Wednesday, October 21, 2015

A Brutal Year For Top Hedge Funds?

Jeff Cox of CNBC reports, Hedge funds see worst year since financial crisis:
Hedge fund performance over the past three months hearkened back to the bad old days of the financial crisis.

Poor performance weighed heavily on the industry, causing the biggest net loss in capital since the fourth quarter of 2008, according to data released Tuesday by HFR. The $95 billion decline pushed total industry assets further from the vaunted $3 trillion mark.

As measured by the HFRI Fund Weighted Composite Index, the industry saw a 3.9 percent performance drop in the third quarter, taking the barometer into negative territory for the year at minus 1.5 percent. At this pace, hedge funds will turn in their worst performance year since 2011.

The bright side is that the industry actually outperformed the equity market through the end of the quarter, as the S&P 500 fell more than 6 percent through the first nine months. The S&P has since rebounded, jumping 5.6 percent in October to pull within 1.5 percent of breakeven for the year.

Kenneth J. Heinz, HFR's president, said funds have followed suit and should be able to reverse the earlier money drain.

"Recent market turmoil has resulted in increased risk aversion by investors but has also created opportunities for innovative approaches in key tactical and strategic areas," Heinz said in a statement. "Funds of all sizes have already experienced a powerful performance recovery through mid-October, which is likely to drive industry capital gains into year end."

Investors actually have been putting money to work in hedge funds this year.

Total inflows came to $47.9 billion in the third quarter, offsetting $42.3 billion in redemptions for $5.6 billion in net flows, according to HFR. Event-driven strategies have performed poorly, losing 5.1 percent in the quarter and 2.85 percent for the year, yet saw inflows of $5.4 billion.

Equity strategies have received the most cash, pulling in $23.8 billion for the year and $2.4 billion for the quarter despite losing 2.3 percent through the first nine months.

The best performing industry strategy has been volatility, which was up 5.5 percent, while Latin America (down 20.2 percent) and energy (off 12.4 percent) represented the biggest losses.
It's going to be another terrible year for hedge funds. They took a beating in Q3 and many of the industry's premiere funds aren't going to recover.

How bad is it for some top hedge funds? Jennifer Ablan of Reuters reports, Bridgewater's $70 bln 'All Weather Fund' down 6 pct in 2015 - sources:
The $70 billion Bridgewater All Weather Fund, managed by hedge fund titan Ray Dalio, was down 1.9 percent in September and is down 6 percent through the first nine months of the year, three people familiar with the fund's performance said on Tuesday.

The All Weather Fund is one of two big portfolios managed by Bridgewater Associates and uses a so-called "risk parity" strategy that is supposed to make money for investors if bonds or stocks sell off, though not simultaneously.

Bridgewater is the latest in a series of alternative asset managers that have struggled to outperform rocky markets this year, dashing their investors' hopes that their strategies would provide a safe haven. Hedge fund managers including Armored Wolf and Fortress Investment Group Inc, have shuttered some macro funds as they have consistently underperformed their benchmarks.

Some other hedge funds who have struggled with poor performance in recent months, including Leon Cooperman's and Steven Einhorn's Omega Advisors, have even accused "risk parity" strategies of contributing to wider market volatility and forced selling that drove stocks down 10 percent in five sessions near the end of August.

Dalio strenuously denied that contention in a 17-page research note released last month.

So far in October, the All Weather portfolio is up 3.7 percent as of Friday, Oct. 16, an improvement, but still short of the S&P 500, which has rallied 5.8 percent over the same period. Bridgewater, the world's largest hedge fund, manages approximately $154 billion in assets and the All Weather Fund is one of its two big portfolios.

The Pure Alpha II Fund, which was down 6.9 percent in August, posted a loss of 0.10 percent last month for a year-to-date total return of 3.9 percent through September, the sources said. Pure Alpha, including Pure Alpha Major Markets, has $81 billion in assets under management.

Pure Alpha is a traditional hedge fund strategy that actively bets on the direction of various types of securities, including stocks, bonds, commodities and currencies, by predicting macroeconomic trends.

Equity markets worldwide stumbled in August and September, driven lower by concerns about China's growth and worries the U.S. Federal Reserve will soon raise interest rates. The moves, coupled with weakness in commodities and bonds, wreaked havoc on hedge funds that use risk-parity strategies.

