For a long time, it seemed like nothing could diminish investor appetite for hedge funds. Even after the financial crisis embarrassed some of the industry’s most high-profile investors and caused the industry’s assets to tumble as hundreds of hedge fund closed in 2008, the hedge fund business quickly recovered. Last year the industry’s assets reached an all-time high of $2 trillion.
But 2011 turned out to be one of the hedge fund industry’s worst years ever. The average hedge fund fell by 5%. The average hedge fund specializing in equities fell by 8%. Hedge fund titans like billionaire John Paulson had a terrible year and lost massive amounts of money. At the same time, the S&P 500 returned a positive 2%. Evidence has started to emerge that some investors may have had enough.
According to research firms Barclays Hedge and TrimTabs, investors redeemed $15.2 billion from hedge funds in January, the highest outflow since the height of the credit crisis in January 2009.
This could only be the start of a river of outflows if hedge fund performance doesn’t improve soon. In January, hedge funds again trailed the U.S. stock market. The average hedge fund posted a positive return of 3.1%, underperforming the S&P 500, which returned 4.2% in January. Bank of America Merrill Lynch says that its investable hedge fund composite index was up 1.19% in February, yet still underperformed the S&P 500 by 2.87%.
“If hedge funds don’t deliver in aggregate this year, it is going to be a very real problem for the industry,” says Brad Balter, a Boston-based investment advisor who oversees just under $1 billion and farms out money to hedge funds. “2011 had a very volatile 3rd quarter which hurt everyone, but if we go through another period of underperformance investors will question using them.”
FINalternatives also reports, Hedge fund redemptions , assets up in February:
Investors pulled $15.2 billion from hedge funds in January 2012, as overall industry assets climbed to $1.70 trillion from $1.68 trillion at end-2011.
According to BarclayHedge and TrimTabs Investment Research, hedge funds underperformed the S&P 500 by 110 basis points for the month.
“Hedge funds managed a 3.1% return in January after posting losses in seven out of the last eight months of 2011,” said Sol Waksman, founder and president of BarclayHedge. The benchmark S&P 500 Index returned 4.2% in January after outperforming the hedge fund industry for all of 2011.
“January marked the biggest monthly outflow since July 2009, when hedge funds redeemed $17.7 billion,” said Leon Mirochnik, an analyst at TrimTabs. “The hedge fund industry has experienced net outflows in four out of the last five months.”
Fixed income, multi-strategy, and merger arbitrage hedge funds are the only strategies to have seen net inflows since September 2011. Multi-strategy funds led, pulling in $2.6 billion in January. Mirochnik says investors seem to be “piling into strategies that can benefit from geopolitical uncertainty around the world.”
Funds of hedge funds underperformed their hedge fund counterparts by 140 bps, returning 1.7% in January and Mirochnik thinks FoF managers might have difficulty explaining “their layers of fees” to clients given that funds of funds have underperformed hedge funds by 200 bps over the past year.
In related news, hedge fund managers polled by TrimTabs/BarclayHedge remain bullish on U.S. securities, although the sentiment was less marked in February 2012 than in the previous month. Of the 105 hedge fund managers surveyed in the third week of February 2012, 40% were bullish on the S&P 500, compared to 45.4% in January. Bearish sentiment rose to 30.5% in February from 25.0% in January.
Nearly 30.0% of managers believe that U.S. equities will be the top-performing investment over the next three months. Gold came in second at nearly 23.0% followed by oil with 20.0%.
So what is going on? Are investors "losing faith" in hedge funds? Not exactly. They are simply becoming more aware that most hedge funds are full of it, charging 2% management fee and 20% performance fee for beta. And as we saw in 2011, most hedge funds had a a hard time even delivering beta, underperforming the market.
All this prompted Mindful Money to ask, Is this the end of the hedge fund manager?:
The headline that hedge fund bosses seem to have made a bit of cash in 2011 will hardly surprise many of the cynics who see them as more bogeymen of the financial services industry, alongside bankers. But these inflated pay-packets certainly seem counterintuitive at a time when many are predicting the end of the hedge fund manager altogether.
This Reuters piece, based on a Forbes survey showed that: "The top 40 highest-earning hedge fund managers took home a combined $13.2 billion... The top 10 hedge fund managers made more than $200 million each, while the lowest earning managers made $40 million each."
But the report coincides with a Times article (paywall) predicting the end of an era for hedge fund managers: "Last year was a disaster for the $2 trillion hedge-fund industry. Desperately hoping for a recovery from the 2008 financial crisis, hedge funds actually lost investors 5 per cent in 2011, with some slipping as much as 50 per cent. Investors pulled millions of pounds out and hundreds of smaller hedge funds have closed."
