Wednesday, August 29, 2012

Annus Horribilis Seals Hedge Funds' Fate?

Kate Kelly of CNBC reports, Paulson & Co. Facing Some Frustrated Investors:
Many of Paulson & Co.'s investors hung with it last year despite an annus horribilis in which the company's flagship hedge fund lost 35 percent. But with returns continuing to sag amid a rising equities market, some of those investors are now jumping ship.

Citigroup (C) announced last week that it was pulling Paulson off its hedge-fund investment platform and planned to take back $410 million in assets.

Morgan Stanley's (MS) brokerage firm has reportedly had the fund company on watch for possible removal from its hedge-fund platform for months now. And other investors big and small are considering redeeming their capital soon as well, say bank officials and fund of funds managers.

During a phone call with clients and employees of Bank of America late Tuesday, Paulson & Co. founder John Paulson said he was “disappointed” about the loss of Citigroup as an investor, according to someone briefed on the call, but noted that the bank’s platform accounted for less than 2 percent of his company’s overall investments. Paulson also said that he wanted to “reaffirm” his commitment to the flagship fund and the “entire business,” this person added.

Still, the investor scrutiny comes at a sensitive time for the money manager.

These developments come at a difficult time for John Paulson, the former Bear Stearns banker who opened his eponymous hedge fund eighteen years ago.

Paulson has gone from managing more than $38 billion in assets at his company's peak to $19.5 billion today. And while a number of his funds are up this year - including the merger fund, which is up 3.6 percent, and the recovery fund, which is up 3.9 percent - his flagship funds, which consist of holdings that represent an array of different strategies, continue to suffer.

Even worse has been Paulson’s gold fund, which he acknowledged during the BofA call as the worst-faring in his portfolio so far this year. But given the tumult in Europe, which the fund-company founder thinks could benefit the yellow metal, Paulson remains bullish on gold over the next five years, according to the person briefed on the call. (Indeed, the Bank of America executive who led the call described Paulson’s funds as a great way to play the “gold miner thesis,” this person added.)

So far this year, Paulson's main flagship fund, known as Paulson Advantage, is down about 13 percent, according to people familiar with the matter, and its levered sibling, Paulson Advantage Plus, is down 18 percent. And while the so-called redemption window - the moment at which investors can pull back, or redeem, their capital from a hedge fund - varies for Paulson investors according to which fund they are in and when they invested, the protracted slump in the flagship funds is prompting hard looks at investor portfolios.

"Given the success he had, [Paulson] is going to have a longer leash than other managers. But at some point, every investor has to decide to lock away if they don't see it coming again," said Nick Bollen, a professor of finance who studies hedge funds at Vanderbilt University's Owen Graduate School of Management.

Even though Paulson performed phenomenally well during the credit crisis, Bollen added, "there's no assurance that he'd be able to make similar timely calls in the future."

One fund of funds manager who redeemed investor money from the Advantage fund during its downturn last summer said he thought that Citigroup was simply late to recognize a plummeting investment, and that the bank should have fired Paulson months ago.

Still, other investors said it made little sense to redeem their money even after the losses of 2011, given that Paulson is now so far below his high-water mark - the asset level at which he must stay in order to charge fees to his investors - that he is now essentially managing their money for free.

In addition, added a second fund of funds manager, pulling Paulson off a platform like Citigroup's is problematic because it runs the risk of locking in losses, rather than letting clients who still like Paulson's funds to remain involved and potentially enjoy future upside returns.

"Clearly, [Paulson] has not performed well," said the money manager.

"We'll certainly discuss the pros and cons with our clients prior to the [next] redemption date," he added, which, in his case, would be the end of this year.

Paulson investor redemption windows vary according to individual fund and the timeframe of the original capital inflows. Some Advantage investors, for instance, are on quarterly redemption time frames, while others are on semiannual or even annual ones.

In all cases, investors must provide 60 days' notice if they want to pull out their money.

While Citigroup has already closed Paulson funds off to new investors, its redemptions will play out over a yearlong period that begins in March 2013, said someone familiar with the matter.

I agree with the investor who pulled out of Paulson months ago. I would have invested with Paulson prior to the crisis and jumped ship after his outsized returns during the crisis.

As I wrote in the rise and fall of hedge fund titans, the media portrayed Paulson to be some sort of investment god, and many dumb funds chasing performance got whacked investing in his funds after the crisis.

Reuters reports that Paulson soothes nervy investors on BofA conference call, but Josh Brown of the Reformed Broker blog commented that it was a tough crowd on the Paulson call:

Using my advanced ninja skills I got myself onto the Bank of America Wealth Management-hosted conference call starring John Paulson of Paulson & Co this evening.

The notoriously press- and attention-shy Paulson agreed to be on the call a week after Citigroup pulled $410 million from the hedge fund manager and so at least some part of this was about damage control.

Paulson was quick to point out that Citi's financial advisors had not pulled their support for him directly, rather it was Citi's feeder fund. He also expressed gratitude to the BAML advisors for their longstanding relationship with Paulson & Co.

