Tuesday, July 30, 2013

The Hedge Fund Myth?

A few weeks ago, Bloomberg Businessweek published a piece by Sheelah Kolhatkar, The Hedge Fund Myth:
At the height of the financial crisis in 2008, a group of famous hedge fund managers was made to stand before Congress like thieves in a stockade and defend their existence to an angry public. The gilded five included George Soros, co-founder of the Quantum Fund; James Simons of Renaissance Technologies; John Paulson of Paulson & Co.; Philip Falcone of Harbinger Capital; and Kenneth Griffin of Citadel. Each man had made hundreds of millions, or billions, of dollars in the preceding years through his own form of glorified gambling, and in some cases, the investors who had poured money into their hedge funds had done OK, too. They were brought to Washington to stand up for their industry and their paychecks, and to address the question of whether their business should be more tightly regulated. They all refused to apologize for their success. They appeared untouchable.

What’s happened since then is instructive. Soros, considered by some to be one of the greatest investors in history, announced in 2011 that he was returning most of his investors’ money and converting his fund into a family office. Simons, a former mathematician and code cracker for the National Security Agency, retired from managing his funds in 2010. After several spectacular years, Paulson saw performance at his largest funds plummet, while Falcone reached a tentative settlement in May with the U.S. Securities and Exchange Commission over claims that he’d borrowed money from his fund to pay his taxes, barring him from the industry for two years. Griffin recently scaled back his ambition of turning his firm into the next Goldman Sachs (GS) after his funds struggled to recover from huge losses in 2008.

As a symbol of the state of the hedge fund industry, the humbling of these financial gods couldn’t be more apt. Hedge funds may have gotten too big for their yachts, for their market, and for their own possibilities for success. After a decade as rock stars, hedge fund managers seem to be fading just as quickly as musicians do. Each day brings disappointing headlines about the returns generated by formerly highflying funds, from Paulson, whose Advantage Plus fund is up 3.4 percent this year, after losing 19 percent in 2012 and 51 percent in 2011, to Bridgewater Associates, the largest in the world.

This reversal of fortunes comes at a time when one of the most successful traders of his time, Steven Cohen, founder of the $15 billion hedge fund firm SAC Capital Advisors, is at the center of a government investigation into insider trading. Two SAC portfolio managers, one current and one former, face criminal trials in November, and further charges from the Department of Justice and the SEC could come at any moment. The Federal Bureau of Investigation continues to probe the company, and the government is weighing criminal and civil actions against SAC and Cohen. Cohen has not been charged and denies any wrongdoing, but the industry is on high alert for the possible downfall of one of its towering figures.

Despite all the speculation and the loss of billions in investor capital, Cohen’s flagship hedge fund managed to be the most profitable in the world in 2012, making $789.5 million in the first 10 months of the year, according to Bloomberg Markets. His competitors haven’t fared as well. One thing hedge funds are supposed to do—generate “alpha,” a macho term for risk-adjusted returns that surpass the overall market because of the skill of the investor—is slipping further out of reach.

According to a report by Goldman Sachs released in May, hedge fund performance lagged the Standard & Poor’s 500-stock index by approximately 10 percentage points this year, although most fund managers still charged enormous fees in exchange for access to their brilliance. As of the end of June, hedge funds had gained just 1.4 percent for 2013 and have fallen behind the MSCI All Country World Index for five of the past seven years, according to data compiled by Bloomberg. This comes as the SEC passed a rule that will allow hedge funds to advertise to the public for the first time in 80 years, prompting a flurry of joke marketing slogans to appear on Twitter, such as “Creating alpha since, well, mostly never” (Barry Ritholtz) and “Leave The Frontrunning To Us!” (@IvanTheK).
I will let you read the entire article here but it ends off by stating the following:
As their returns have fallen, the biggest hedge funds have started to seem more like glorified mutual funds for the wealthy, and those rich folks might start to take a harder look at whether they’re getting their money’s worth. This could be an encouraging development for the world economy, considering that hedge funds provided huge demand for the toxic mortgage derivatives that helped lead to the financial collapse of 2008. At the same time, the tens of billions that pension funds have plowed into funds such as Bridgewater’s All Weather Fund—down 8 percent for the year as of late June, according to Reuters, compared with a 10.3 percent rise in the S&P 500—mean that the financial security of untold numbers of retirees could be threatened by a full-scale hedge fund meltdown.

