Friday, July 6, 2012

Hedge Funds Fail to Wow in First Half?

Svea Herbst-Bayliss of Reuters reports, Hedge funds fail to wow in first half:

Hedge funds have little to brag about halfway through 2012, with some of the biggest names reporting only small returns and trailing the benchmark U.S. stock index.

Paul Tudor Jones' flagship fund is up 1.59 percent through the third week in June, David Einhorn's biggest portfolio is up 3.7 percent in the first half, while Daniel Loeb told investors that his largest fund rose 3.9 percent during the first six months of 2012, investors in their funds said.

Compared with a year ago when many hedge funds were losing money, these returns might sound like something to cheer, especially since they beat the benchmark HFRX Global Index's 1.22 percent gain.

But they pale measured against the 8 percent rise in the Standard & Poor's 500 stock index during the first half, with the $2.1 trillion industry failing to wow at a time that public pension funds are increasingly turning to hedge funds to shore up ailing returns.

The industry's underperformance may again raise questions whether it makes sense for institutional investors to pay hefty fees to managers when they can get better returns by buying shares of low-cost index funds. Unlike most other portfolios, hedge funds take a management fee plus a performance fee that is often 20 percent or more.

Europe's seemingly endless debt crisis is getting much of the blame for the year's anemic returns, but fears about U.S. growth and how China will perform are also making for uncertain trading conditions, experts said.

"People are over-managing their positions," said Peter Rup, chief executive and chief investment officer at Artemis Wealth Advisors, explaining that funds moved to short positions only to see those turn against them when markets rebounded after having tumbled.

There are some bright spots, with some managers who specialize in selecting stocks making savvy picks and some managers specializing in credit also performing well.

Leon Cooperman's Omega Advisors Inc was up 10 percent in the first half, benefiting from its long-time investment in student lender Sallie Mae, whose shares have rebounded recently.

Marcato Capital Management, founded by Mick McGuire after he left Bill Ackman's Pershing Square Capital Management, jumped 12.7 percent in the first half.

Andor Capital Management, run by technology investor Dan Benton, who recently came out of retirement, is up 6 percent, while Steven Cohen's SAC Capital Advisors, one of the industry's most closely watched funds, was up 5.2 percent in the first half.

Boaz Weinstein's Saba Capital, which took the other side of some of the trades that resulted in huge losses for J.P. Morgan, was up 2.3 percent through the third week of June. Blue Mountain, another fund that also made money on the other side of J.P. Morgan's failed trades, was up 9.54 percent through the third week of June, a person familiar with the numbers said.

And among the funds managed by men who commanded the biggest salaries in the industry only a few years ago, Kenneth Griffin's Citadel notched a 9 percent increase in the first half.

There are losers as well, including the two men who made the most off betting against the subprime mortgage market. Philip Falcone, now being sued by financial regulators and often slow in releasing his numbers, told investors his Harbinger II fund was off 33 percent during the first five months of 2012. John Paulson's Advantage Plus fund was off 10 percent through the first five months of the year.

It's been a tough couple of years for all active managers, not just hedge funds. These rigged markets dominated by macro and political news have wreaked havoc on stock picker's portfolios.

And as I wrote last week, the rise and fall of hedge fund titans isn't something new but it pains me to watch institutions making the same mistakes over and over, paying alpha fees for beta or even worse, sub-beta performance.

Hedge funds will counter "yeah but we mitigate downside risk". There is some truth to this but been around far too long to listen to this utter nonsense. Most hedge funds are not worth the fees they're charging clients. They are glorified asset gathers. Period.

There are a few top managers, and even newcomers, who are delivering true alpha but the industry is populated by slick marketing types who peddle horseshit to unsuspecting institutional investors looking for their "alpha fix".

Will the second half be better than the first half for hedge funds and active managers? I think so. Michael A. Gayed, chief investment strategist at Pension Partners, LLC., wrote an interesting comment, Don’t miss out on the IYCBTJT market:

While momentum is a well-documented market phenomenon which counters the idea that markets are efficient, the reasons for its existence are largely not understood.

