Thursday, March 29, 2012

Smaller Hedge Funds Best Larger Rivals?

Sarah Krouse of Dow Jones Financial News reports, Smaller hedge funds best larger rivals:
Smaller hedge funds have outperformed their larger rivals over the last 16 years, according to an exhaustive study of over 20,000 funds by a team at the Imperial College of London.

The Risk Management Laboratory at the Imperial College of London’s business school used figures from research providers BarclayHedge, EurekaHedge, Hedge Fund Research, Morningstar and Tass in a bid to confirm previously studied trends in the industry.

They presented their findings at panel event in London this week.

The combined database, which the centre plans to update several times a year, includes 24,749 unique hedge funds and 48,121 share classes, covering the period from 1994 to 2010.

It shows that funds with assets under management of less than $10m delivered average annual returns of 9.89%, while those managing between $250 to $500m returned of 4.84%. Funds with between $500m and $1bn had average yearly returns of 5.84% and those with more than $1bn in assets delivered 5.45%.

The same was largely true for alpha, or the excess return; funds with less than $10m in assets under management delivered alpha returns of 7.25% per year; those with $250m to $500m posted 1.59%; those with $500m and $1bn delivered 2.8%; and funds with more than $1bn had alpha of 1.58%.

Robert Kosowski, director of the Risk Management Laboratory who co-authored a paper on the merged databases, said: "When there is evidence of performance persistence, it seems to be driven by small funds, not large funds."

The industry as a whole ultimately added value over the last 16 years, researchers found, pointing to an annual average value-weighted return of 7.36%. The study also found that younger funds outperformed older rivals and that those with management incentives performed better than those without.

Kosowski underscored the challenges involved in hedge fund data such as reporting biases and missing information on assets under management, both of which can skew results and not paint a full picture of a given fund or the larger industry. He stressed the importance of using multiple databases in drawing conclusions.

Despite the number of funds and share classes covered by the data, the Risk Management Laboratory at Imperial College found that only 3.7% of all hedge fund share classes appeared in all five databases, highlighting the lack of consistency across various data sources. Nearly two thirds of all fund share classes were only covered by one database.

The researchers are still working on a total figure for the assets under management in the industry.

Experts speaking at the panel event this week attributed the stronger performance of younger funds to factors such as their ability to move quickly in and out of markets and the fact that their managers oversee a limited number of funds.

Jeroen Tielman, founder and chief executive of seeding firm IMQubator, said: “If you have one moment to prove yourself in the market, you’re going to do everything in your power to perform well."

Panellists nevertheless highlighted the challenge that smaller funds face in securing investments from institutional groups with more rigid risk management requirements, as these tend to favour firms with longer track records.

David Yim, director at KPMG, who works with firms that invest in hedge funds, said: “Established managers have a momentum. What it all boils down to is that they want a return on their investment given a certain risk appetite."

There is nothing new here. Academics are merely pointing out what industry practitioners have known for years, namely, that performance typically tapers off as hedge funds grow their assets under management (AUM) beyond a critical threshold.

Importantly, when hedge funds become large asset gatherers, hiring more sales staff than investment staff, their alignment of interests become distorted, and they're content collecting the 2% management fee, leaving the 20% performance by the wayside.

Of course, there are always exceptions. Bridgewater is the largest and one of the best hedge funds with a long, stellar track record. There are many other exceptional large hedge funds but the truth is the majority are large, lazy asset gatherers.

I've seen hedge funds go from $500 million to a billion to $10 billion in a matter of a few years and seen their performance plummet as assets mushroomed. Investors who rush into hedge funds should pay attention to how they grow assets under management and where the managers are aligning their interests.

Think about it, 2% on $10 billion, $20 billion or more is a hell of a lot of money. Large hedge funds can afford to hire top talent with that kind of dough. However, most of them are just slick marketing machines which over-promise and under-deliver.

If the industry as a whole adopted new rules where for example, pass $2 billion, no hedge fund is allowed to charge a management fee, then it would be interesting as large hedge funds would be forced to compete more fiercely and keep the focus solely on performance.

