Thursday, August 13, 2015

Beware of Small Hedge Funds?

Mark Fahey of CNBC reports, Small hedge funds aren't as great as they say:
You've probably heard the conventional wisdom: Smaller, younger hedge funds are more nimble, and tend to bring better returns than their bulky, aging cousins.

But youth and size are not the same thing. About 85 percent of young funds—under 2 years old—manage less than $250 million in assets, but only about 14 percent of all small funds are young. That's down from 42 percent of all small funds about a decade ago.

That may sound like simple semantics, but it matters because "young" funds and "small" funds don't behave the same when it comes to returns. While young funds do, in fact, tend to outperform older funds, small funds haven't been doing as well in recent years.

Looking at Sharpe ratios, a measure of risk-adjusted return, small hedge funds have been underperforming medium-sized funds for the last six years, a stark difference from strong returns before the financial downturn, according to an analysis of thousands of reporting funds by eVestment Alternatives Research (click on image):


"Everyone thinks that small funds perform well, but we see that disappearing over time," said Peter Laurelli, vice president of research at eVestment.

What changed? Both the market environment and the strategy composition of the different categories shifted over that time, said Laurelli. Most of the early outperformance from the smaller funds came from emerging market strategies, where smaller funds were more likely to be focused on specific countries and to operate in more volatile environments. Later, small funds also outperformed in managed futures and macro strategies, he said.

"The post-financial crisis environment has seen each of these groups go through periods of difficulty, driven by their respective market environments," said Laurelli.

Investors seem to be catching on. The proportion of small hedge funds has been falling, and investors seem to be favoring medium and large funds. New funds also tend to be larger, with the percentage of young funds that are medium-sized growing from less than 8 percent before the financial crisis to about 13 percent in 2013.

As for young hedge funds, they tend to have healthy returns because by definition they have a timing advantage—funds tend to be formed at times that are advantageous for their specific strategies. For example, a crop of successful securitized credit strategy funds was founded after the recession in response to opportunities in that area, and while all types of funds saw good returns for that type of strategy at that time, those returns will raise the "young fund" category because they were created at that time.

The biggest funds are big for a reason

The 30 largest, most prominent hedge funds at the end of 2014 performed better than any group aside from the average young fund. Last year, those funds returned a little more than 6 percent—missing the young funds by just 5 basis points.


The biggest funds together manage nearly $450 billion, yet was one of the only groups—again, along with young funds—to end in the black in 2011. Even in 2008, the largest funds limited their losses to an average of 0.65 percent, despite the added difficulty of moving their much larger investments.

About 10 of those 30 largest funds use macro or managed futures strategies, that led to healthy returns around the time of the financial crisis. Eight used credit strategies, which were strong after the crisis. Others were multistrategy or distressed and special situation investing, said Laurelli. Few are pure equity products, so the losses of 2008 and 2011 harmed the largest group the least.

And of course, big funds don't usually get big by being bad at what they do.

"Prominent funds become prominent because their performance warrants growth of assets," said Laurelli. "Performance is a mix of opportunity, the ability to attract and pay the talent to exploit opportunity, and the scale needed to profitably exploit opportunities."

Return isn't everything

While some small funds have struggled to raise capital and gone bust, some have had solid returns and will continue to attract interest, said Amy Bensted, head of hedge fund products at Preqin, an alternative assets intelligence firm.

Preqin classifies funds with $100 million or less in assets as small, but the company sees similar results to eVestment, said Bensted. Preqin hasn't looked specifically at the top 30, but the firm generally finds that it's the middle range—funds with $100 million to $500 million in assets—that perform the best in returns.

But there is more to hedge fund investing than simply looking at average returns or risk-adjusted returns, she said.

"It's not just about returns and long-term gains, it's more about the types of investors who may be interested in these funds," said Bensted, "Maybe they're looking for a true hedge fund with a unique strategy, or they might have lower fees."

It's difficult to categorize funds or judge them on one metric alone. Size and age are just two of many ways to break apart the market.

"Every one is unique, and size is part of that uniqueness," said Bensted. "It's an interesting way to look at it, and a good way to frame the market."

Stephen Weiss, managing partner for Short Hills Capital Partners and a CNBC contributor, said that his "fund of funds" strongly prefers smaller funds that are one or two years old and run by managers with a "strong pedigree."

"However, it takes a lot more work to find these funds," said Weiss. "Larger funds have more assets because endowments and pensions—institutional investors—have a bogie of 5 to 8 percent return and a self-imposed mandate to not lose their jobs by recommending a non-brand name fund."

Smaller, younger managers are more driven by returns because they haven't made their fortunes yet, said Weiss. Categorical returns are averages, so if an investor can pick the right small funds, they can still pay off.
The article above delves deeply into a topic that I've covered over the years. My own thinking has evolved on the subject as I'm ever more convinced this is a brutal environment for all hedge funds and only the strongest will survive. This is why I keep warning Soros wannabes to really rethink their plan to start a hedge fund, unless of course they are his protégé, in which case the chances of success are infinitely higher.