And then it was game on.

I have a few observations I'd like to make, in no particular order...

First, Paulson was measured during his introductory remarks and did not at all come off as defensive. He seemed to have kept his cool through a barrage of questions, some smart and some stupid, that were lobbed at him from the brokers.

Also, the fact that he agreed to the call counts for a lot, many upper-tier hedge fund managers would simply say, "they don't like the performance or the strategy? Let 'em leave." Which you can still do when you're running $19 billion, even if your AUM was double that 24 months ago.

The Merrill guys did not seem to be overly hung up what's already gone on, although they did reference it in framing their questions. No, they were much more curious about the current strategy and holdings, which is how it ought to be.

One question concerned the Recovery Fund which over the last three years seemed to have missed out on the recovery, with almost flat performance in the context of the ninth biggest bull market in history.

Specifically, John was asked to defend his overweights to the casinos like MGM and CZR. The concern seemed to be Macao was cooling off and Vegas was dead - what's the thesis here? John made the case that in a truly robust economic recovery (which has yet to materialize) these positions would be highly levered to the upside.

Another advisor asked about the various positions that seemed to contradict each other - "crosscurrents within the portfolio." He's referring to being long gold and short the euro for example, trades that would appear to cancel themselves out. "How do I frame this for clients and in what environment would this portfolio work?" the perplexed advisor wanted to know. JP's answer was that a lot of these should be looked at as hedges as opposed to opposing trades.

There were a few questions about personnel at the firm. One advisor asked about whether it was a coincidence that a bank analyst departed around the same time that Paulson & Co trimmed some of their bank holdings and I don't recall if there was a straight answer or not.

The real question is whether or not the call did more good than harm. I truly came away from it with a deep respect for John's thought process but not a lot of clarity in terms of how this collection of trades is meant to work going forward. I wanted to be more impressed than I was.

The intro to the call by the Merrill guy was about how Paulson had evolved from an arb guy into an investor who is much more macro-oriented as a result of his experiences during the 2007-2009 Greatest Trade Ever era. But of all the macro calls I've been on - and let me tell you something, I've been in meetings with Felix Motherf*cking Zulauf and at dinner with Jim Chanos - this one gave me the least confidence that there is any kind of hidden depth or the potential that the manager is seeing something no one else sees.

So to sum up, I have a ton of respect for John Paulson...but if I were a Merrill broker with a lot of client cash parked in his funds, I might be facing a really tough decision this fall about whether to stick it out.

That's a nice way to say if he were a broker with a lot of client cash parked in his funds, he'd be nervous as hell now.

Go back to view Paulson's holdings in my comment on top funds activity during Q2 2012. As shown below, Paulson significantly increased his stake in 15 holdings, chief among them was the SPDR Gold (GLD) Trust (click on image to enlarge):

Bloomberg reports that Paulson & Co., which owns the biggest stake in the SPDR Gold Trust, increased its holdings to 21.8 million shares in the three months through June.

The question that all investors should be thinking hard about is why pay Paulson, Soros or some other 'hedge fund god' 2 & 20 in fees to go long gold? Paying 2 & 20 for beta on a gold ETF is simply insane!

Moreover, brokers were right to note "crosscurrents in the portfolio". Paulson hedged his outsized bet on long gold/ short euro by adding a new stake in JP Morgan in Q2. In my opinion, that was his best move last quarter.

The most ridiculous comment I read above is that given that Paulson is now so far below his high-water mark - the asset level at which he must stay in order to charge fees to his investors - that he is now essentially managing their money for free.

Really? For free? That 2% management fee is being charged regardless of the terrible performance and that goes for all hedge funds and private equity funds. Come rain or shine, you can be sure these funds are collecting that 2% management fee!

When pensions invest billions in alternatives, these management fees alone add up to a huge chunk of change. And when they invest in hedge fund or private equity fund of funds, they get a double-whammy on fees (an extra 1 & 10 over the 2 & 20).

Luckily, many large US pension funds are finally waking up and taking action. aiCIO reports that MassPRIM has no regrets over breaking up with funds-of-funds:

The Massachusetts’ public pension system is adamant about directly investing with hedge funds—and its initial foray into the strategy has been an unqualified success.

“All indications so far say it was the right thing to do,” Board Chairman and State Treasurer Steven Grossman told aiCIO. “It’s going well—we’re steadily moving funds. Certain assets we can get at right away, others we have to wait.”

The Massachusetts Pension Reserves Investment Management Board (MassPRIM) is just over a year into the process of pulling out nearly all of its funds-of-funds investments, cutting ties with most of those asset managers, and reallocating those assets directly into hedge funds.

At this point, Grossman estimated, about 60% of MassPRIM’s hedge fund allocation is directly invested, with the target being 85%. Pacific Alternative Asset Management Co. (PAAMCO) takes the entire remaining 15% for funds-of-funds investments heavy on emerging managers. “That’s an area we want to broaden our outreach to, and we’re doing that through PAAMCO,” he said.

