Friday, August 23, 2013

Hedge Funds Coming Up Short?

Steven Russolillo of the Wall Street Journal reports, Hedge Funds Severely Underperforming This Year:
It’s been a great year for the stock market. It’s been a tough year for a hedge-fund manager.

A typical hedge fund has risen 4%, on average, this year through Aug. 9, according to an analysis conducted by Goldman Sachs. That performance compares to a 20% total return (including dividends) for the S&P 500 over the same time frame, meaning the market has outperformed an average hedge fund by five times this year (click on image below).

Hedge funds, on average, underperformed the markets last year as well, with an 8% gain, compared to a 16% total return for the S&P 500.

Hedge funds typically shine when markets struggle and underperform during long rallies, largely because they hedge their bets to try to generate steady performance. But the gap this year has been wider than usual. Fewer than 5% of the hedge funds that Goldman monitored have outperformed the S&P 500 this year, while about 25% of these funds have posted absolute losses.

Goldman’s analysis tracked the investments of 708 hedge funds that had $1.5 trillion of gross equity positions ($1 trillion long and about $500 billion short) as of the beginning of the third quarter. Google Inc.’s shares were the most widely held by hedge funds, followed by Apple and AIG. Citigroup and General Motors rounded out the top five, according to Goldman.  Here’s a look at the 50 stocks most loved by hedge-fund managers.

Part of the blame for the weak performance in 2013 was due to how detrimental short positions have been for hedge funds.

“While key hedge funds long positions have outpaced the S&P 500 year-to-date, short selections have hampered returns,” Goldman analysts said in a note to client. The firm pointed out the 50 stocks with the highest short interest as a percentage of market cap have soared 30%, on average, this year. Here’s a deeper dive into the 50 stocks that are most heavily shorted by hedge funds.

Goldman’s analysis meshes with WSJ’s Page One story Wednesday that detailed how short sellers are facing their worst losses in at least a decade. In the Russell 3000 index, the 100 most heavily shorted stocks are up by an average of 33.8% through Aug. 16, versus 18.3% for all stocks in the index, according to a Journal analysis of data provided by S&P Capital IQ.

The gap between the performance of the most-shorted shares and the market as a whole is wider than it has been in at least a decade.

Goldman found that these hedge funds operate 51% net long, representing a slight decline from record high levels of 53% last quarter. “Risk appetite remained roughly flat despite the S&P 500 rising to new all-time highs,” the firm said.

Turnover in these funds remained low, at about 30%. Popular positions included holding large net-short positions in emerging-market stocks, volatility, gold and high-yield bond ETFs.

“Hedge funds generally use ETFs more as a hedging tool than directional investment vehicles, but these positions reflect large changes versus the prior quarter,” Goldman says.

The upshot, however, is hedge funds continue to struggle as stocks hover around record highs.
Similarly, Tommy Wilkes of Reuters reports, Equity hedge funds come up short in 2013:
Less than 5 percent of hedge funds betting on share prices have outperformed the S&P 500 this year after rallying stock markets hit managers holding short positions, a report by Goldman Sachs shows.

Hedge funds generated an average return of 4 per cent from the start of the year to Aug. 9, against a 20 percent rise in the U.S. benchmark index, with one in four having lost money over the period.

The Goldman Sachs report, which analyzed the positions of 708 hedge funds with $1.5 trillion of gross assets, said that short positions - a bet on the price of shares falling - had weighed on managers.

The 50 stocks that attracted the highest amount of short-selling have risen by an average of 30 percent this year, leaving managers with losses, the report found.

A rebound in developed market economies and the more stable macroeconomic environment have encouraged investors to buy equities this year. The S&P 500 has hit record highs several times in recent months, aided by strong company earnings.

Hedge funds have fared better on the long side. Stocks among hedge funds' top 10 holdings - in the expectation of rising share prices - outperformed the S&P by nearly 12 percent this year.

Shares that most frequently appear among the largest hedge fund holdings include AIG, Google, Apple , General Motors and Citigroup.
The message is clear, equity hedge funds are struggling and they're better at picking stocks in their long book than shorting stocks (no wonder hedge fund clone ETFs are whooping the index and hedge funds). One hedge fund manager told me that shorting stocks is increasingly more difficult and harder to do in the size required by large hedge funds. He fears the next crisis will be worse than 2008 and equity hedge funds will get "smoked."

I'm not sure if shorting stocks is harder but there are plenty of opportunities in this market to make money on the short and long end. For example, the recent backup in yields hit dividend stocks hard and obliterated mortgage REITs.