One analyst, who recently left a hedge fund, is quoted as saying: "The industry's gone through cataclysmic change. There's much more scrutiny. People are asked to work harder, in a more regulated environment, for less money. Everything's more serious - you can't send rude e-mails any more - it's death by a thousand cuts."
So how to explain these giant pay-packers? The Reuters article points to the fact that the more successful hedge funds are mopping up disillusioned investment bankers ahead of the imposition of the Volker rule, which seems to have benefited groups such as Europe's Brevin Howard.
There certainly is more interest in alternatives. The most recent Morningstar fund flows survey showed that as risk appetite has increased, so has interest in alternatives: "Other broad asset classes also reversed the negative momentum of 2011's second half. Funds in the allocation, alternatives, and commodities groups all enjoyed modest inflows in January."
But this is benefiting some groups more than others. Man Group, the largest listed hedge fund managers has reversed a run of difficult performance: "Man said assets under management had risen to $59.5bn from $58.4bn at the end of December. Chief executive Peter Clarke told Reuters: If sentiment is maintained and performance continues, we'd expect it to translate into rising sales and net inflows. Man also held its dividend payment, which some analysts had suggested might be cut."
The big money has tended to be made in the larger macro hedge funds, which have been able to use the market volatility to their advantage. The trouble is that the environment has exposed those hedge funds that are not doing anything very different to long-only managers and charging a lot more for it.
This Zerohedge article goes some way to exposing the lack of imagination in some hedge funds. It points to Goldman research into hedge funds, which demonstrates, among other points, that; "hedge fund returns are highly dependent on the performance of a few key stocks. The typical hedge fund has an average of 64% of its long equity assets invested in its 10 largest positions compared with 34% for the typical large-cap mutual fund, 18% for a small-cap mutual fund, 20% for the S&P 500 and just 2% for the Russell 2000 index." Secondly, the Goldman research found: "Apple (AAPL) matters. One out of five long/short hedge funds has AAPL among its ten largest long positions and approximately 30% of hedge funds own at least one share of AAPL. When it ranks among the top ten holdings, AAPL represents an average of 8% of single-stock long equity exposure. In aggregate, hedge funds own only 4% of AAPL equity cap. The average hedge fund AAPL position equals 1.6%, given 70% of funds own no AAPL."
As the Times piece points out, both markets and investors are getting smarter. The credit crisis exposed the limitations of the hedge fund industry and created a new scepticism about financial services generally: "In his book The Hedge Fund Mirage, industry insider Simon Lack calculated that between 1998 and 2010 hedge-fund managers earned an estimated $379 billion in fees, out of total investment gains of $449 billion. In other words, they took 84 per cent of the investment profits, leaving just 15 per cent for investors." This may work in bullish times, but not when investors are short of cash and have Madoff in the back of their minds.
Weakening returns have also exposed the high fixed costs of some hedge funds: "While some larger hedge funds are still profitable, many smaller ones cannot afford the high Mayfair rents they took for granted until recently" says the article.
In other words, the hedge fund industry is the same as any other, the strong are getting stronger and the weak are falling away. The credit crunch has ensured that the hedge fund industry is becoming as Darwinist as any other.
The strong are getting stronger, able to attract talent because they have the big bucks to pay top managers, but it goes far beyond this.
According to the fifth annual global study released by SEI in collaboration with Greenwich Associates, with significant dollars poised to flow into hedge funds in 2012, managers must address investor transparency and liquidity concerns to take advantage of new funding opportunities:
The second report in the two-part series, entitled “The New Dynamics of Hedge Fund Competitiveness,” indicates a need for hedge fund managers to move beyond portfolio transparency to provide investors with consistent and insightful communications along with direct access to investment teams. Liquidity and the inability to control exit strategies have also emerged as key concerns for hedge fund investors.
“Transparency has been the focus for managers in recent years, but we’re seeing clients look for increased personal interaction and dialogue. This Era of the Investor™ is pushing managers to look beyond standard expectations,” said Philip Masterson, Senior Vice President and Head of Business Development, Europe, for SEI’s Investment Manager Services division. “The environment is shifting and while managers are showing improvements in reporting, the study shows that portfolio transparency is simply not enough to satisfy investors anymore.”
Beyond communication, the survey shows that investors want greater detail in terms of security-level disclosure, including leverage detail, valuation methodology, and risk analytics. The study also showed that liquidity has emerged as a key area of concern among investors. Nearly a third of respondents (31 percent) cited ongoing liquidity risk among their biggest hedge fund investing worries, while “an inability to control exit strategy” was named by 46 percent of respondents.
