Friday, January 13, 2012

The Great Hedge Fund Humbling of 2011?

Svea Herbst and Katya Wachtel of Reuters report on the great hedge fund humbling of 2011:

Excuses, excuses and more excuses.

Some of the best-known hedge fund managers have offered lots of excuses for underperforming the major stock market indexes last year, with many large funds posting double-digit losses.

In letters to investors, managers pointed to things like Europe's debt crisis, a slower-than-expected economic recovery in the United States, and unforeseen events like Japan's nuclear disaster all coming together to create a tricky trading environment that was characterized by big and often unpredictable swings in stock prices.

The result was a humbling year for the $1.7 trillion (1.1 trillion pounds) hedge fund industry, with the average fund dropping 4.8 percent and some stock-focused funds suffering an average 19 percent decline, according to research compiled by Hedge Fund Research and Bank of America Merrill Lynch analysts.

Investors who sidestepped hedge funds and instead chose mutual funds fared much better. For example, the Vanguard 500 Index fund gained 2 percent, and PIMCO's StocksPLUS Long Duration Fund, 2011's best performing mutual fund, enjoyed a 21.2 percent return.

Not everyone is buying the hedge fund managers' excuses. These skeptics are saying that no matter how smart the managers may be, they are prone to make mistakes just like everyone else and are not necessarily blessed with perpetual special insight into markets.

Industry observers say what tripped up many famous managers in 2011 was that far too many traders were piling into the same large stocks.

"Investors anoint a new hedge fund demi-god all the time," said professor Jim Liew, who teaches hedge fund strategies at New York University's Stern School of Business. "But they are bound to be disappointed because the rule of thumb is that a manager who can be up 40 percent one year can be down 40 percent the next. They are absolutely human."

One example is Whitney Tilson. His $250 million T2 Partners LLC has generally outperformed the major stock market indexes, but last year was a far different story, with his main fund tumbling 25 percent after losing big on stocks like Iridium and Netflix.

"It has been an extremely frustrating -- and humbling -- experience," Tilson wrote in a recent letter to investor.

Some in the hedge fund industry say investors should exercise caution before throwing in the towel on managers who lost big in 2011. Industry analysts say that over the long haul, hedge funds have outperformed the major indexes, and last year may simply have been one of those rare times that trip up even the smartest and savviest traders.

After all, hedge funds, unlike most mutual funds, can bet that stock prices will fall by shorting a security, something that has helped them earn eye-popping returns in the past.

"I'm not saying hedge funds did everything perfectly, but it is hard to fight the type of headwinds these managers are facing," said Francis Frecentese, who oversees hedge fund investments for Citigroup's private bank.

But analysts at Goldman Sachs found there was plenty of opportunity for hedge fund managers to make money in stocks last year despite all the market turmoil.

To be fair, some stock pickers fared very well, including Tiger Global's Chase Coleman, whose fund gained 45 percent, largely through smart short bets.

Other managers who did well include Philippe Lafont, whose Coatue Management gained 17 percent, and John Thaler, whose JAT Capital was up 13 percent.

In a recent research note, a team of Goldman analysts led by chief U.S. equity strategist David Kostin wrote that the poor performance of so many mangers in 2011 is surprising since the opportunity for stock picking was not much worse than in any other year over the past three decades.

Each quarter, Kostin's team assembles a list of the 50 stocks that "matter most to the performance of hedge funds." Last year, he found that this basket underperformed the broader Standard & Poor's 500 stock index by 5 percent.

"There were too many players chasing too few opportunities," Mary Ann Bartels, head of Technical and Market Analysis at Bank of America Merrill Lynch, said of last year's moves.

Hedge funds have long said their returns would not mirror or be correlated to the stock markets. But Bartels' team concluded that the correlation between hedge fund performance and the S&P 500 hit historic highs late last year.

BANK PAIN

Some of hedge funds' biggest losses last year were rooted in their love for financial stocks like Bank of America, which tumbled 60 percent. For hedge fund manager John Paulson, whose bet on gold earned him a record $5 billion payout in 2010, Bank of America's sharp drop dramatically tarnished his reputation. His Advantage Plus fund lost more than half of its assets in 2011.

Paulson and others reasoned that banks would begin lending again as the economy recovered. But their timing was off, and by the time they cut their exposure to Bank of America, Citigroup and JPMorgan Chase -- some of the stocks that many hedge fund managers were invested in -- it was too late to erase their heavy losses, according to investors with some big funds.

