Are Hedge Funds Playing a Loser's Game?
The financial crisis trashed many reputations in the City of London and on Wall Street. But not those of the financial aristocracy – the hedge fund bosses. While the bankers took it in the neck for the carnage, some of the savvier hedgies – such as John Paulson, who made billions shorting the US housing market – actually saw their stock soar ever higher.
Other investment vehicles may have become pariahs but hedge funds have remained stubbornly fashionable. Since 2009, investors have pumped nearly $150bn of net new money into them, allowing the industry not only to rebound from the crisis but to resume its expansion. At last count, hedge funds managed $2.1tn in assets, more than they did on the eve of the financial crisis five years ago.
Among the most enthusiastic buyers of hedge fund services have been pension funds. Driven by the need to fulfill past promises made to beneficiaries, trustees have been prepared to punt ever more money on so-called alternative investments. Some US retirement funds intend to put up to 15 per cent of their assets into hedge funds in coming years against the 5-10 per cent many have invested now.
This is an ill-judged bet that gets ever harder to justify as hedge funds get bigger. For all its self-proclaimed brainpower, there is little evidence that the industry has the capacity to earn superior returns on the vast ocean of cash it already has at its disposal – let alone all this new money. Even before the financial crisis, results were fairly lacklustre and they are worse now.
Far from carrying all before him, Mr Paulson is making thumping losses. Other “masters of the universe” – most recently Louis Bacon of Moore Capital – have been handing funds back to investors, in part because of the difficulty of earning satisfactory returns. George Soros, fabled as the “man who broke the Bank of England”, gave his investors all their money back last year.
Hedge fund bosses blame many of their difficulties on the dire financial environment and it is true that low interest rates and limited liquidity have conspired to crimp trading opportunities. But it is hard to avoid the impression that hubris is also a factor: hedge funds are now too big and numerous for their own good.
While the industry seems loath to accept the idea that there should be any limits to its size, there are clear problems associated with scale. It becomes harder to devise distinctive strategies. Funds find it more difficult to trade in and out of markets without moving prices against themselves.
An even bigger concern is that size has turned the industry into what is known as a “loser’s game”. This is one in which victory goes not to the player with the best offensive strategy but to the one who makes the fewest mistakes – and has the lowest costs. Hedge fundery has become a loser’s game because the funds themselves are no longer the exotic and small offshoot of mainstream fund management they were in the 1990s. Increasingly, they are the market.
Although hedge fund assets account for less than 10 per cent of investment funds worldwide, they account for a far bigger proportion of all trading on UK and US stock exchanges. The industry is increasingly engaged in a zero-sum game in which one fund’s profit is another’s loss, less the costs of the transaction. Given the high fees and trading expenses incurred by hedge funds, the majority are mathematically likely to disappoint.
This is not a problem the industry finds easy to address. Although some star managers – such as Mr Bacon – may have the self-confidence to limit the size of their funds, many are beguiled by the industry’s lucrative fee structure into gathering assets without much thought as to whether they can put them to profitable use.
Discipline can only be imposed by outside investors. A good place to start would be to take a hard look at the way hedge funds report returns. This has obscured the size-related decline in performance. The industry uses “time-weighted” figures that simply record the return of each fund irrespective of how big it is. So a huge return on a tiny fund has the same weighting as a mediocre return on a giant one.
This, given the constant budding of tiny spin-off funds, which (if they report figures publicly at all) tend to perform well at least in their early years, has flattered the indices.
A better way to assess the merit of a hedge fund investment is to use a “dollar-weighted” approach, meaning looking at what happens to dollars when they are actually invested. This is more akin to calculating a profit and loss account for hedge funds and, as such, takes size into account.
At the start of this year, Simon Lack, a hedge fund investor, performed precisely this analysis for the whole industry going back to the 1990s. The results were miserable. Mr Lack concluded that investors would have been better off putting their money in US Treasury bills yielding just 2.3 per cent a year. Roughly 98 per cent of all the returns generated by hedge funds, he estimated, had been eaten by fees.
Tellingly, the Alternative Investment Management Association, the hedge fund industry body, has devoted a great deal of effort to rubbishing Mr Lack’s claims, recently publishing a 24-page paper (after six months of study) seeking to rebut his argument point by point. But far from demolishing his analysis, the series of quibbles the organisation ultimately offered actually (if unwittingly) reinforced it.
There are great hedge funds and investors have done well by backing them. It is not clear, however, that there would be many more such funds were the industry to have $3tn of assets rather than the current $2.1tn. “Large amounts of money under management and high fees spell eventual performance disappointment,” observed the late investor Barton Biggs. If the pension fund industry does not learn this lesson then it – and its beneficiaries – may face a rude awakening.
Earlier this week, I commented on how cash-strapped US pension funds are running out of alternatives, piling into hedge funds and private equity funds to achieve their ridiculous investment target of 7.5% to 8%.
But Simon Lack is right to sound the alarm because as more money flows into hedge funds, returns are coming down in all alpha strategies. The fact that AIMA has spent time and money vigorously defending the industry's embarrassing track record just goes to show you that Simon has touched a very sensitive hedge fund nerve.While there will always be exceptional alpha managers, for the most part, hedge funds are nothing more than overpaid glorified beta funds burning investors, charging alpha fees for beta or sub-beta performance. In justifying these fees, they all claim to offer high risk-adjusted returns, but that is pure rubbish and the proof is in the data (especially when you take the selection bias into account).