“Evaluating and selecting fund managers has always been a top-of-mind concern for investors,” said Rodger Smith, Managing Director of Greenwich Associates. “What this study brought to light is that, as long as they can articulate their value proposition and differentiate themselves from their peers, there is a place for smaller and newer funds in institutional portfolios. In fact, one in five investors polled said they have no asset minimum requirements in order to invest, and while a majority of those surveyed said they seek hedge funds with a history of at least three years, roughly a quarter would consider less, and 14 percent would not eliminate a fund without a track record at all.”
Highlighting the increasing inability of investors to distinguish among strategies, 17 percent of respondents said manager selection is the single most important challenge facing hedge fund investors today. While 95 percent of respondents said clarity of investment philosophy is important or very important in the selection process, more than half of respondents (61 percent) said there are too many look-alike strategies in the hedge fund industry.
Given that challenge, more than half of respondents (51 percent) said hedge funds are too complex to evaluate without a consultant’s help. Respondents were decidedly mixed on the importance of brand in the selection process, while operations are clearly a critical aspect in selecting managers, with 80 percent of those polled agreeing that operational strength is a hallmark of an institutional-quality fund.
The white paper is published by the SEI Knowledge Partnership, which provides ongoing business intelligence and guidance to SEI’s investment manager clients. To request the full paper, visit http://www.seic.com/HedgeResearch2012.
Some consultants are working to address investors' concerns over liquidity and transparency. Roger Kenyon, Senior VP at FIS Group, told me they have found a way to address the liquidity, transparency and investment concerns of investors looking to allocate to emerging hedge fund managers. Roger sent me these comments:
Investors have always been interested in investing in emerging hedge fund managers. No doubt this has been a natural inquisitiveness about anything new; the hope of discovering a spectacular talent; and also a possible morbid belief in discovering a future blow up. Research shows that new managers with limited assets to manage outperform more established managers.
Yet this has not prevented investors from introducing all sorts of preconditions that the manager must satisfy before investors will act. Even the definition of what constitutes an emerging manager seems to be unsettled. In the long-only area some investors define the category to be managers with assets below $2 Billion. Among hedge fund investors the cutoff seems to be $200 MM.
The difficulty in getting access to funding by emerging managers is primarily due to the fact that they do not share the same characteristics of established managers. This does not refer to their potential to produce skill based returns, but primarily to the absence of the support infrastructure of larger funds.
These structures usually provide investors with a sense of confidence that management is governed with features such as oversight, liquidity and transparency. Emerging managers would not be so classified if they were required to build up these capabilities before starting a business as the time and costs would be severe impediments.
Luckily, the market has responded to this gap and has addressed these infrastructure problems in a comprehensive manner. Emerging managers can now access all the institutional level back up required to produce accurate and timely valuations, counterparty controls, risk controls and limit monitoring. In this way the manager has the freedom to leverage his investment skills; and the investor can be confident in the investment decision because of the high level transparency.
The characteristics of these processes cannot be undervalued. They allow a smooth flow of information in periods agreed upon by both manager and investor. These periods can be daily or wider spaced. Each partner can communicate with each other as needed. Investors can view the information from a viewpoint chosen by the investor. No longer will the investor wait for the manager to an interpret performance. He will have seen the results and he will have been able to see whether they were within his investment framework.
Needless to say, both manager and investor can set benchmarks, allowable securities, risk controls, and general operating features that both feel comfortable with. With this capability in place, concerns about performance, strategy, strategy drift, use of cash, leverage, and tracking error and returns attribution can be analyzed rather than be an issue of uncertainty .
These types of facilities should provide investors to be more aggressive in sourcing, investing and having a positive returns experience with emerging managers. Investors will be able to continually tailor their allocations as required because they can be assured of being able to call on the liquidity conditions which were agreed.
Roger and I discussed how useless monthly "risk transparency" reports are and how investors who are looking to allocate to emerging managers are adopting this new approach to manage risk properly.
I cannot stress how important it is to look at emerging alpha talent, especially in this environment where there is a placebo effect of investing in large hedge funds. There is talent out there worth seeding but investors have to approach the seeding game a lot more intelligently.
Reuters reports that HSBC's alternative asset management arm is scouring the market for promising new hedge fund managers, whose ranks are swelling ahead of the imposition of the Volcker rule, which cracks down on banks trading with their own money:
The rule could prove a boon for HSBC's recently launched emerging manager programme as it is providing hedge fund managers across strategies such as long-short equity, distressed debt and trading funds.