The backup in yields is also hitting credit hedge funds but some are still managing to outperform:
As bond yields spike all across the developed markets and stock markets plummet in most countries, credit focused hedge funds are up for a tough time ahead. This comes after a very rosy year for funds who invest in debt of corporates and sovereigns, when several of them managed to beat the market in 2012. Benchmark credit indices have done poorly, iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG) was down 3.6% till the end of July, Credit Suisse Leveraged Bond Index was up 2.8% and Barclays US Corp. HY Index has gained only 1.4% through the first half of the year. This year has so far proved to be far less profitable for these funds, however there are a few who have gained a decent sum through the year.

Tough year after a profitable 2012

One of the best performing hedge funds of the year has been David Tepper’s Palomino Fund which applies a long/short credit strategy, the fund has gained 23% in the seven months ending on July 31, after a brilliant +5% gain in last month. Palomino was down in June when credit markets shook, so if more difficult months are ahead, the returns may not remain as healthy anymore.

Josh Brinbaum’s Tilden Park Offshore Fund, which principally invests in MBS instruments, has netted a 14% gain in the same period, after a +0.78% return in July. However the moderate return does not compare at all with the whopping +41% that the fund returned in last year.

Mitchel Julis and Joshu Firedman $2.3 billion Canyon Balanced Fund has gained 12.3% thorugh July after a +20.5% return in last year. Canyon Value Realization Fund which manages $5.7 billion is up 9.6% in this year.

Edward Mule’s Silver Point Capital Offshore is up 11.6% in the $5.1 billion fund. John Paulson is up 12.5% through July in Paulson Credit Opportunities Fund.

Smaller funds like, Brazil based BTG Pactual’s Distressed Mortagage Fund is up 11% for the year, in stark contrast to the +46% gain it posted in 2012. Chenavari Toro Capital IA has netted a 15.4% gain through the first half of the year, and at this rate seems on track to come head to head with the 32% return the fund posted in 2012.
Clearly there have been some stellar outperformers in credit hedge funds but the road ahead will be much tougher. Nevertheless, credit hedge funds resumed their upward path in July while macro & futures dragged down overall performance of hedge funds:
Hedge funds rose an average of 1.2% in July and have returned an average of 4.5% through the first seven months of 2013. On an annualized basis the industry is on pace to return 7.8% in 2013, or 12.1% with Macro and Managed Futures strategies removed.

Funds most willing to embrace the current equity market euphoria have been among the industry’s best performers. On a sector by sector basis, technology, healthcare and micro cap funds were best situated in July for another month of new records from equity indices.

Hedge fund returns in July, and for much of 2013, were again weighed down by poor aggregate performance from Macro and Managed Futures strategies. Whether losses are mainly due to the recent three month surge in treasury yields, falling AUD or the surge in oil, the group is simply not getting the trend or momentum right.

The last three month cumulative return for Macro strategies has been their worst stretch since the three months ending October 2008. For Managed Futures funds you have to look back to June 2004 to find a worse three month period, however they have come close to matching the magnitude of the current drawdown several times in just the last year.

Credit strategies resumed their path upward in July with securitized credit funds again leading the way. Those focused on mortgage markets have faired relatively well during the recent treasury induced MBS market declines, returning an average of 0.4% while the Barclays US MBS Index has fallen 2.6%.

Investor flows for credit strategies have remained strong despite the recent bond market turbulence, with a preference away from purely directional exposures. It is the aforementioned relative performance which has likely been a key reason for this strength as institutional investors seek alternative exposures to their substantial traditional long-only bond fund allocations.

Emerging market hedge fund returns rebounded in July, with the exception of Brazil. Brazil focused funds have shown mixed results in an otherwise positive market environment in July and trail only India as the worst exposure for hedge funds in 2013. Funds investing in the Middle East & Africa have been one of the best performing universes by region and relative to the overall industry in both 2013 and 2012.

Commodities trail only exposures to India and Brazil in terms of loss generation in 2013 after yet another negative month in July, the universe’s sixth consecutive negative month during which they have posted an aggregate decline of 5.5%.
As rates rise, there could be a significant shift in the performance of all these hedge fund strategies. But there is no doubt that macro & futures funds are struggling. When you see traders departing Brevan Howard because of poor performance and Bridgewater patching up its All Weather Fund's risk, you know it's a tough environment for macro funds.

Still, as Sam Jones of the FT reported in early August, macro and other hedge funds that bet heavily on a US recovery are reaping huge rewards:
John Paulson, the widely followed US hedge fund manager, may have been spectacularly wrong on the gold market this year, but he has been right with his other big wager.

Betting on a US recovery – as Mr Paulson’s aptly named Recovery Fund does – has been one of the most profitable trades around. And not just for Mr Paulson.