“We were paying an extra 84 basis points over standard direct management fees on our funds-of-funds investments,” said Grossman. “On $5 billion, that’s $36 million. We hadn’t been particularly happy with our returns on those investments. And with funds-of-funds, they do the due diligence, and we’re simply more comfortable doing it ourselves.” Given all of these factors, the $48.8 billion fund’s board “carefully, thoughtfully decided to make the move.” And move it did.

MassPRIM started with a $500 million pilot project to work out the legal and logistical kinks involved in withdrawing the equivalent of Barbados’ GDP from roughly 200 illiquid investments. “We wanted to test everything out first, and make sure we knew all the details before going ahead with it,” explained Grossman.

Cliffwater, MassPRIM’s advisors for this whole process, concluded that optimal diversification could be reached through direct allocations to roughly 20 hedge funds, as opposed to the more than 200 indirect, often redundant, funds-of-funds investments MassPRIM had been dealing with (and paying for).

And now, a little over a year into the process, what’s the verdict? “You might as well own directly, get close to the source, keep due diligence internal, and save $36 million,” Grossman said. “We’re looking forward to cutting out the middle man and working closely with a group of 20 or so hedge funds that we’ve selected ourselves.”

Smart move, there is no need to allocate to over 200 funds through funds of funds, getting raped on fees, not knowing your risk profile as many positions overlap. Moreover, I like the use of PAAMCO specifically to find emerging managers. This is where funds of funds can add real value and justify their fees.

As far as Cliffwater's assertion that 20 is the 'optimal number' of hedge funds, take that with a grain of salt. Those academic studies have been around for years and have more holes in them than Swiss cheese. 200 funds is ridiculous but so is 20 when you are the size of MassPRIM!

Let me end off by examining the question I asked in my title, will hedge funds survive another terrible year? My short answer is most won't. Paulson has the funds to survive the coming shakeout in Hedge Land but he will likely suffer a long wave of redemptions as investors grow increasingly frustrated with his poor performance.

But most funds that don't have Paulson's multi-billions, and even some that do, are going to struggle to keep their doors open as investors pull the plug on them and funds of funds. It will be very tough, if not impossible, to defend the industry's embarrassing performance two years in a row.

This last point was underscored in a Forbes article from Nathan Vardi looking at the fallout of hedge funds getting clobbered in 2012:

The hedge fund crowd is licking its wounds heading into the Labor Day weekend after getting clobbered by the market. As hedge funds look toward the homestretch of 2012 they will have to pull off a sector-wide miracle to stop 2012 from being one of the worst years their rich industry has ever experienced.

The numbers are truly terrible. Bank of America Merrill Lynch’s investible hedge fund composite index shows hedge funds are up 1.85% so far in 2012. That means investors in many hedge funds are paying big fees for the luxury of getting creamed by the U.S. stock market, which has returned 13.8% in 2012, at least as measured by the Standard & Poor’s 500 index. Goldman Sachs has put out a report showing that the average hedge fund is up 4.6% in 2012 and that only 11% of the hedge funds it tracks have beaten an ordinary S&P 500 index fund.

The big question is whether investors will overwhelmingly lose faith in hedge funds and start heading for the exits in a big way. So far they have only been creeping toward the door, although there are signs investor patience might be coming to an end. Reuters recently reported that a hedge fund administrator’s redemption indicator hit its second-highest level of the year in August and that big investors, like Citigroup’s private bank, in John Paulson’s prominent but struggling hedge funds have requested to redeem hundreds of millions of dollars. Man Group, the world’s biggest publicly-traded hedge fund, has seen its stock drop by 40% this year after its assets under management fell by almost a third.

Investors have stuck with hedge funds through rough times before and have shown they are willing to forgive one bad year. But 2011 was also a loser for most hedge funds. It was one of the hedge fund industry’s worst years ever, with the average hedge fund falling 5% while the S&P 500 returned 2%. Two bad years in a row might be tougher for some investors to accept.

I think two bad years in a row will be the final blow to investors who piled into hedge funds hoping for absolute returns and getting absolute garbage. Could be wrong but the fascination with hedge funds is over as most investors get a rude awakening paying high fees, getting low profits in return.

The best hedge funds will survive this shakeout. Just like in private equity, the divide between the haves and have-nots will grow ever wider but the industry as a whole is playing a loser's game and will suffer the wrath of frustrated investors.

Below, leave you with a fascinating CNBC interview with Tom Barrack, CEO and founder of Colony Capital, discussing why now is the moment to make long-term contrarian bets in real estate and other sectors. Barrack is betting on a US housing recovery (Bloomberg interview) and added to his Mideast portfolio in 2011, another contrarian bet. Watch both interviews below.

My long-term contrarian bet remains in Big Coal, a sector which has suffered a terrible slump due to an 'unusual confluence' of negative factors. Even with all these headwinds, I'd take a position in Big Coal over Paulson's bet on gold over the next five years. Unfortunately, I don't have the luxury of charging 2 & 20 for such beta bets! -:)

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