"Several opportunities are arising from the Volcker rule. People are leaving the banks and launching their own funds," Peter Rigg, head of HSBC's alternative investment group told Reuters at a presentation in Zurich.
The Volcker rule, named after former Federal Reserve Chairman Paul Volcker, prohibits banks from trading with their own funds for profit, encouraging so-called proprietary traders to set up shop on their own.
U.S. regulators said on Wednesday they are unlikely to have the rule finalised by a July deadline, but many managers are still exiting banks ahead of when the ban is due to come into force.
Ex-Goldman Sachs stars like Pierre-Henri Flamand and Morgan Sze are among those to have already made the move.
Rigg said many managers perform best in the early years, when their funds are still small and they rely on strong returns to earn performance fees and draw in clients, rather than living off management fees levied on large asset bases.
He said HSBC's $38 billion (23.8 billion pound) alternatives investment business can negotiate good fee discounts with these managers which it then passes on to its clients.
Rigg said HSBC's funds of hedge funds were currently in "risk off" mode, meaning they are underweight strategies like long-short equities which rely more on market fundamentals than investor sentiment, while favouring strategies which look to profit from market trends, as well as smaller, nimble managers.
Tim Gascoigne, who was global head of portfolio management at HSBC Alternative Investments Limited, and who ran the $2.4 billion (1.5 billion pounds) GH fund of hedge funds left last month, after global banking group decided to merge its discretionary and advisory businesses.
Fund of funds are finding it increasingly tough to compete in an environment where investors are unwilling to pay an extra layer of fees. I happen to think that only the best funds of funds will survive the coming shakeout in the hedge fund industry, those that are able to add value in portfolio construction and identify new and existing talent.
And there are plenty of opportunities to seed emerging hedge funds. Bloomberg reports that Mike Stewart, who JPMorgan (JPM) Chase & Co. picked last year to oversee a unit of traders being moved out of its investment bank, has left to start a hedge fund.
Finally, Azam Ahmed of Dealbook wrote an excellent comment on Texas Teachers' investment into Bridgewater. I quote the following:
If Bridgewater’s assets, and returns, continue to soar, the pension could do quite well. But if it has a string of bad years and investors withdraw their money, inflows could suffer.
“The investor has huge market risk,” said George J. Mazin, a partner at Dechert, a global law firm. “There have been a number of deals where investors bought high at the top of the market and in the next couple of years there was no growth and an attrition in assets.”
Such investments have been a mixed bag over the years.
Goldman Sachs, which started an in-house group to buy hedge fund stakes, has made some smart bets. Goldman’s Petershill fund bought a piece of Winton Capital in 2007 when the firm had less than $10 billion under management. Since then, its assets have swelled to nearly $29 billion, and performance has been strong, including a 6 percent return in 2011.
But Goldman has also had prominent losses. The Petershill fund bought a stake in Shumway Capital Partners not long before the firm’s founder decided to shut it down and return capital to investors. Another holding, Level Global Investors, was swept up in an insider trading investigation and decided to close shortly thereafter. Goldman lost big on its investment.
Morgan Stanley offers another cautionary tale. In 2006, it bought FrontPoint Partners, a hedge fund firm with $5.5 billion in assets. But soon, top managers started to leave. The relationship worsened when a FrontPoint manager was accused of insider trading in 2010.
In 2010, Morgan Stanley took a $193 million impairment charge related to FrontPoint. The bank sold its stake back to FrontPoint last year.
The deals can also prove treacherous for the hedge funds, as they try to navigate the relationships with their partners and their investors. An owner, like the Texas pension, may want fund assets to grow, because it means more money in hand. But an investor in the fund may want to keep a lid on the size, fearful that if the fund gets too large it will hurt performance.
I think Texas Teachers' went overboard with this investment and time will prove me right. The landscape is changing in the hedge fund world. Investors fixated on the 'old model', chasing after the latest 'superstar manager', are going to be sorely disappointed. Those taking intelligent risks, changing without regret, will come out ahead.
Below, Bloomberg's Dominic Chu reports that John Paulson lost 1.5 percent in February in one of his largest hedge funds, according to an investor update, paring this year’s gain and setting back efforts by the New York-based manager to recoup record losses in 2011. He speaks on Bloomberg Television's "Inside Track."
Also, Anita Nemes, Deutsche Bank AG's London-based global head of capital introduction, talks about the outlook for the hedge-fund industry. Global hedge fund assets may rise 12 percent this year to a record $2.26 trillion as investors reduce cash and seek returns, according to an annual survey of investors by Deutsche Bank. Nemes speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "InsideTrack."