Human beings are hard-wired to herd. Studies, for example, show that the feeling of rejection gets interpreted by the brain as if one is in physical pain, the avoidance of which occurs through joining the crowd.

From an evolutionary standpoint this should make some sense. After all, one had a higher chance of survival by staying with the group than by being alone if there is a woolly mammoth on the horizon.

Behaviorally, because the feeling of not being part of the crowd is registered literally as physical pain, individuals tend to gravitate together to remove that pain, creating fads, trends, bubbles, and busts.

With the European Central Bank, People's Bank of China, and the remainder of “SuperBen and the League of Extraordinary Bankers” keeping stimulus on, and with bond yields below inflation rates and overvaluation in income sectors (dividendsanity), the crowd may be about to magnify stock market gains.

Analysts, strategists, institutions, and the retail public are unjustifiably bearish when the negative narrative is by no means guaranteed to play out the way most think, and with housing recovering in a meaningful way.

Meanwhile, equities have produced strong returns so far this year, and the best may yet come in what may end up being the "if you can't beat them, join them" (IYCBTJT) stock market.

What makes me believe this is recent price action in high beta small-cap stocks. Take a look below at the price ratio of the iShares Russell 2000 ETF (IWM) relative to the large-cap S&P 500 (IVV). As a reminder, a rising price ratio means the numerator/IWM is outperforming (up more/down less) the denominator/IVV. For a larger chart, visit here.

Notice the vertical strength small-caps have experienced in the past few weeks. Because small-cap stocks are less liquid than large-caps names, and are more volatile with a higher sensitivity to market gyrations, leadership in smaller capitalization companies means investors are willing to hold on to risk and are more comfortable with equities more generally. Prior periods of uptrends in the ratio coincide with strong periods for risk assets. This trend may just be getting started.

If this ratio continues to trend higher, as I suspect it will, then herding and the feeling of rejection/missing out on further gains will only strengthen momentum more, and continue the theme of reflation and the end to the end of the world trade (the "Summer Surprise").

The crowd sets price, and if this is what price is signaling the crowd is likely to do, then it will get harder and harder for money on the sidelines to miss out not because of greed, but because not being with the crowd profiting from rising stocks may be just too painful.

I've been warning investors to prepare for a summer melt-up. I put my money where my mouth is and know exactly what Michael means when he writes about strength in high beta small caps as a leading indicator for risk appetite.

Last week, I bought a ton of Patriot Coal (PCX) shares at $1.05 and sold them yesterday afternoon at $2.30, for an 100%+ gain in a week! Admittedly, this rarely happens and is highly risky trading, but I did my homework and took the risk. I am tracking and trading coal shares very closely because they've been decimated, especially smaller players like Patriot Coal (PCX) and James River Coal (JRCC).

But it's not just high beta small caps. If you trade stocks and paid attention to big moves in the last week, you'd think something is changing. For example, Netflix popped from $68 to $82 in the last few trading days, despite very negative press on its $3B bomb on its balance sheet. This doesn't seem to deter top funds, many of which loaded up on Netflix in Q1 2012.

I'm giving you just a few examples here. There are many, many more. Go back to read my comment on Q1 holdings of top funds, but remember to use this information as a tool and never buy or sell anything based on any top fund's activity (in the hands of an amateur, this information is lethal!).

Instead of paying hedgies 2 & 20 for beta or sub-beta, institutions should be donating and subscribing to my blog. The information I put out on a daily basis is nothing short of outstanding but I've come to accept that most people are cheap (there are a few exceptions) and they'll never pay up, especially when they get it for free!

Finally, a comment on today's jobs report. At this writing, Bloomberg reports that US payrolls rose 80,000 last month after a 77,000 increase in May. I'm glad I booked my profits and went all cash yesterday afternoon as these jobs reports are notoriously difficult to predict. I actually thought it would be a lot better than this headline figure but remain convinced that job growth will improve in the coming months.

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