public education in the second- biggest U.S. state by population. The board voted 13-0 today to draw up a detailed plan for making the change, said Tom Ratliff, a member of the board’s investment committee.

Driven by Competition

“Big-brand hedge funds have been able to maintain their fee levels, but other funds have had to react to the marketplace and make adjustments,” said Brian Bruce, a former finance instructor at Southern Methodist University who previously worked for PanAgora Asset Management Inc. in Boston. “But that’s been more driven by competition rather than people saying these fees are too high.”

The Standard & Poor’s 500 Index of equities gained 2.3 percent including reinvested dividends from March 31, 2008, through November 30, 2011. The reserve’s hedge funds had a gain of 0.75 percent through that month, according to Timmins.

Timmins proposed hiring one of the current investment managers to advise on allocating assets to hedge funds, while one or more of the poorly performing companies would be dropped. The adviser would be picked from among the five firms, according to Patricia Hardy, the head of the board’s finance committee.

Picking the adviser from among the current providers would save time, as they are familiar to the board and know the reserve’s investment goals, board members said.

Fee Estimate

About 68 percent of the reserve’s costs, or about $34 million a year, is tied to absolute-return and private-equity investments that hold just 16 percent of its assets, Timmins said at a July meeting. Absolute-return fees are projected to be $114.7 million from 2012 to 2016 under the current system, excluding private-equity investment costs, he said.

The fund had $2.42 billion in hedge-fund assets as of Aug. 31, 2010, according to its annual report.

The proposed arrangement would deliver the same strategic advice provided by outside companies at a lower cost, said Ratliff. “They will still be making plenty of money,” he said of the hedge fund companies.

The Legislature last year added $18 million annually to the fund for new employees to manage assets and cut costs, Ratliff said. The board hasn’t acted in deference to Texas Education Agency Commissioner Robert Scott, who is hiring a deputy commissioner to focus on the fund, he said.

Five Companies

The five companies that oversee the reserve’s hedge-fund investments are K2 Advisors LLC, Grosvenor Capital Management Holdings LLP, Mesirow Advanced Strategies Inc., Blackstone Alternative Asset Management and GAM Holding AG (GAM), according to documents distributed in July. The fund dismissed Goldman Sachs Group Inc. (GS) last year, citing performance issues.

Timmins didn’t say how many new employees would be hired if his proposal is set in motion. In July, he estimated about 30 would be added.

Christine Anderson, a Blackstone Group LP (BX) spokeswoman, and William Douglass III, a K2 co-founder, didn’t immediately respond to telephone calls seeking comment on the proposal. Bill Blase, a spokesman for GAM, declined to comment. Officials of Mesirow and Grosvenor didn’t immediately respond to telephone calls or e-mails.

I think this fund and a lot of other pension funds are waking up to the reality that they're getting "eaten alive" by hedge fund and private equity fees. They're also probably asking themselves where are the customers' yachts?

Does it make sense to hire in-house managers? HELL YES!!! Why pay $72 million in fees for mediocre results from funds that can't even deliver beta? At a fraction of the cost, you can hire some excellent portfolio managers who know how deliver alpha. Just make sure you pay these people properly, especially US pension funds which are notoriously cheap on compensation.

I have an even better idea for Mr. Timmins, contact me (LKolivakis@gmail.com) and I will give you all sorts of ideas on rethinking your hedge fund strategy, including seeding some excellent Canadian hedge fund managers in commodity relative value strategies, global macro, CTA and L/S Equity. All liquid, all alpha, no egos, no bullshit, just the way I like it. And these are all great managers who deliver results and can be used as an extension of your investment team.

I am tired of seeing pension funds waste millions in fees to under-performing hedge funds or worse still, fund of funds. For Pete's sake, stop wasting your money on hedge fund hype. The entire industry has grown way out of proportion and just like private equity, most hedge fund managers are mediocre. In fact, as a group, hedge fund performance is ‘shockingly bad':

We often hear that hedge funds are run by the best and the brightest. Their strategies tend to give them ultimate flexibility and of course the highest fees. And most marketing materials claim they can offer investors absolute returns, with lower levels of risk than the market.

Unfortunately for many investors this is simply not the case. I don't want to overgeneralise because there are many excellent hedge funds with great records but as a group they really have not delivered the goods. In fact their performance has been shockingly bad. Here are the findings of some of my research:

1) In Simon Lack's recently released book titled The Hedge Fund Mirage: Illusion of Big Money and Why It's Too Good to Be True, Lack mentions that hedge funds lost enough money in 2008 to cancel out the entirety of the profits they made in the prior ten years. Many will point out that mutual funds have underperformed as well but I would suggest many people are less upset paying 0.75 percent to 1.75 percent in fees than paying two percent plus 20 percent of returns to have the privilege of losing money.