What has changed? First and foremost, the institutionalization of hedge funds has fundamentally altered the landscape and there are reasons why the biggest hedge funds keep growing bigger:
  • The biggest hedge funds are typically trading in highly scalable, liquid strategies and are a better fit for large global pension and sovereign wealth funds that prefer allocating to a few large "brand name" hedge funds than to many small hedge funds. It's not just about reputation or career risk, it's also about allocating human resources to perform due diligence on all these smaller funds and monitor them carefully.
  • The biggest hedge funds have the resources to hire the very best investment, back office and middle office personnel. Not only do they attract top talent away from banks and smaller hedge funds but also from large, rival hedge funds. More importantly, they're able to hire top compliance and risk officers, which helps them pass the due diligence from large institutions. 
Having said this, there are pros and cons to investing with the 'biggest and the best," especially in Hedgeland where useless consultants typically recommend the hottest hedge funds to their clueless clients, even though these are the funds they should be avoiding at all cost.

What are the other problems with the biggest hedge funds? I outline a few below:
  • The big hedge funds attract billions in assets and collect 1.5% to 2% in management fee no matter how well or how poorly they perform. This incentivizes them to focus more on asset gathering and less on performance. Collecting a 2% management fee is fine when you're starting off a hedge fund; not so much when you pass the $10 billion mark in AUM (and some think even less than that).
  •  Large hedge funds are typically led by larger-than-life personalities who don't give even their biggest investors the time of day. You're never going to get to meet Ray Dalio, Ken Griffin, or many other big hedge fund hot shots when conducting your on-site visits (I was lucky to meet Ray Dalio because I was accompanied by the president of PSP at the time and insisted on it). 
  • This means you won't gain the same rapport and knowledge leverage that you can gain by investing in a smaller manager who is more open to cultivating a deeper relationship with a long term investor.
But smaller hedge funds are still courted by the top funds of funds that are more focused on performance (they have to be to charge that extra layer of fees) and are looking to grow their assets and find the next Dalio, Griffin, Soros, Tepper, etc.

If I was a large sovereign wealth fund or pension fund, I would definitely give a $500 million, $1 or even a $2 billion  mandate to one or a few well established fund of funds like Blackstone, PAAMCO, or even someone more specialized in a specific strategy or sector, to fund emerging managers (in a separate account where I am the only investor). I would negotiate hard on fees but be very fair as you want to see emerging talent succeed and thrive in order to eventually shift them into your more established external managers' portfolio. 

Still, there are risks to this strategy. Quebec's absolute return fund which was established to help emerging managers here ended up being a total flop. To be brutally frank, most hedge funds in Quebec and the rest of Canada stink and would never be able to compete with funds in New York, London or Chicago (to be fair, the hedge fund ecosystem stinks in Quebec and is marginally better in the rest of Canada. Moreover, overzealous regulators here make it virtually impossible to open a hedge fund, which is another story you don't want me to get started on).

It's also a tough environment for top established American hedge funds, which makes it even harder to succeed in these brutal Risk On/ Risk Off markets where deflation and China fears loom large. The rout in commodities has hit a lot of big players very hard, including 'God-trader' Andy Hall whose fund, Astenbeck Capital Management, lost $500M in the month of July (see below). Also, not surprisingly, China focused hedge funds have been decimated.

Please go back to read an older comment of mine on the rise and fall of hedge fund titans as well as a more recent comment on alpha, beta and beyond.  Also, go read my comment on Ron Mock's harsh hedge fund lessons to gain more insights in how to properly invest in hedge funds.

On that note, I am off to manage LTK (Leo Thomas Kolivakis) Capital Management, the smallest, least known, and best performing one-man hedge fund in the world. I've been having a ball buying the big dips on small biotechs I love and shorting the huge rips on large energy and commodity stocks I hate.

But I don't collect 2&20 on multi-billions and it takes me a lot of time and energy to write these long comments of mine and provide you with the very best insights on pensions and investments. Please remember to click on my ads and donate or contribute to my blog via PayPal at the top right-hand side. I thank all the institutions that have and hope to see more join their ranks.

Lastly, for all you emerging managers looking to gain a foothold with Canada's large pension funds that invest in hedge funds, please stop wasting my time. If you don't have a scalable strategy that delivers real alpha and pass my smell test, I'm not going to forward your material to anyone or recommend a meeting.

Also, from now on, a minimum of $1000 will be demanded if you want to talk to me, have me review your pitch book and have me introduce you to anyone (if I think you merit it). No more free call options, I simply don't have time to waste with emerging managers who think they are the next big thing in hedge funds. In most cases, they are struggling for a reason and will continue to struggle in these brutal markets for large and small hedge funds.

Below, CNBC's Kate Kelly reports on a recent letter by Andy Hall. I will be nice here but I hate these pathetic excuses from a large well-known commodity manager. I told all of you to invest with Pierre Andurand back in December when he contributed his outlook on oil. Andurand's fund is up roughly 5% this year when most commodity funds are being obliterated and he disagrees with Andy Hall on where oil prices are heading over the next two years.

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