There were other big-name losers too, especially in the technology sector. Managers, including Maverick Capital's Lee Ainslie, who lost 15 percent, were burned by underperforming Chinese companies like SINA Corp and Youku.

Even for stars like Daniel Loeb, who had been up double digits earlier in the year, 2011 ended on a flat note. Loeb's Third Point Offshore fund finished off a smidgen, Richard Perry's Perry Partners International fund fell 7.37 percent, and William Ackman's Pershing Square International slipped 2 percent.

As some managers drift to what critics are calling "group think," several investors reason that it was only a matter of time before the industry's close-knit ties -- many managers went to the same business schools and worked at the same funds -- were felt.

"It is scary how many managers cannot explain why they own certain positions," said Neil Chelo, director of research at Benchmark Plus Partners, which has $1.8 billion in hedge funds.

Last year's hedge fund losses are especially irritating to investors who have paid hefty fees for hedge funds when they might have fared better with less costly mutual funds.

"After 20 years of investing in hedge funds, I finally realize they are not the holy grail but an asset class with enormous fees, illiquidity, high leverage and hidden risk given their lack of transparency," said Bradley Alford, chief investment officer at Alpha Capital Management.

But some investors worry that the very same things that led to problems in 2011 -- Europe's festering debt crisis and too many large funds playing in the same names -- are still around this year. In fact, in some ways the uncertainty may be worse, with millions of voters in Russia, France and the United States expected to go to the polls this year.

"2012 could be a rehash if not worse than 2011," said Kurt Silberstein, who heads alternative investments at U.S. Bank's Ascent Private Capital Management and previously selected hedge funds for Calpers, the biggest U.S. public pension fund.

I'm not with Kurt Silberstein, many of the top hedge funds that experienced a bad year in 2011 are already coming back strong, and I doubt 2012 will be a rehash of 2011. John Paulson persists with his rebounding property bet, and Lee Ainslie and Whitney Tilson are bouncing back with their bets on solar stocks and Netflix.

But there is reason to believe that the hedge fund model is fundamentally broken. James Saft of Reuters asks, Hedge funds (What Are They Good For?):

Not only was it a bad year for the hedge fund industry, but 2011 may be the year the model was exposed as fundamentally broken.

Last year had all of the hallmarks of the kind of year in which hedge funds are supposed to earn their keep. Volatility was extremely high and market performance was very mixed.

The year was rough sledding for some formerly high-flying managers such as John Paulson and Whitney Tilson. Even worse, preliminary data show that not only did hedge funds globally have a losing year, but that the typical fund in every single major geographic region suffered losses.

Most disturbing of all is recent research that indicates that the aggregate data used to justify the performance of the industry is being systematically inflated.

I used to think that hedge funds, like canary yellow Rolls Royces or haute couture, were simply an expensive joke the rich play on themselves, but now that the industry is increasingly marketing itself to retail it is time to truly hold it accountable.

There are grave reasons to believe that the average hedge fund client is not well served by the products, which typically charge an annual fee of about 2 percent as well as 20 percent of all profits over a benchmark. Investors in fund-of-hedge funds or products aimed at retail investors usually pay even more.

Data from HedgeFund Intelligence tell a very sad story about 2011 returns. Its indexes of U.S., European, Asian, fund-of-fund and UCITS (a type of fund offered in Europe) funds all recorded losses for the year, according to preliminary data. here

The global composite index was down 1.91 percent and a whopping 60 percent of funds ended the year in the red. When you consider that the S&P 500 index was up two percent, including dividends, and the bond market returned about 8 percent, this is a very poor showing.

END OF ALPHAVILLE

Hedge funds, as an industry, market themselves in two main ways. One is the "absolute return" idea, that the funds, freed from having to track a given index and able to use leverage, can make good absolute returns and make money in any weather.

Apparently not, at least judged by 2011's showing.

The other is the idea of "alpha," which is essentially the concept of excess returns a manager can generate on a risk-adjusted basis. This magic powder exists, supposedly, and is largely down to the superior skills of the hedge fund managers themselves, who quite naturally work in this industry because it pays them so much better.