For the moment, that possibility seems remote. The age of the multibillionaire celebrity hedge fund manager may be drawing to a close, but the funds themselves can still serve a useful purpose for prudent investors looking to manage risk. Let the industry’s recent underperformance serve as a reality check: No matter how many $100 million Picasso paintings they purchase, hedge fund moguls are not magicians. The sooner investors realize that, the better off they will be.
Similarly, Dan McCrum of the FT reports that hedge funds are gripped by a crisis of performance:
While many hedge funds fared better than the stock market during the financial crisis, and rode the 2009 recovery back to health, they have been confounded by sometimes violent market moves over subsequent years.

Since January 2010 the average equity hedge fund has produced profits for its investors, after fees, of just 14.5 per cent, according to the research group HFR.

Over the same period an investor in the S&P 500 earned, with dividends, a 55 per cent return: a total which 85 per cent of equity hedge funds have failed to match, finds HFR.

Stock trading specialists at hedge funds fared even worse than their peers managing humdrum mutual funds – 83 per cent of mutual fund managers who invest in large-cap stocks and try to beat the S&P 500 have failed to do so, according to the research group Lipper.

Among all mutual funds investing in stocks, one-third are ahead of the market, and the average investor return is 44.5 per cent from the start of 2010 to the end of June this year, Lipper finds.

The comparison may be unfair to some funds which do not aim to beat the market. Some within the industry argue that hedge funds are behaving as they should, performing better as markets plunge, but lagging behind as they steadily rise.

“We haven’t changed our advice,” said Edward O’Malley, hedge fund consultant for Cambridge Associates, “In the same way . . . we weren’t advising clients to exit hedge funds in favour of long-only funds after the crisis.”

While mutual funds are restricted to simple activities such as choosing cheap companies, hedge funds typically try to use leverage to magnify returns. They may also use hedging to mitigate losses, or sell short stocks in the anticipation of falling prices.

As pension funds embraced the use of cheap index funds over the last decade, such advantages were pitched as a way for hedge funds to improve portfolios.

Yet the poor performance of the last three years now far outweighs hedge funds’ resilience through the worst of the crisis. Over the past five years the S&P 500 with dividends has delivered average annual returns of 7 per cent, while equity hedge funds have produced just 1.7 per cent, according to HFR.
Most hedge funds are struggling but this doesn't shock industry veterans. Talk to Ron Mock, the next president and CEO of the Ontario Teachers' Pension Plan, and he'll tell you he saw this coming years ago. 

We can argue about the structural changes that explain why hedge funds are struggling in this environment but one big reason is that institutional investors have been indiscriminately plowing billions into hedge funds since the crisis erupted, expecting the best of both worlds, ie., high returns and mitigation of downside risk. 

In fact, Jason Zweig of the WSJ wrote an article, Plenty to Blame for High-Pressure Hedge-Fund Culture, where he notes the following:
...some big investors seem to buy hedge funds much the way the rest of us pick hotel rooms or buy breakfast cereal.

According to a global survey by Deutsche Bank in December, a third of big investors don't require hedge funds to have a track record before investing in them. Three-quarters of pension funds—and half of insurers and endowments—hire outside consultants to conduct due diligence on their hedge funds instead of doing it themselves. Some pension funds, I am told, even decline to review the exact holdings in their hedge funds because they don't want to be held accountable for the quality of their analyses.


What makes big investors so willing to close one or two eyes—and pay through the nose for the privilege—is the pipe dream of safety and outperformance.

Everyone wants double-digit returns in a world of paltry bond yields. Trillions of dollars are chasing the few managers who can earn high returns on a few billion dollars apiece. Clients pay on average up to 2% of assets and 20% of profits—and occasionally as much as 3% and 50%, as the government alleges at SAC.

"You should pay hedge-fund managers all that extra money so they don't lose you a lot of your capital in bad markets," says Elizabeth Hilpman, chief investment officer at Barlow Partners, which invests exclusively in hedge funds. "But many institutional investors want it all: They want the downside protection and the huge outperformance."

Big institutions are among the most desperate performance-chasers on the planet. "The consultants tell them they can get 8% [annual returns] by playing the same game that's being played by everyone else, if they just play it better," says Keith Ambachtsheer, an expert on pension strategy at KPA Advisory Services in Toronto. "But the math doesn't work."

