Wednesday, January 23, 2013

Hedge Funds Chopping Fees in Half?

Sam Jones of the FT reports, New hedge fund bucks trend with fees cut:
One of the UK’s fastest-growing hedge funds is slashing its fees, in a move that it hopes will spark a rethink of the industry’s notoriously high charges.

The new Core Macro fund being set up by Cambridge-based Cantab Capital will employ similar trading strategies as funds from Man Group, Winton Capital and BlueCrest, three of the world’s biggest hedge funds that manage $100bn between them, but at half the cost to investors.

While the industry standard is an eye-watering “two and 20”, or 2 per cent of all capital invested annually and 20 per cent of all profits, Cantab’s new fund levies only 0.5 per cent and 10 per cent.

Fees are set to become one of the hedge fund industry’s biggest areas of change as large institutional investors try to use their clout to force discounts in a tough trading environment that has dented hedge funds’ once-high returns.

“We are seeing a substantial increase in institutional allocators investing directly in hedge funds and they are typically the most fee-sensitive,” said Daniel Caplan, European head of global prime finance at Deutsche Bank. “A key focus is not paying for returns that are purely correlated to market moves – investors can access that more cost-effectively elsewhere.”

Many hedge funds continue staunchly to resist lowering charges, argue that lower fees equate to lower quality. Man Group, Winton Capital and BlueCrest declined to comment.

Cantab’s new fund, and those from the other three, belong to a class of quantitative funds called trend followers, which use computer algorithms to spot and trade on trends across different markets, and collectively manage around $330bn in assets, according to BarclayHedge.

Ewan Kirk, Cantab’s founder, believes investors are being overcharged by many big quant funds. The trading strategies they provide can be delivered for lower costs, he said: “This is potentially a game changer,” the ex-astrophysicist told the Financial Times. “It’s like when Vanguard came out with the first index trackers.”

Established large trend following funds point out that they invest considerably in constantly refining and tweaking their models to stay ahead of new competitors and ensure investors get what they pay for.

Cantab’s new fund has capacity to manage up to $25bn based on its current trading models, Mr Kirk said. Cantab manages an existing $4.5bn quant fund, which it will continue to charge standard fees for. It capped its size last year because it believes increasing its assets will stymie performance.

Mr Kirk believes investors are being overcharged by many big quant funds. The trading strategies they provide can be delivered for far lower costs, he says.

The biggest quant funds have reduced their ability to deliver big returns as they have swelled dramatically in size in recent years, he adds, but they have not reduced their fees.

Cantab’s new fund’s easy scalability makes it a significant threat to rivals and although Cantab has yet to begin marketing the fund, details of its low charges have already led to disquiet.

The fund made 15.3 per cent last year compared with an average loss of 2.6 per cent for other trend followers, according to Hedge Fund Research. The average hedge fund made 6.2 per cent.
Is Ewan Kirk, Cantab's founder, right about investors being overcharged by big quant funds? You bet he is and I think he's setting a precedent here for other large quant funds and most other hedge funds.

Importantly, in a world of deflation, deleveraging, low single-digit returns, it's increasingly harder for large investors to justify paying hedge funds --  most of whom are underperforming the broader market and don't hedge downside risk properly -- 2% management fee and 20% performance fee.

And quant funds which manage hundreds of billions have struggled lately. Bloomberg reports that hedge funds using computers to follow trends lost money for a second straight year in 2012 as political debates over the U.S. fiscal cliff and Europe’s sovereign-debt crisis roiled markets:
The Newedge CTA Trend Sub-Index, which tracks the performance of the largest computer-driven, or quant funds, fell 3.4 percent last year after a 7.9 percent decline in 2011. David Harding’s $10 billion Winton Futures Fund Ltd. slid 3.5 percent in 2012, its second annual decline since opening in 1997, investors in the pool said. Man Group Plc (EMG)’s $17 billion AHL Diversified fund fell 2.1 percent, while BlueCrest Capital Management’s $14 billion trend-following fund gained 0.02 percent, said the investors, who asked not to be identified because the figures are private.

The performance of the funds belies their popularity with investors, who’ve poured $108.2 billion into the pools since the end of 2008, according to Fairfield, Iowa-based BarclayHedge Ltd. While quants made money during the financial crisis when other hedge funds didn’t, they’ve since stumbled as market sentiment swung from optimism to pessimism following political announcements in Washington and Brussels, breaking up the trends they try to follow. That may force investors to withdraw money.