While those 2011 performance figures look pretty weak, the truth may be far, far worse. A new study by academics Adam L. Aiken, Christopher P. Clifford and Jesse Ellis indicates that the hedge fund industry may be systematically over-reporting its returns to investors.

The thing to understand here is that participating in hedge fund return indices, which are commonly cited as vindicating the industry, is entirely voluntary. That means we should view hedge fund return data about as warily as we would the stories high school kids tell each other about their love lives - entertaining, perhaps, but not to be relied upon.

The study finds a "severe" self-selection bias in these indices, meaning that the established hedge fund benchmarks overestimate returns because many poor performing hedge funds don't choose to submit their statistics.

The industry is like a poker player who tells you about his big wins, but changes the subject to sports when he's on a losing streak.

Hedge funds commonly claim that they cash in on 3 percent to 5 percent annually of alpha, or excess returns on a risk-adjusted basis. Adjust for the self-selection bias found by the authors, however, and you get alpha of just 0.20 percent annually, hardly justification for shelling out a chunky two percent annual fee plus 20 percent of the profits.

"The managerial skill documented in previous studies is, in large part, overstated," the authors wrote. here

"Rather than fund managers having ability to consistently deliver superior risk-adjusted returns, it appears that much of the previously documented skill of hedge fund managers can be explained by the upwardly biased returns data employed by researchers."

This also tends to undermine the argument that hedge funds don't require tighter regulation. Their systemic threat may be larger than estimated, both because the tail-risk among poor performers is greater and also because, human nature being what it is, those poor performers who are not being counted may well include heavy users of leverage.

None of this is to say that great, strong performing hedge fund managers don't exist. The problem rather is that you are unlikely, statistically, to find one and even less likely to be able to get some money in with her if you do.

What is likely, indeed almost a sure thing, is that you will pay more and not get fair value in return.

As I stated last Friday, most hedge funds stink, and deserve an 'F'. But institutional investors keep piling into them, getting raked on fees. It's alright if you are investing in top funds, but even they are not always right and no matter who you are, you're going to get limited access to their top fund managers (limited knowledge transfer) and very few, if any, offer managed accounts (no transparency and limited liquidity).

That's why I've been urging investors to rethink their hedge funds strategy and follow the real smart money which is seeding hedge funds. Paying 2 & 20 to hedge funds that are nothing but large asset gatherers is absolutely insane. Even worse, some brand name hedge funds severely underperformed the market.

Are there amazing hedge funds worth investing with? Absolutely, no question about it, but not all of them are open to new investors. FINalternatives reports that Tiger Global was the top-performing hedge fund heavyweight last year, returning 45%. According to Bloomberg, Brevan Howard proves master of hedge funds with four in top 100. A fund managed by Ray Dalio's Bridgewater Associates was the most profitable hedge fund in the world last year, bringing home almost $2.5bn in profits, according to annual rankings by Bloomberg Markets magazine.

And Dealbook notes the gods of redemption are smiling on the hedge fund Citadel (told you so!). Ever since the investment powerhouse lost more than 50% in a devastating 2008, prompting whispers about the end of Citadel and its boy wonder manager, Ken Griffin, the Chicago-based fund has been on a tear, gaining 20% in 2011. Along with other top hedge funds, including SAC Capital Advisors and Caxton, Citadel is betting on a housing recovery.

In fact, late last night, I shut the lights and grabbed my iPad to look at Citadel's 13-F holdings from the third quarter of 2011. I noticed that one of their top holdings is homebuilder Lennar Corporation (LEN) which has been surging over the last few months. It has room to gain more, especially if housing is recovering. I then spent the night going over top and new holdings of other top hedge funds to gain more trading/investment insights (don't ask, I go nuts on this stuff!!). I'm sticking with my call on La Dolce Beta and will discuss more ideas in the future.

Below, Carrie McCabe, founder and chief executive officer at Lasair Capital LLC, talks about the outlook for hedge funds. She speaks with Pimm Fox on Bloomberg Television's "Taking Stock." Pay attention to what she says about the extreme volatility in 2011 and how it impacted hedge funds' performance in 2011.

Again, no excuse for their poor performance. Top hedge funds managed to perform well and I believe this performance persistence will continue but investors should also start seeding hungry, performance-driven emerging managers using a managed account platform. When it comes to hedge funds, make sure you get proper alignment of interests, and stop paying arrogant jerks 2 & 20 for leveraged beta.

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