Wednesday, September 12, 2012

Pulling Out of Hedge Funds and Commodities?

Svea Herbst-Bayliss of Reuters reports, Investors pull more money away from hedge funds:
Investors took more money away from hedge funds in July when they asked for $7.4 billion back, underscoring their frustration with an industry that has long promised to make money in all markets but is currently delivering only middling returns.

July's redemption requests were up sharply from the $4.2 billion pulled out in June, according to data released by BarclayHedge and TrimTabs Investment Research on Tuesday.

That leaves hedge funds industry assets at roughly $1.87 trillion, down 23 percent from their peak four years ago before the financial crisis hit, the research report found.

"We've seen a notable reversal in hedge fund industry fortunes during the past year," said Sol Waksman, founder and president of BarclayHedge.

This is troubling news in an industry dwarfed in size by the mutual fund industry but able to attract some of the world's savviest investors with the promises of big paychecks and more investing freedoms. Similarly big name investors including pension funds and wealthy individuals have long been attracted to hedge funds because their managers can short, or bet against a security, thereby having more tools at their disposal to deliver better returns.

But performance has been less robust and investors have been quicker to pull out.

In the year from August 2011 to July 2012, hedge funds reported outflows in seven out of 12 months, marking a stark contrast to the previous year, when the industry boasted inflows in 10 out of 12 months and took in $976.2 billion.

Investors' patience is clearly wearing thin as returns failed to recover dramatically this year after last year's roughly 5 pct loss.

In the first seven months of 2012, the Hennessee Hedge Fund Index returned 3.82 percent while the main stock market index, the Standard & Poor's 500, climbed 9.7 percent.

Even strategies that are performing well were not immune from redemptions with investors asking for $188 million back from fixed income funds even as these types of portfolios returned 6.17 percent on average, posting some of the industry's best returns.

After years of giving managers lots of time to let their strategies work, investors are more worried about having to pay hefty fees but getting only lackluster returns.

Managers often take 20 percent of the gains and add on another 2 percent management fee, far more than mutual funds, which generally charge only a management fee.

Some high profile managers are among the funds struggling to deliver strong returns this year amid volatile market conditions shaped by Europe's ongoing debt crisis, fears about new market regulation, health care costs and the outcome of the U.S. presidential election.

Louis Bacon's Moore Global Investors Fund was up only a smidgen through late August while Paul Tudor Jones' Tudor BVI Global Fund was up about 3 percent through last August, according to data released to investors.

There are some stars on the horizon, however, including industry veteran Lee Ainslie, who is staging a dramatic turnaround with his fund up 20.12 percent through the end of August after having fallen 14.8 percent last year, numbers released to investors show.
There are many well-known funds delivering stellar results. For example, Brevan Howard reaped rewards from being on the other side of JPMorgan’s infamous “London Whale” trade earlier this year by buying up tranches of mortgage and corporate bonds.

The BH Credit Catalysts Master Fund, which trades credit and mortgage-backed securities and purchased the credit-default swap (CDS) contracts from JPMorgan, posted gains of 9.46 percent, year to date through August 31. (Brevan Howard’s Macro Fund has fared worse this year. That fund posted losses of 0.45 percent on the year, compared to gains of 12.5 percent in 2011.)

Ken Griffin's hedge fund Citadel which saw its equities fund rise 1.55 percent in August, pushing year-to-date returns to about 11.5 percent. According to Reuters, the roughly $13 billion fund's flagship Kensington and Wellington funds also gained 1.7 percent in August, up almost 14 percent for the year.

Some well-known hedge funds are piling into the reinsurance business, seeking sources of permanent capital not tied to fickle investors. But if they aren't able to produce returns in their hedge funds, their reinsurance side ventures could prove disastrous. Others are improving risk management to attract and retain  institutional investors. 

Nonetheless, while hedge fund returns inched up in August, extending summer gains on euro optimism, they still trail the broader stock market, which gained 2.25 percent last month. The S&P 500 stock index rallied 13.5 percent through Aug. 31.

Any way you slice it, hedge funds are doing terribly this year, leading some to ask whether the end to alpha is stressing fund managers:
It is no secret that investors of all stripes have struggled to beat the market since the financial crisis. The majority of hedge funds, for instance, have trailed both global stocks and bonds since the start of 2010, meaning that they have not added value to the simplest of portfolios.