“In 2008, we had very nice returns, and it was a pleasure being invested,” said Gabriel Garcin, a portfolio manager at Europanel Research and Alternative Asset Management in Paris. “Since then, it’s been a complete disaster” for trend- following hedge funds, he said.
Having invested with Winton Capital and a few of  the world's best CTAs in the past, I can tell you that none of this shocks me. These trend followers typically don't do well in macro news driven environments where markets  turn on a dime following every major political announcement. Excessive volatility will kill their returns.

CTAs provided good diversification in 2008, hedging against tail risk, but have since struggled. I believe that as markets slowly return to normal and correlations fall back to historic norms, these quant funds will come back strong. In other words, don't look at recent paltry performance to extrapolate their future performance (you'll regret it).

Having said this, because they invest in liquid instruments (futures) and are highly scalable, garnering a huge portion of hedge fund assets, they can easily cut the fees in half and still make a killing. I could say the same thing about large global macro funds like Bridgewater and Brevan Howard. Why pay them "2 & 20" for managing hundreds of billions?

The truth is that large investors use their size and clout to negotiate fees down as much as possible. But in an ideal world, past a certain threshold of assets under management, all large hedge funds should be doing what Cantab is doing, cutting fees in half or just charging a performance fee, foregoing the management fee. This would align their interests better with investors, making sure they don't become large asset gatherers who lose their focus on performance.

And the article is right, more and more investors are shunning funds of funds which add an extra layer of fees, investing directly into hedge funds. Facing extinction, something I predicted here back in 2008,  funds of funds are reinventing themselves and now eying retail to halt the meltdown.

But smart funds of funds are still valuable to institutions looking to invest in hedge funds and they're increasingly seeding new alpha talent. Kris Devasabai of Hedge Funds Review reports, Ex-Citadel managing director's structured credit hedge fund secures seed deal:
Continuum Investment Management expects to launch its maiden hedge fund on February 1 with close to $100 million in assets, including $85 million in seed capital from fund of hedge funds manager Grosvenor Capital Management.
The fund will take a multi-strategy approach to investing in structured credit markets, focusing on pre-payment and credit-centric trades in residential and commercial mortgage-backed securities (RMBS and CMBS) and other asset-backed securities.

Continuum is led by Kevin Scherer, a former managing director and senior portfolio manager at Citadel. From 2008 to 2011, Scherer managed Citadel's Single Investor Fund, which primarily invested in agency and non-agency RMBS. Prior to Citadel, Scherer spent 8 years at Midway Group, a mortgage-focused hedge fund he co-founded in 2000.

Continuum's management team includes three of Scherer's former colleagues at Citadel: senior portfolio manager Brian McDonald, chief technology officer Jimmy Rizos and head of research and development Stephen Cameron. Chief operating officer Greg Scarffe joins from Credit Suisse, where he was a prime brokerage executive.

Funds investing in structured credit assets returned 16.72% on average in 2012, making them by far the best performing sector of the hedge fund industry, according to data from Hedge Fund Research. Structured credit strategies are widely tipped to outperform again in 2013, though some investors have expressed concerns that certain traded may be overcrowded.

Scherer says he is "very constructive" on structured credit markets. "There was a tremendous beta trade [in 2012], but now you have to proactively manage your risk and be able to do deep fundamental analysis, understand the collateral and structure of these bonds and have a lot of trading acumen to realise attractive returns," he says.

He says Continuum's portfolio will be tilted towards pre-payment themes in agency RMBs in the short-term.

Continuum is looking to raise $250 million to $500 million for the fund in the next three to six months, according to Scherer.
Scherer knows what he's talking about, the big beta trade for structured credit funds in 2012 is over, and as investors pile into this space hunting for yield, many are going to get killed investing in fund managers that don't proactively manage risk.

In related news, Svea Herbst-Bayliss of Reuters reports that hedge fund managers at conference forecast stock gains:
After years of favoring fixed income, investors are ready to put their money back into equities and they might be rewarded with strong returns, especially in U.S. stocks, hedge fund managers and investors said at a conference on Tuesday.