For many hedge funds, US equities are back in vogue as one of the most opportunity-rich markets worldwide, with the promise of big returns as corporate profitability rises and companies geared to the underlying state of the American economy re-rate.

As if to underscore the point, the S&P 500 passed the 1,700 mark on Thursday to reach an all-time high.

Indeed, among main markets, US equities are second only to Japanese equities, whose valuation has soared on the back of prime minister Shinzo Abe’s radical expansionist monetary agenda, when it comes to performance for 2013.

The case for US equities is “very compelling”, says Troy Gayeski, senior portfolio manager at the hedge fund investor SkyBridge Capital. “The US market is performing much better than Europe and most emerging market countries. The bottom line is that among developed market economies, the fundamentals in the US are the best.

“The yield on US Treasuries will probably never go back to 1.3 [per cent] whatever happens, but equities have every chance of going higher.”

Mr Paulson’s Recovery Fund, which according to an investor is up 35 per cent this year, has had some spectacularly good bets. Among its two largest holdings are mortgage insurers MGIC and Radian.

As Mr Paulson explained to investors in the first quarter, both offered an attractive opportunity to play the resurgence of the US housing market in a purer form than through bank stocks. Radian’s shares have soared 137 per cent this year and MGIC’s are up nearly 200 per cent.

If the US recovery started with the rebound of the housing market, it is also filtering through into the broader economy.

Lansdowne Partners, one of the world’s biggest equity hedge funds, has seen significant gains from its holdings in US blue-chips, which it has intensified in recent months. Investments in US-consumer focused businesses such as Amazon, Google, Bank of America, Comcast and Delta Air Lines have made between 22 and 85 per cent this year.

Other equity hedge fund winners include Larry Robbins Glenview Capital, up nearly 30 per cent at the end of May after bets on US healthcare stocks, and Ricky Sandler’s Eminence Capital, up 24 per cent as of the end of June.

The latest numbers on the US economy have only served to underscore the bull equity investing thesis.

On Thursday, figures from the Institute for Supply Management showed the fastest rise in US factory activity in two years. The ISM’s widely followed index rose from 50.9 in June to 55.4 in July, with any number above 50 indicating growth.

Meanwhile, the US unemployment rate on Friday dropped from 7.6 per cent to 7.4 per cent.

If the fundamentals are strong, then so too are the headwinds from global asset flows – a factor some investors consider to be even more important to the future of US equity markets.

For Caxton Associates, one of the world’s most prominent global macro hedge funds – which use a range of instruments to speculate on broad shifts in the world economy – US equities have been the most profitable bet this year.

Many global macro funds see potentially large sums moving into developed market equities as bonds come to be seen as increasingly less attractive and emerging market growth slows markedly.

Ever since Federal Reserve chairman Ben Bernanke’s comments to the US Congress on May 22 that the central bank may taper its quantitative easing programme, investors worldwide have been on notice that the era of ultra-low bond yields may be coming to an end, macro traders note.

There is “a wall of money” heading for traditional risk assets and US equities, in particular, says one top macro trader. On Friday, Singapore’s $100bn sovereign wealth fund GIC told the FT that it was turning its focus to US stocks.

All of which, however, is not to say that any US stock is a good stock.

“Yes, 90 per cent of the S&P is up, year to date,” says Anthony Lawler, portfolio manager at GAM, “but there is also real dispersion [a measure of divergence in performance among stocks] going on.”

“Cross asset correlations have dropped dramatically,” says Mr Lawler, and sectors have performed markedly differently. The CBOE implied correlation index on the S&P 500, for example, has declined from 60 in January to 47 – close to its lowest level in five years.

“Healthcare, consumer and financials have all done well, but commodity and tech stocks have all underperformed.”

For hedge fund managers, the real test of their abilities will come not from performing in line with a soaraway US equity market, but doing better than it – and indeed, being mindful of a correction.
True, the real test for hedge funds will come when the next big downturn hits financial markets. And while the hedge fund myth has been exposed, prompting some big funds to dodge Wall Street and family offices to increase their scrutiny, I would caution investors not to throw the hedge fund baby out with the bathwater.

Importantly, there will always be excellent hedge funds delivering performance worth paying for. As you read above, yesterday's losers can recover nicely just like past winners can falter. In this environment, you need to beef up your due diligence, monitor your hedge funds very closely and understand how a significant change in the macro environment will impact each strategy and who is best positioned for such a shift.

Below, Bloomberg’s Nathaniel Baker discusses the changing face of hedge funds with Deirdre Bolton on Bloomberg Television’s “Money Moves.” And Mark Dowding, co-head of investment grade at Bluebay Asset Management, discusses the bond markets with his outlook for Treasury yields and what it means to tapering form the Federal Reserve. He speaks on Bloomberg Television's "Countdown."