Mutual funds are not performing as badly as last year, when just 27 per cent offered better returns than the benchmark they choose to track, according to research group Lipper. But, again, the majority still trail in 2012.

Much of the blame for this tends to be attributed to the fact that markets now move to a drumbeat of statements from politicians and central bankers, such as the head of the US Federal Reserve. “All 500 S&P companies have the same chairman and his name is Ben Bernanke,” says Jurrien Timmer of the Fidelity Global Strategies Fund.

It is also true that securities within markets, as well as far-flung debt and equity markets have been trading more “in sync” with each other: the willingness of investors to take on risk being a common factor behind price moves.

But something more fundamental may be happening. Changes to the availability of information and in the capital to act on it mean it has become harder, perhaps impossible, to beat the market consistently through active management. There may be no more “alpha”.

Consider that any young business school graduate with the money to pay for the data feed can sit in front of a Bloomberg terminal and, with a few keystrokes, bring up years of financial statements for businesses across the globe. Tap again and an investor can ponder charts showing the predictions of professional analysts, details of the company’s debt, as well as the identities of shareholders, competitors and peers.

The service, and others like it that sit user friendly screens atop vast databases of information, have made it far easier to analyse asset prices, but harder to gain an edge over peers by acting faster, or more smartly.

John Longhurst, head of emerging market equity research for Pimco, says that when he became a stock analyst in the mid-1980s, “information advantage covering continental European companies was often little more than being able to get an annual report in English”.

Mr Longhurst, who previously worked for Capital Research, says that “10 to 15 years ago I could sit with clients and talk about how being globally connected through multiple offices and working in a well-resourced entity were competitive advantages. No more.”

Pimco is organising its research teams around global value chains rather than by simple sector or country to spot attractive investments. But the move by the world’s largest corporate bond manager as it tries to build a new equity business highlights how much capital, both financial and intellectual, is chasing fleeting opportunities.

“When hedge funds were at $200bn, there were probably a lot of inefficiencies in the markets that the smart guys could identify,” says Denis Bastin, a consultant to asset managers. Now that the industry is more than 10 times that size, however, before using leverage, the market inefficiencies must be far larger for it to generate alpha, even as the number of smart investors hunting them has mushroomed.

The effect can be seen in the narrowing dispersion of hedge fund returns – the difference between the best and worst performers. In 2011, while the average hedge fund lost money, according to HFR, a data provider, the top 10 per cent of funds made a respectable 19.5 per cent on average.

Yet that respectable return was the worst performance by the hedge fund elite since 2000. The top 10th of the industry had made at least twice as much in each year of the previous decade. These relatively muted returns continued into 2012.

Of course, a world of very low interest rates may simply have shone more light on returns for active management that have always been below par. Past studies have found that mutual funds, in aggregate, fare worse than passive index following.

Russel Kinnel, head of Mutual Fund research for Morningstar, says “relative to say indexes, or other benchmarks, fund performance does not change that much”. He finds that in any given year about a third of active funds perform well.

Even among bond funds, which have taken the lion’s share of US investor inflows since the 2008-09 financial crisis, less than a third have beaten their benchmark on average each year since 2000, according to Lipper.

Experienced investors, then, struggling to match past performance may just be baseball players in world suddenly playing cricket. The skills needed to select securities that worked as stocks and bonds rose in value for much of the preceding three decades have simply become out-of-date.

“Every time we go through a new market cycle a few of the heroes get shed,” says Mr Kinnel. This market favours the few able to distil the intricacies of Beijing politics into investment themes, or to spot where the next Samsung or Apple will rise.

Mr Bastin says: “Yes, we have a lot of information that is readily available, but you still have to interpret it. What really counts is the skill set and the ability to interpret those numbers.” Such skills, though, are held by perhaps 5 to 10 per cent of the current investor universe. “Most of the others have no business being in the space.”
I agree, there will be new stars in the industry rising up and old stars dying down, but the low rate environment has many investors looking more closely at returns for active management and the fees they pay out to all alternative investment funds.

And as hedge funds go net long commodities, pension funds are pulling out of them. Greg Meyer of the Financial Times reports, US funds fall out of love with commodities:
A brief love affair with commodities is over at the $36bn Illinois Teachers’ Retirement System, one of the biggest public pension funds in America.