According to Lack, “If all the money that's ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good.” In analysing funds from 1998 through 2010, Lack adjusted the HFRX Index (an index that tracks hedge funds) by factors such as the “survivor bias” (only surviving hedge funds report returns), and found that fees were $324 billion while real investor's profits equate to a loss of $308 billion.

2) In another study published by the Journal of Financial Economics in 2011 titled “Higher risks, lower returns: What hedge fund investors really earn” researchers compared actual investor returns in hedge funds versus buy-and-hold strategies using dollar-weighted returns (which is just a fancy way of estimating how the actual money people had invested in the strategy performed).

Their “main finding is that annualised dollar-weighted returns are on the magnitude of 3 percent to 7 percent lower than corresponding buy-and-hold fund returns.”

In fact they suggest “the real alpha of hedge fund investors is close to zero” and that in absolute terms the “dollar-weighted returns are reliably lower than the returns on the S&P 500 index, and are only marginally higher than risk-free rates as of the end of 2008.”

3) On the whole Funds of Hedge Funds (FoHFs) have also not been very effective in adding much value according to the 2011 study titled “Assessing the Performance of Funds of Hedge Funds”. The authors suggest that “the vast majority of FoHFs do not exhibit alpha.

Furthermore, “only a small fraction of FoHFs deliver alpha per se, i.e. above the one already delivered by the universe of single-manager hedge funds. This means that the additional layer of fees that FoHFs charge eats away any manager added value”. The key here is fees. Jack Bogle, the founder of Vanguard, once said: “Performance comes and goes, but costs roll on forever”.

4) Speaking of Vanguard, a white paper written in 2010 called “Alternative Investments Versus Indexing: An Evaluation of Hedge Fund Performance” concluded that they were unable to “find merit in the argument that hedge funds provide diversification as an alternative asset class. The average returns for hedge funds have been highly correlated with those of long-only indexes. While it is true that hedge funds have been capable of insulating their investors from the worst declines in the broad stocks market, they missed the upturn in the broad market as well.” They also addressed why they felt investors have flocked to this segment and suggest it's simply “irrational exuberance”, the hope while others might have failed, they could consistently pick winners.

5) A Global Asset Allocation note by the research firm BCA titled “Do Hedge Funds Diversify Risk?” on November 30, 2011 suggests that diversification benefits of hedge funds are overstated. Their increasing correlation with the market and each other shows no sign of abating. Style selection is becoming less important.

They also conclude that “As an industry, hedge funds have not met their original objective. Positive returns have not been generated in both bull and bear markets.”

It may be that 2012 is the year hedge funds return to strong performance and outperform. If not, it's likely we will see widespread redemptions from the industry when the opportunity arises. In my opinion the comparison between alternatives and traditional asset allocation is very simple.

Traditional balanced asset allocation has provided diversification, superior performance, liquidity and much cheaper fees, yet investors continue to shun the traditional approach. (See Chart 1/Source: Bloomberg/Anchor Investment).

In 2000 the hedge fund industry was quite small with some $200 billion in assets. It subsequently climbed to around $2 trillion under management by early 2008. In the last two years portfolio allocations to alternatives has jumped from 7 to 17 percent (BCA Research/Scorpio Partnership).

Alternatives have underperformed, tend to be much more correlated to other asset classes than advertised, have limited liquidity, and charge much higher fees, so why do investors continue to pile into such investment vehicles? It is concerning to see an increasing allocation to what one many consider to be an inferior and more expensive product compared to a superior less expensive product.

This is all stuff I know because I invested in hedge funds and can tell you from experience, most hedge funds and funds of funds are full of shit, all hype to gather assets. They couldn't pay me to invest in them (some have tried).

And yes there are excellent hedge funds. In a punishing year, the biggest one thrived. But be careful, don't get too impressed by press coverage on Bridgewater's excellent returns and keep asking them very tough questions (like what is up with cameras following your employees' every move?!? Radical transparency? Sounds more like a paranoid police state!).

I get nervous when I see hedge funds all over the media. I prefer the guys who keep their heads down and deliver alpha. I am very impressed with Ken Griffin and Citadel whose flagships recently cleared their high-water marks, allowing them to start collecting performance fees after getting clobbered in 2008. Coming back strongly from a significant loss tells me a lot about a hedge fund.

Bottom line: If you're forking over huge fees, make sure you're paying for true alpha which you can't replicate internally and don't be a sucker, falling prey to hedge fund hype. I can rip apart any hedge fund and private equity fund (have done it plenty of times). And above and beyond doling out fees, make sure you get knowledge transfer and use your external managers as an extension of your investment staff. Never underestimate the importance of knowledge transfer.

Below, Troy Gayeski, senior portfolio manager at SkyBridge Capital LLC, discusses liquidity conditions for hedge funds and high-yield bonds, and efforts by the U.S. government to boost the housing market. He speaks with Scarlet Fu and Stephanie Ruhle on Bloomberg Television's "InsideTrack."

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