Many hedge-fund managers, such as Seth Klarman of the Baupost Group, James Simons of Renaissance Technologies and George Soros of the Quantum Fund, have made their clients rich. But only one in 10 institutions reported earning at least 10% on hedge funds in 2012, according to the Deutsche Bank survey. But one-third expect their hedge funds to return at least 10% this year.

So far at least, that doesn't look likely. The HFRI Fund Weighted Composite, an index of hedge-fund performance, gained 3.55% in the first half of this year; it was up 6.36% for all of 2012.

Despite their recent trailing returns, most hedge funds still charge the same high fees. As the great economist Tibor Scitovsky explained decades ago, when sellers of a complex product or service are the only ones who fully understand what they are selling, buyers can't objectively distinguish quality. The result: an automatic oligopoly in which sellers compete on the appearance, not the reality, of high quality.

Perhaps we should be indicting—not criminally, but intellectually—an entire ecosystem. Yes, plenty of hedge funds are guilty of exploiting their clients with lavish fees for flaccid performance; some might even be breaking the law. But their clients are far from blameless: "Sophisticated" institutional investors still insist on believing in a Tooth Fairy that can somehow miraculously provide market-beating returns for everyone. Maybe that is the biggest crime of all.
I don't believe in the Hedge Fund Tooth Fairy and think many institutions investing in hedge funds don't have a clue of the risks they're taking. In most cases, they're getting raked on fees, expecting some sort of magical returns once markets turn south. They're in for a nasty surprise.

To be sure, there are and will always be excellent hedge funds, but picking them isn't easy and yesterday's superstars can turn out to be tomorrow's losers. This is why it's insane to chase performance without understanding why some strategies outperform in some environments and why few managers can consistently deliver stellar outperformance.

What are some of the trends which will shape the hedge fund landscape going forward? Here are a few of my thoughts:
  • The rise of alternatives powerhouses: Take a look at how Blackstone has evolved from a private equity giant to an "alternatives powerhouse," investing in PE, real estate and hedge funds. Other private equity giants are following suit but Blackstone remains the leader in alternatives and is best poised in a rising rate environment. As assets get increasingly concentrated in the hands of these alternatives powerhouses, they will play a key role in influencing industry trends.
  • More direct investments in hedge funds: While many pensions will invest in hedge funds via the Blackstones of this world, others are shunning funds of funds and investing directly into hedge funds. Sophisticated Canadian pension funds like Ontario Teachers, the Caisse, and CPPIB, have been investing directly in hedge funds for years and so do other Canadian funds. The same will happen in the United States where investors' first foray into hedge funds might be through a Blackstone but eventually they want to build internal capabilities to invest directly. Of course, there will always be legal concerns at some U.S. public pension funds which will prevent them from investing directly into hedge funds. These public pension funds will never invest directly. 
  • Lower alpha, lower fees: Hedge funds aren't dead but lower alpha will put increasing pressure on the industry to lower fees. It's already happening as many hedge fund managers realize to stay competitive and align interest with their investors, they need to lower fees. Big institutions writing big tickets are negotiating hard on fees and so they should. The last thing they want is to pay hedge fund managers "2 and 20" (2% management fee and 20% performance fee) so they can beef up their marketing group and become large, lazy asset gatherers sitting comfortably on billions.
  • Start-ups are dying: Some of the world’s biggest hedge funds, including Marshall Wace, Millennium Management, CQS and BlueCrest Capital Management, are among firms that are capitalizing on a difficult environment for start-ups, hiring potential managers who might once have considered setting up on their own. I think it will become increasingly difficult for hedge fund start-ups. Having said this, sophisticated institutions will work with top funds of funds to invest in a portfolio of start-ups. Also, large family offices and established hedge fund managers will be a source of new funds for start-ups. 
Hope you enjoyed reading this comment and if you have any thoughts, feel free to contact me directly (LKolivakis@gmail.com). Once again, institutional investors and individuals looking to support my blog can do so by subscribing or donating at the top-right side under the banner. I thank all of you who have supported my efforts.

Below, Tiger Management's Julian Robertson and Tiger Ratan's Nehal Chopra discuss the hedge fund myth on Bloomberg Television's "Lunch Money."

And Lawrence Schloss, New York City's chief investment officer and deputy comptroller for pensions, talks about the city's pension fund returns and investment strategy. He speaks with Scarlet Fu on Bloomberg Television's "Money Moves."