Four years after hiring managers to make new commodities investments, the pension fund has scrapped the strategy and shuffled money into a portfolio it says “better reflects conditions in the world economy”.

Specialised commodities markets may have become popular as an asset class, but US pension funds are approaching them with extreme caution. Some, such as Illinois Teachers’, are in retreat. This wary stance has turned an expected torrent of money into a trickle and adds up to less for commodity asset managers to manage.

Commodities are marketed to pension funds as a way to diversify risks, hedge against the risk of inflation and harness gains from economic growth. But correlated returns, where commodities have moved more “in sync” with other assets, low inflation in developed countries and continued economic fragility have made some investment committees pause.

Illinois Teachers’ hired three groups in February 2008 to manage its first commodities investment of $600m, announcing the fund was taking “additional steps to protect retirement nest eggs”. By June 30 2008, the investment had swelled to $652.8m. Two days later, what was then known as the Dow Jones-AIG commodity index peaked before tumbling 57 per cent in the financial crisis.

In June 2011 the Illinois commodities portfolio was worth $324.7m, according to a fund report. In May this year the fund eliminated its commodities allocation and ended the mandates of managers Schroders and Gresham Investment Management, citing “volatility within commodity investments”.

The California State Teachers’ Retirement System, the second-biggest public plan, has approved four groups including Hermes and State Street Global Advisors to manage a new commodities strategy. The allocation is just $150m, one-tenth of 1 per cent of Calstrs’ total assets and smaller than its operating budget. After three years, the fund says it will decide whether to keep, grow or abandon its “incubation strategy”.

The Los Angeles Fire and Police Pensions approved putting 5 per cent of its $13.75bn portfolio, or $690m, into commodities in 2010. Now the fund’s board is reconsidering as it reviews fees, William Raggio, interim general manager, says. “As such, its implementation is on hold.”

In northern California, the $2bn San Joaquin County Employees Retirement Association, which pays pension benefits to 11,000 former government employees, lowered its commodities allocation from 6 per cent to 5 per cent in 2011 and cut it again to 3 per cent this year to make room for a “risk parity” allocation, says Annette St. Urbain, chief executive.

Boris Shrayer, head of commodities marketing at Morgan Stanley, says: “At the moment this asset class is not seeing the most investor demand.”

Barclays estimates $6bn has flowed out of commodity indices, the primary way pension funds invest in commodities, in 2012.

While inflows may have stalled, they have not stopped. The Indiana Public Retirement System is seeking managers to run a new 8 per cent commodities allocation, or $1.6bn. The Texas Permanent School Fund in July hired Pimco and Credit Suisse to oversee $700m in commodities. In California, the $2.8bn Kern County Employees’ Retirement Association has a 6 per cent commodities allocation.

The $237.5bn California Public Employees’ Retirement System, the biggest US public plan, has 1.4 per cent of assets in commodities, within its target allocation. Foreign peers such as PGGM in the Netherlands and the Ontario Teachers’ Pension Plan in Canada adopted commodities years earlier.

“Often [pension funds] start with something smaller,” says Jon Fraade of JPMorgan Asset Management. “As they gain more knowledge and comfort, they increase their exposure over time.”

Many pension funds include commodities in portfolios as a way to protect against the risk of rising inflation. However, their liabilities to pensioners often are not adjusted for the cost of living, eroding the real cost of payouts they make.

The temperate outlook for US inflation outlook could change as soon as Thursday when the Federal Reserve is due to decide on whether to launch further monetary easing.
We shall see what the Fed decides but when it comes to commodities, investors should steer clear of long-only indexes and focus their attention on active management. Still, even in this space there are lots of charlatans peddling all sorts of nonsense so tread carefully.

Finally, Wall Street is focusing its attention on the Fed today (Main Street is more interested in the latest iPhone). I agree with Michael Gayed, most investors are all wrong about Europe and QE. Pay attention to the euphoria in cyclicals, even Bridgwater is finding value in commodities, playing coal stocks.

Below, David Kotok, chief investment officer at Cumberland Advisors Inc., talks about political unrest in Libya, the European debt crisis and global markets. Kotok, speaking with Tom Keene and Sara Eisen on Bloomberg Television's "Surveillance," also talks about Fed policy.