A Hedge Fund's Lesson in Volatility?
A year ago, John A. Thaler was the talk of Wall Street. His hedge fund was up more than 30 percent, defying a broad slump in the market and the debt turmoil in Europe. Investors, starved for returns, scrambled to hand him their money.
This year, things appear to have cooled off for Mr. Thaler. Rapidly.
His JAT Capital is down nearly 20 percent so far, according to internal documents from the fund, as big concentrated bets on consumer stocks have plunged. Investments in the mattress maker Tempur-Pedic, which has fallen 70 percent since April, have punctuated the fall.
Much could change for Mr. Thaler and his fund before the year ends. Managers have recovered big losses in a single month, or exacerbated them beyond repair. John A. Paulson, who rose to fame and fortune with a prescient bet against the subprime mortgage market, has done both.
Yet the sudden reversal of fortune for Mr. Thaler is another cautionary tale for investors who chase the returns of the latest must-have managers. As institutions like pensions plow tens of billions of public dollars into hedge funds every year, many are struggling to locate new talent. But in the fast-money world of hedge funds, what has investors raving one year can drive them mad the next.
“Investors move in herds,” said Hany A. Shawky, a professor of finance at the business school at the State University of New York at Albany. “Once a hedge fund manager gets noticed one year, there’s a buzz, one or two publications write about them and they get flooded with money.”
He added, “Sometimes they are not really ready to invest that kind of money,”
The world of hedge funds has always been opaque. Managers are notoriously secretive, refusing to tip their hand even to their own investors, which can help create an image of the wily genius beating the markets.
In reality, returns are often volatile, and managers rarely repeat stellar gains year after year. One academic study that tracked hedge fund performance found that the average hedge fund investor made about 6 percent a year from 1980 to 2008, a return only slightly better than United States Treasury securities.
“There’s a life cycle for all hedge fund managers,” said Robin Lowe, head of equities investing at the Man Group’s fund of hedge funds. “The mathematics of putting up large percentage gains as you become larger is much more difficult. The whole incentive of why you’re doing something changes.”
Mr. Thaler, a former Merrill Lynch analyst who specializes in technology, media and telecommunications companies, has historically made big gains — and taken big risks. Such bets have paid off. His returns are historically higher than most competitors. He jumps into his best ideas with a fervor that can mean big wins or big losses.
By the end of April, for instance, his top five stock picks represented about 43 percent of his $2.3 billion in assets, according to a potential investor briefed on the fund who did not want to be identified as revealing confidential information. But his bloody first half is as much about losses on long-term bets like Tempur-Pedic as negative bets on companies like Alibaba.com and Weight Watchers gone wrong.
In the case of Alibaba.com, the Chinese Internet site, the company was taken private, sending share prices higher. Weight Watchers and Sears, two additional short positions, rose when the company or insiders bought up shares.
Mr. Thaler noted that his biggest losses came from bets on the consumer sector, which contributed to 81 percent of the losses through April. The firm lost a top analyst, Jonathan Lennon, who departed to start his own fund, Pleasant Lake Partners, in January.
“While I am a firm believer in evaluating everything we do based on the process rather than the outcome,” Mr. Thaler wrote in his letter to investors, “it is difficult for me to ignore the loss we have taken in this sector, the volatility it has added to the funds and the fact that this loss and volatility has forced us to play defense in other sectors of the book.”
As such, the losses have prompted Mr. Thaler to revert to his core specialty, the technology, media and telecommunications industries, where he first made his name as a portfolio manager.
Mr. Thaler, 36, earned his stripes at Shumway Capital Partners, a hedge fund that shut down in 2010. While there, he worked as a technology analyst and eventually took over as a portfolio manager of one the fund’s most important funds, earning nearly 19 percent for investors in 2006.
In late 2007, Mr. Thaler started JAT Capital with about $200 million. Chris Shumway, the founder of Shumway Capital and a former top lieutenant of the highly successful investor Julian Robertson, believed so strongly in Mr. Thaler that he gave JAT Capital seed money.
Mr. Shumway, who now manages his own money and has invested start-up capital with a number of his former portfolio managers, still advises Mr. Thaler on business decisions, according to people briefed on the matter who asked for anonymity because the information was confidential.
In marketing materials, Mr. Thaler says he still deploys the same investment strategy he had at Shumway. Like many managers in his field, he dives into companies he thinks are undervalued and those he thinks are overvalued, taking on 60 to 100 positions at any time. Unlike some managers, Mr. Thaler typically holds more short positions in his portfolio than long ones.
Through a spokeswoman, Mr. Thaler declined to comment for this article.
Over the last few years, Mr. Thaler’s success has won many admirers. And his strategy, while volatile, has worked. In 2008, when the Standard & Poor’s 500-stock index was down about 37 percent and hedge funds lost more than 20 percent, Mr. Thaler lost just 6 percent. In 2009, he gained 20 percent and the year after put up a respectable 10 percent. Last year, when the average hedge fund lost 5 percent, Mr. Thaler scored a gain of roughly 17 percent.