"We have seen outflows from government bonds and the next big migration is going to be into equities," said Tim Garry, a portfolio manager at $3.7 billion Passport Capital.

This shift, the first since the 2008 financial crisis, could come as welcome news for thousands of hedge fund managers who specialize in stocks.

Debating exactly where strong returns might come from after a largely lackluster year for hedge funds was the key topic at the GAIM USA 2013 conference in Florida.

"There has been lots of money flowing into credit strategies, but I also think there are more returns to be made in equities," said Patrick Wolff, whose $120 million Grandmaster Capital Management gained 22 percent last year.

Wolff has a particular taste for U.S. stocks, noting the shares he expects to do best are from companies in regions that will not suffer big economic traumas.

"I'm a big proponent of Fortress America," he said, noting that conditions now appear ripe for stronger growth in the United States.

Even as many managers still believe that growth will come from countries such as China, Wolff declares himself a China bear who is worried the bubble of fast growth is ready to burst.

"I like to own businesses that are not exposed to this big risk factor," he said.

Hedge fund managers paid as much as $4,000 to attend one of the year's first industry conferences and mingle with investors on the manicured lawns at the Boca Raton Resort & Club at a time when pension funds, endowments and wealthy investors are eager to put new money to work.

But as a group, the industry has a lot to prove and explain after returning only 6 percent last year, far less than the Standard & Poor's 500 index' 13 percent.

The GAIM conference is the first of a handful of industry get-togethers this month that includes next week's Morgan Stanley Breakers conference, where some of the industry biggest stars converge in Palm Beach, Florida.

Steven Cohen, whose $14 billion SAC Capital Advisors is currently embroiled in the government's insider trading investigation, will be one of the big names flying to Florida. He is offering investors a chance to dine or golf with him, a person familiar with the conference said.

Cohen has been a sporadic guest at the Breakers conference in the last years and will appear this year only weeks before his investors have to decide whether to stay put or pull money out of his fund.

A spokesman for SAC declined to comment.

At the GAIM conference managers ticked off their ideas with some being thousands of miles away. Marko Dimitrijevic, who founded $1.7 billion Everest Capital, likes homebuilders in India.

Mark Yusko, who invests $7 billion with hedge funds as chief investment officer at Morgan Creek Capital likes a manager "who is kicking the crap out of everyone else by owning precious metals."

And Kyle Bass, who runs $1.1 billion Hayman Capital Management again expressed his concerns about Japan.

Besides wanting to hear where the big money can be made, managers and investors also debated who would be able to deliver those returns now after small investors roundly trounced their bigger rivals last year.

Conventional wisdom has long held that smaller managers with less than $1 billion in assets beat out the bigger funds and that may well suit the managers here, who tend to be on the smaller side with less than $5 billion in assets.

But many investors were still not ready to make that leap.

"You will see over time that smaller funds will outperform, but the larger ones add more downside protection," said Henry Davis, managing director at Arden Asset Management, which invests $7 billion for pension funds and other clients with some of the world's biggest and most prominent hedge fund managers.

Because of their size the bigger funds can often have better risk controls, he noted.

Many investors held private meetings with managers, but in the end, the biggest names were not in Florida, but at their offices in New York, Stamford and London.

"People who deliver on their promises are making good inroads," Morgan Creek's Yusko said, adding however that "the trend of going with the big names still isn't over."
Most of these hedge fund conferences are useless and a total waste of time. The best institutional investors (and top hedge fund managers) shun the big conferences and couldn't care less about playing golf with the perfect hedge fund predator or being charmed by some Tatiana from MCM Capital Management.

But I agree with managers that are bullish on America and bullish on stocks. As I wrote yesterday, this bull market gets no respect, and many fund managers and retail investors skeptical and sitting on the sidelines will cave and jump in at much higher levels. The best hedge fund managers know this and are positioned accordingly.

Below, an excellent CNBC discussion on why investors should be bullish, with Brian Belski, BMO Capital Markets; Rich Bernstein, Richard Bernstein Advisors CEO; and CNBC's Courtney Reagan. I like Bernstein and think he's right on the money on US small and mid cap industrials, and unlike most, shunning emerging markets as inflation becomes a serious concern in many of these countries. Keep an eye on inflation expectations, this is the key going forward.