Friday, February 10, 2012

Hedges With Few Edges?

Alistair Blair of Investors Chronicle reports, Hedges with few edges:

Performance data on individual hedge funds will trickle out over the next month or two, but last week Hedge Fund Research - the industry's key index publisher - finalised its 2011 figures. They're dreadful. The HFRX Global Hedge Fund Index, which tracks 40 large funds, fell 8.8 per cent. For an investment that is supposed to deliver an "absolute return", that's pretty dismal. Especially since the S&P 500 index of leading US shares was down just 0.7 per cent and US investment-grade corporate bonds were up 4.1 per cent.

Of course, you should never put too much emphasis on a single year, but 2011 was the third year in a row in which the HFRX index underperformed both equities and bonds, and it's more than 10 years since the HFRX was a real standout.

In 1999, the S&P 500 returned 21 per cent and bonds fell 3 per cent, but hedge funds trounced them both with 27 per cent. The following year, equities headed south while bonds recovered, but hedge funds again came out on top by a handsome margin. Sayonara. HFRX occupied the bottom slot for six of the subsequent 11 years, and never recovered the top slot.

My chart shows what this boils down to in terms of cumulative performance. If your had put one dollar in each of these three sectors every year since 1997 (coinciding with the launch of the HFRX) you would have invested $14 per sector. Your equity pot and your hedge fund pot would both now be worth $17 (in fact, the equity pot fractionally more) and your bond pot would be worth $24. The only hedge fund investments you would feel remotely happy with would have been those made in 2000 or earlier, and even these would still have trailed your bond pot by a mile.

This of course is the average picture across all hedge funds (weighted by their assets - there are about 7,000 hedge funds, but I estimate that about 90 per cent of all hedge fund investments are accounted for by the top 200 funds). Within the average were high profits earned by a few celebrated funds, including John Paulson and George Soros, but there were obviously some pretty dire performances by other funds, including total blowouts such as Peloton and Amaranth.

Nevertheless, the past 10 years have been extremely prosperous for hedge funds. In January 2000, the total value of all hedge funds was about $200bn. But the excellent turn-of-the-century performances resulted in institutional investors throwing money at the sector. Hedge fund assets doubled to $400m within 18 months and motored to $2 trillion by 2007. After redemptions and losses, they currently stand at around $1.6 trillion.

It is hard to imagine that institutional investors are proud of these decisions, especially because hedge funds charge such high fees - I estimate in the region of four to eight times the fees charged by more conventional investment managers. These fee levels undoubtedly account for the poor performance of the hedge fund sector over the past decade as depicted in the chart.

But inside hedge funds the picture has been very different. In 2000, the total fees charged by all funds and funds of funds were about $15bn. Subsequently they rose to $70bn and currently stand at around $35bn.

Much of the data above is from a new book on hedge funds, The Hedge Fund Mirage by Simon Lack. It contains a series of sensational tables analysing how hedge fund profits have been split between hedge fund managers and their clients. However, the tables are difficult to interpret and have been attacked by representatives of the hedge fund industry. That alone makes them worth of a closer look.

A closer look? The entire industry needs to be massively regulated. Hedgies will scream and bitch at me for saying this but that's how I feel. You have massive unemployment, people are struggling and these hedge fund hucksters are getting away with murder by donating millions to super PACs.

Worse still, the figures above do not take into account survivorship bias where only the funds still operating report their returns. Clients are also weary, asking themselves where are their yachts, questioning why they're getting eaten alive on hedge fund fees. But institutional investors remain fully committed to hedge funds, especially after the strong start to the new year. In fact, hedge fund exits hit a record low after a bumper January. Hedge funds are thrilled to death, for now.

Only sovereign wealth funds are turning away from hedge funds, but they still invest a huge chunk of money in them. And U.S. public pension funds are going ballistic trying to allocate more to hedge funds. North Carolina's main state public pension fund is set to add billions of dollars to its hedge fund allocation (meanwhile, South Carolina is throwing in the towel on alts):

Having won legislative approval to almost double its hedge fund investments last year, the $71.8 billion North Carolina Retirement System is set to take advantage with a series of new searches for credit and equity hedge funds. No requests for proposals will be issued, with managers picked and hired on an "as needed basis," spokeswoman Julia Vail told Pensions & Investments.

The system plans to invest as much as $2 billion in new stock hedge funds over the next three to five years, a 6% allocation. North Carolina will focus on long/short strategies, Vail said.

It will also invest about $360 million in credit funds over the next two years.

North Carolina currently has about $2.44 billion invested in hedge funds, or 3.4% of its assets.

The system is also planning to invest a 2.5% increase in its broadly diversified, non-equity-based hedge fund strategies allocation allowance in private equity.

Stock hedge funds? Most of them are momentum driven beta chasers, all part of Malakia Capital Management. Not that the other strategies are any better. Just look at credit, where strong fund flows are fueling a junk bond bubble. Admittedly, so long as companies avoid default, investors can pile into the high-yield sector and gain returns that are less prone to the volatility that affects equities, but flows into credit worry me.

Nevertheless, money keeps pouring into hedge funds. I tweet about it almost every day. According to HFMweek, the Texas County & District Retirement System (TCDRS), which has $17.7bn in assets, has allocated $305m between two hedge funds, two months after making an extra $885m available to the space:

TCDRS, which upped its hedge fund target allocation from 20% to 25% at the start of this year, has hired, Asian Century Quest and Graham Global Investment Fund for $130m and $175m respectively.

The two new hires join a 28-strong line up, which includes hedge fund giants Winton and Brevan Howard.

TCDRS, which is advised on its investment decisions by Cliffwater Associates, now has a roughly $2.8bn hedge fund portfolio, leaving around $1.6bn open for potential new searches.

The decision to increase hedge fund exposure was swiftly kick started by a $200m allocation to Highfields Capital IV, a Boston based investment management firm, HFMWeek reported at the time.

Now, I'm not a fan of pension consultants but Cliffwater seems to know what they're doing. I can tell you Brevan Howard and Winton are two of the best hedge funds in the industry. My only concern with consultants is they charge a lot of money to "advise" clients and many have conflicts of interests where they invest in hedge funds they are recommending. That is another scandal in the pension world that rarely gets covered.

Again, I am not against hedge funds. There are excellent hedge funds but the media hypes them up too. For example, I read an article on where five top hedge funds made money in the stock market in January and I chuckled because I'm up 55% YTD in my PA, trouncing all of them, betting heavily on a recovery in solar stocks.

And if you do your homework, you too can learn a lot by tracking the activity of top funds like T2 Partners and Pershing Square. It's all discussed in my piece on Malakia Capital Management but I will circle back to spoonfeed you some more as Q4 2011 13-F filings come out. When you become good at the game, you don't even need to wait for them to come out, you anticipate where top hedgies are investing before public records come out.

Speaking of malakies, SAC Capital's Steve Cohen was seen dining Tuesday with New Jersey Gov. Chris Christie at Manhattan steakhouse Quality Meats (I loved the Prime Grill, thx Jonathan!). Speculation is running amok that Cohen, feeling the heat from the Feds, is cozying up to Republicans, but just like Sabia's séjour chez Desmarais, I think this is much ado about nothing. Just more gossip for Charlie Gasparino and those 'hard hitting' reporters at Fox Business News (see below).

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