Those gains have also allowed Mr. Thaler to ascend the hedge fund pecking order, having recently sold a condo on the Upper East Side and taken an 11,000-square-foot home, with seven bedrooms and 9 1/2 bathrooms, in Greenwich, Conn. Some things, however, have not changed. An avid baseball fan, Mr. Thaler sponsors a team each year and plays shortstop.
Returns like Mr. Thaler’s can be hard to ignore for institutional investors, especially when interest rates are idling near zero and the market is troubled with volatility. But other factors have also helped fuel Mr. Thaler’s rapid growth to roughly $2.3 billion from a little more than $1 billion last year.
Some investors looked to Mr. Thaler after Mr. Shumway closed down his hedge fund in 2010. And top competitors, like Chase Coleman’s Tiger Global and Philipe Laffont’s Coatue Management, were already turning investors away, according to investors who considered placing money with Mr. Thaler.
Whatever the case, money has flowed in so fast that Mr. Thaler, who was an economics major at the University of Chicago, decided last year to close his hedge fund to new investors. Now, those who squeaked in could be feeling buyer’s remorse because their first year with Mr. Thaler is turning out to be a big loss.
Part of the challenge of growth is what to invest in. With more money to put to work, the range of investments needs to expand. In part, Mr. Thaler’s move into consumer-related investing reflects an effort to broaden his portfolio. In his letter to investors, he acknowledged that the move had been wrongheaded.
That Mr. Thaler’s fund has been volatile is not entirely unexpected. At the end of last summer, the fund was up more than 30 percent, sending institutional investors into a tizzy, according to one consultant who looked into the fund and did not want to be identified because the matter was private.
A short while later, a drop in some of the fund’s largest holdings, like Green Mountain Coffee Roasters, ate up nearly half of JAT Capital’s gains before the year ended.
“The performance of the funds over the last seven months has been a great disappointment to the team and to me personally,” Mr. Thaler wrote in his quarterly letter to investors. “After any period like this, we are left to examine the drawdown and review if a change should be made.”
Great article, it highlights many of the problems that are typical in the rise and fall of hedge fund titans which I discussed last week. Here you have a smart hedge fund manager who got seeded by Chris Shumway, a successful hedge fund manager who was part of Julian Robertson's Tiger cubs, and when he posted solid returns in difficult years, assets under management mushroomed.
But the problem is as assets grew, he started delving into sectors that aren't his area of expertise (technology). Worse still, he takes highly concentrated bets in his portfolio to produce outsized returns but the flip side to this is when he's wrong, his portfolio gets creamed, down 20% YTD.
I want all of you institutional investors and rich family offices to pay attention. No matter how famous or successful, stop coddling, glorifying and sucking up to hedge fund managers. Always ask them tough questions, especially when things are going smoothly (not just in difficult periods).
If you invested in JAT Capital or Paulson and were shocked to see their portfolio get slammed, you shouldn't be investing in hedge funds. Period. You failed to understand the concentration risk these managers took at at a security, sector and portfolio level. All you saw was magazine covers and 'BLING-BLING'.
Why did Paulson get slammed in 2011? Because he bet heavily on US banks and got creamed. Why did Thaler get slammed this year? Because he took concentrated bets on consumer stocks like Temper-Pedic and he got creamed too.
Now, there is nothing wrong with taking concentrated bets. I've invested and met with plenty of excellent hedge funds who took concentrated bets. But when you invest in such managers, understand you're vulnerable to large beta swings and allocate your risk accordingly. They might be right one year or even two or three years, but when they get hit, they get hit hard.
And when they get hit, it could impact their business in many ways. You need to really pay attention to how they deal with losses. This is critical. The best managers know how to retrench and come back strong. Most perish and close their fund after sustaining big losses.
When you lose 20% or 50% as Thaler and Paulson just did, it's a huge hole to dig yourself out of. They have to cut risk across the board and figure out where they went wrong, regroup and try to come back stronger. If they don't, they'll lose credibility with their institutional investors.
You might also be asking yourself how does a hedge fund lose so much? Aren't they suppose to mitigate against downside risk? Absolutely. The very best hedge funds are always focused on mitigating downside risk. If, for example, you trade at Brevan Howard, one of the best global macro funds, you won't survive long enough to lose 10% (after being down 5%, they'll pull the plug on you).
But in these rigged markets dominated by high-frequency trading algos and dark pools of capital, some hedge funds are getting exotic while others are 'retrenching into core positions', meaning they're taking more concentrated bets in stocks and sectors.
Over the weekend, I spoke with a bright hedge fund manager about the hedge fund insanity in the industry. He told me he went to a hedge fund conference where star managers typically go to "talk up postilions they want to unload," and was floored at the questions directed toward John Paulson. "A bunch of hedge fund managers were asking him silly questions, kissing his ass."