The problem is that pension funds are hooked on the notion that more alternatives is the way to go. Spurred on by their clueless consultants, they refuse to see this strategy has delivered nothing more than high fees and low profits. It's all great for the hedge fund and private equity industry, but not sure how this benefits pension beneficiaries who are trying to keep the costs of managing their plans down.
Ironically, the institutionalization of hedge funds has become the industry's worst enemy. To a certain extent, I agree with those who are calling hedge funds the new dumb money. For example, Beverly Goodman at Barron's reports, Hedge Funds Trade More Bonds, Do Badly in Stocks:
Efforts at regulating the financial industry can seem like a game of whack-a-mole. This past week, for instance, it became clear where all those proprietary trading desks went—into hedge funds.
Regulators are putting the final touches on the Volcker Rule, which prohibits banks from trading their own, proprietary money in an effort to boost profit. Even though that change won't take effect until January, banks have been disbanding these trading desks, many of which have found a home in the hedge-fund world, as evidenced by a pickup in the funds' activity.
Hedge funds generated nearly a quarter of overall trading volume in the fixed-income markets in the 12 months through June 30. That's more than 30% above the level in the corresponding period a year earlier. "With all the regulations we've seen, there's definitely been a shift in bank proprietary trading desks moving to hedge funds," says Brian A. Jones, vice president for Greenwich Associates, a research and strategy consulting firm that has published a report on this topic. "Hedge funds are not buying and holding; they're trading huge volumes in milliseconds."
Trading volume in Treasury bonds, of course, was high across the board. Investors vacillating between "risk on" bets in riskier stocks and bonds and "risk off" assets, such as Treasury securities, certainly contributed to the overall volume. Treasuries are the most liquid securities, with some $1 trillion traded every day, says Andy Nybo, a partner with the Tabb Group, another research and strategy firm. "That's very attractive for funds trying to get in and out of positions quickly," Nybo says. The pickup in hedge-fund trading volume far surpassed the 20% increase among all institutions and the 14% rise among other types of funds and advisers.
But what does this mean for investors? "When hedge funds go into a particular market, they shift market dynamics," Jones says. "People notice these huge moves, and they're seeing that hedge funds are back in play."
They might notice, but they don't all care. Other big bond traders, many of which, like Pimco and BlackRock, are much larger than most hedge funds, make macro-economic calls that determine when they buy and sell. And executing trades efficiently is hardly a problem for firms of that size. Security selection doesn't get much harder, either. The rapid trading of hedge funds doesn't do much to alter the fundamental value of the bonds, says Rick Rieder, chief investment officer for BlackRock's $624 billion in actively managed fixed-income assets.
That should come as some relief, since virtually everyone agrees that hedge funds are likely to increase their trading, especially as interest rates begin to rise and economic news shifts. "You definitely see a lot more trading around significant events, like when the Federal Reserve minutes are released and there's a change in tone, or on payroll days" when monthly employment figures are released, Rieder says. "Whenever there's a surprise, we definitely see hedge funds being more active around Treasuries. But they're mostly smoothing out the aberrations. Beyond that, we don't pay attention."
MAYBE ALL THAT FIXED-INCOME trading is an attempt to make up for some pretty abysmal stock returns.
A report released by Goldman Sachs last week focused solely on the equity trading of hedge funds. And guess what? The news wasn't good. Again. This year, just 11% of hedge funds are outperforming the S&P 500, and 20% are losing money. Even mutual funds, which also are underperforming the broad market, are doing so by a much less embarrassing margin. The average large-company mutual fund managed to return 10% through Aug. 3, the date that Goldman used for the performance figures in the report.
Sure, you can argue that it's not fair to compare the complex trading strategies of a hedge fund to the simple strategy of an index mutual fund. But hedge funds have been trending toward large-company shares for almost 10 years, and now 46% of their aggregate assets are in stocks with a market value exceeding $10 billion. So, when the S&P 500 returns 12%, as it has this year, and the average hedge fund returns less than 5% in the same period, as it did, the comparison seems more reasonable.
Hedge-fund returns depend highly on a few key stocks, the report notes. The typical hedge fund has 64% of its long equity assets in its 10 largest positions. While there are plenty of "focused" mutual funds as well, the typical large-company fund has just 36% in its top 10 holdings. Mutual funds focused on small companies—a sector to which, many argue, hedge funds could bring additional expertise and therefore excel—generally have just 18% of their holdings in the top 10. And index adherents have 21% of their assets in the top 10 companies in the Standard & Poor's 500 index, but just 2% in the top 10 in the Russell 2000.
When I see hedge funds aggressively moving into fixed income, I know they're chasing yield. And why not? The bond market is large, liquid and the so-called bubble isn't popping anytime soon.
Still, all this tells me is that most hedgies are overpaid momentum chasers, chasing beta in stocks and bonds. It will be interesting to compare their "risk-adjusted returns" when the next crisis strikes.
Finally, there will always be admiration for true pioneers in any field. Bloomberg reports that Neil Armstrong, who set mankind’s first steps on the moon during Apollo 11, has died. He was 82. Below, amazing footage of when the "eagle landed" back in 1969.