Don't hold your breath, however, as all hedge funds think it's their god-given right to keep charging 2 & 20 no matter how many AUM they obtain. It's a joke, and the irony in all this is that the smaller, hungrier fund managers, are being shunned by large institutions writing big tickets. The placebo effect of large hedge funds is alive and well, distorting the alignment of interests that originally gave hedge funds their competitive edge.

Interestingly, there are always new funds popping up, many of which are worth investing in. Bloomberg reports that Neal Shear, who spent 25 years at Morgan Stanley, and Jean Bourlot, former commodities head at UBS, are starting Higgs Capital Management LLP, a commodities hedge fund in London (don't know them but heard they're good).

In Canada, I know of many mangers who deserve seed capital. Montreal and to a lesser extent, Toronto, are pathetic markets for seeding new funds. It's a travesty and drives me crazy because foreign institutions are clueless on the amount of alpha talent we have in these cities and our own institutions fail to support our home grown talent.

There are however interesting developments even in Canada. The Globe and Mail reports that former star hedge fund manager Jean-François Tardif, who “retired” from Sprott Asset Management LP in 2009, is now back in the investment business. Mr. Tardif, who is in his early 40s, has been hired by First Asset Investment Management Inc. to run a new closed-end hedge fund to list on Toronto Stock Exchange in May. Jean-François is a great guy and I'd invest with him in a flash.

Another French Canadian investment "star" who recently announced the opening of his first hedge fund in Montreal is my friend, François Trahan of Wolfe Trahan & Co. The fund is scheduled to open next week and I wouldn't bat an eyelash to invest with François. I've known him since my days at BCA Research and tracked him as he ascended from Ned Davis, to Bear Stearns, to ISI Economics and finally to Wolfe Trahan & Co.

François is an exceptional strategist and I think he will be an equally exceptional hedge fund manager. Apart from understanding the importance of macro investing (read the book he co-authored with Kathy Krantz, a great gal, The Era of Uncertainty), he's a person with high integrity and pretty much one of the nicest guys you'll meet in the industry (most people who achieve his success are full of themselves!).

In his recent Seeking Alpha article, Investing During Major Bear Markets, Jim Puplava of Financial Sense mentions Trahan's research:

In fact, supplemental data from last week continue to support the case for a strengthening U.S. economy:

1. Unemployment claims: 355k: 4-year low
2. ISM Non-mfg PMI 57.3%
3. Vehicle production: + 19% q/q a.r. in 2Q
4. Vehicle sales: 15.0 m, a 4-year high
5. Mfg IP: + 0.8% in January
6. Consumer Credit $17.8 billion
7. Total payrolls rose by 227,000 in February

Even more critical to the economic recovery is the fact that general inflation remains subdued as reflected in the monthly ECRI Future Inflation Gauge, which remained unchanged at 101.4 in February. Francois Trahan at Wolfe Trahan maintains that in a zero interest rate environment, inflation has become the equivalent of the fed funds rate. A lower inflation rate means that consumers have more purchasing power than when the rate of inflation is rising.

Given the improving data on the economic front, it should come as no surprise that stock prices are up this year. Even more revealing is the performance of the various sectors within the S&P 500. As shown in the following table, those sectors that are outperforming the general index are the very sectors that would do well in an improving economy.


Given the above, the next logical progression of this data should be a continued improvement in corporate earnings. Current consensus earnings for the S&P 500 Index are $105.13, reflecting a growth rate of 8.61% over the previous year. What if earnings surprise on the upside? If the economic data point to an improving economy it would make sense that earnings follow suit. Also, keep in mind that estimates going into the year were conservative given the plethora of worries heading into the end of last year.

But skeptics abound in this market. Yesterday, I wrote about hedge funds snapping up commodity shares at quarter-end. Today I read that RAB Capital's flagship Special Situations hedge fund has cut its holdings in some commodity stocks after a rebound in markets this year.

Below,
Gregory Peters, global head of fixed-income research at Morgan Stanley, talks about the outlook for U.S. stocks, global investment strategy and Federal Reserve policy. He speaks with Tom Keene on Bloomberg Television's "Surveillance Midday." Note the cautionary tone.

I remain bullish on financials, commodities, tech, energy and think the current weakness is another buying opportunity. This "liquidity lull" is a pause and once the tsunami really hits, you'll likely see a melt-up unlike anything you've ever seen before.