Lucky for Paulson I wasn't at that conference because I wouldn't kiss his ass or that of any other hedge fund titan. He would have been answering some mighty tough questions on risk management, and if he gave me any attitude, I would have grilled him even harder in front of everyone.
On risk management, this bright hedge fund manager told me how everyone in the industry is using RiskMetrics analytics to "stress test their portfolio to a Lehman type event." However, he rightly warned there is a 'survivor bias' as many of the names in the index are gone because they went bankrupt. "This means these stress tests are underestimating the real risk of the next crisis."
He told me that the only reason Citadel and many other large hedge funds survived the last crisis was because they put up gates "but that option won't be there the next crisis and many of these funds will get smoked or taken out by large broker dealers." He's right, investors learned a bitter lesson during the crisis when hedgies closed the gates of hedge hell. That option still exists but is much harder, if not suicidal, to implement.
He also told me many hedge funds suffer from 'group think'. The top guys meet regularly to discuss investment themes and these ideas get filtered through the channels to other hedge fund managers. This is why you often see hedge funds pouncing on the same investment theme (and why it often pays to take the opposite side of that trade).
I also spoke with a senior Canadian pension fund manager, one of the best hedge fund investors in the world. He agreed with me that things are getting silly again in Hedgeland. He explained why hedge funds shift from performance oriented to asset gathering oriented. "As assets mushroom, the focus shifts on the business. They become more conservative and focus primarily on marketing and investors relations."
That's great when you're getting 2 & 20 in fees, charging alpha fees for leveraged beta, managing Malakia Capital Management, but it sucks for investors wondering why they too don't have yachts and Ferraris.
The entire hedge fund industry needs a reset. Hell, the entire financial industry needs a reset. I've never seen more overpaid whiners trying to justify their outrageously high compensation.
But with pressure mounting on pensions to boost returns, many are turning to or increasing allocations to hedge funds in an attempt to do this using a variety of asset allocation techniques. I wish these pensions luck. Most of them will get burned investing in hedge funds and other alternative investments. The same goes for ultra-wealthy individuals jumping on the hedge fund bandwagon, looking to juice up their investment portfolios.
Finally, Chris Flood of the FT reports, Detecting good and bad hedge fund managers:
How can investors know that their chosen hedge fund manager is not a gambler or a crook?
Well, they could talk to Michael Markov, chief executive of Markov Processes International.
Mr Markov’s company MPI has developed software that allows investors to check whether managers are sticking to their investment strategies and to detect potential fraud.
The company met significant interest at an investor presentation in Japan when Mr Markov demonstrated how it provided red warning flags for AIJ Investment Advisors, which admitted earlier this year that it could not account for nearly $2.5bn in assets.
In the case of Galleon hedge fund, whose co-founder Raj Rajaratnam was convicted of insider trading, MPI was able to detect the “alpha outliers” hidden in published monthly returns. These unexpected gains were later shown to have coincided with the months when Galleon was benefiting from insider trading.
Mr Markov declines to comment on the extent of fraudulent activities in the hedge fund industry.
MPI’s software is primarily designed to help select good managers rather than detect fraud, he says.
To demonstrate the software’s effectiveness, MPI recently analysed the trading strategies of Bridgewater Associates, the world’s largest hedge fund house.
MPI does not know Bridgewater’s holdings, positions or strategies. But using its quantitative tools and monthly returns data, Mr Markov says it has been possible to track the returns delivered by the Bridgewater Pure Alpha II fund over the past three years.
Pure Alpha II is unconstrained so it can use leverage and derivatives in long, short or spread positions in equity, fixed income, commodities and currency markets.
But investors have confirmed that MPI’s analysis has correctly identified the various sources of Bridgewater’s returns.
The need for independent verification of hedge funds behaviour was underlined by a study published last year by the Oxford-Man Institute of Quantitative Finance.
It showed nearly 40 per cent of hedge funds provided investors with incorrect information about investment performance.
MPI’s ability to reverse engineer fund returns is of interest to sovereign wealth funds and other institutional investors.
A risk officer at a sovereign wealth fund said: “No single tool can tell you everything but MPI’s software provides valuable insights into how a hedge fund delivers returns. It can help an investor understand whether a manager is adding value. If some parts of returns are left unexplained, it can be a way to raise warning flags, especially when combined with other sources of information.”
Very interesting software indeed, but I warn investors, never over-rely on any software when it comes to gauging the performance and risk profile of hedge funds or any active manager. There are far too many 'intangibles' that come from the culture of the organization which is itself a product of its leaders.
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Below, Columbia University Finance Professor Fabio Savoldelli discusses hedge fund managers' strategies throughout the economic crisis in Europe. He speaks with Deirdre Bolton on Bloomberg Television's "Money Moves."