Omega's funds fell between 9 percent and 11 percent in August.
Dalio is worried about the next downturn but maybe he should worry more about his funds' lackluster performance. Almost two years ago, I wrote a comment on whether the world's biggest hedge fund was in deep trouble where I noted the following:
So is everything peachy at Bridgewater? Are there legitimate reasons to be concerned about performance going forward? As I've already stated when I saw Texas Teachers losing its Bridgewater mind, there are plenty of things that raised yellow flags in my mind about where Bridgewater is heading and how big it can grow while maintaining its focus on performance.

When I invested in Bridgewater over 13 years ago, it was just starting to garner serious institutional attention. Now, the whole world knows about Ray Dalio, Bob Prince and Bridgewater's approach. When I hear investors telling me investing in Bridgewater is a "no-brainer," I get very nervous and start thinking that the firm's success has become its worst enemy.

Let me be clear, I've met Ray Dalio, Bob Prince and many others from Bridgewater. There is no doubt they run a first-rate shop, striking the right balance, and deserve their place among the world's biggest and best hedge funds. But in this industry success is a double-edged sword and I don't like seeing hedge fund managers plastered all over news articles and engaging in silly deals.
Success in the ultra competitive hedge fund industry is most definitely a double-edged sword. Just ask Bill Ackman of Pershing Square who has given his critics something else to gripe about:
Billionaire activist-investor Bill Ackman has no shortage of critics, and it's not hard to see why.

When he goes after a new target, Ackman can be vicious, with over-the-top presentations and personal attacks. With his most famous short position — Herbalife — he has promised investors a smoking gun more than once, only to come up short.

A guy like that ought to, then, be wary of giving his enemies ammunition.

The latest attack on the Pershing Square manager is self-inflicted and the product of poor disclosure. Some people are making it out to be an effort to mask Ackman's performance in September.

Here's the issue. Last week, Pershing Square Holdings, the publicly traded part of Ackman's hedge fund, made a change to the way it reports its numbers.

Pershing Square used to report weekly returns and net asset values, meaning the value of an entity's assets minus its liabilities, based on calculations as of close of business every Tuesday. You can see historical reports here.

Last week, however, those numbers came in based on close of business on Wednesday, September 30, instead of Tuesday, September 29. They showed a 12.6% year-to-date loss. Then, on October 2, Pershing Square Holdings released a statement officially announcing the changes to its NAV reporting policies.

One of those changes, according to the statement, was that the company would only report results once on a week that included the end of the month — rather than on the Tuesday and again on the last day of the month.

The reason for that tweak, according to the release, is to prevent investors from using the periodic reporting to front-run, or determine portfolio changes in advance of official disclosures.

The statement also noted that weekly and monthly reporting would now be provided on a one-business-day lag instead of two business days.
Valeant losses

Pershing didn't give a reason for waiting to make the announcement until after it had made the changes to its reporting.

But the criticism that has emerged is that the change seems awfully convenient. It saved Pershing from reporting a loss September 29 that was even bigger than the 12.6% loss it reported the next day.

By Australia-based fund manager John Hempton's calculation, Pershing's year-to-date return September 29 would've been closer to -16.6%. Hempton owns shares of Herbalife, the company Ackman has called a pyramid scheme and against which the New York-based manager has a massive short position.
Another blogger and prolific Herbalife bull made similar calculations about Pershing's returns here.

The dramatic difference over a single day is that Pershing's stake in drugmaker Valeant plummeted in September, especially Monday and Tuesday, but rebounded around 12% Wednesday.

Hempton suggests that Pershing Square made the change to mask the month-end changes to its performance, saying that such a move "opens Bill Ackman up for allegations of deception — allegations that Bill should neutralize immediately by reporting the interim data point as originally planned."

Another way to look at this is that the worst thing that Pershing Square did was fumble the way it explained the changes. It wasn't until after it had already reported September's numbers that the fund explained what it was doing.

This is an error for sure — the fund is publicly traded and that means changes ought to be outlined before they are rolled out. But it's only a problem if Pershing Square repeats this kind of thing over and over.

There are other reasons not to read too much into the change: Pershing Square's portfolio consists of publicly traded companies, so its day-to-day performance can mostly be tracked. This is how we can guess that it recovered a chunk of losses on the last day of the month.

And nobody's claiming that the numbers Pershing Square reported September 30 are inaccurate.
It looks like Pershing Square is pulling a Saba Capital on its investors, getting creative on reporting its performance and potentially opening itself up to lawsuits. Of course, none of this shocks me as I warned my readers last August to avoid the hottest hedge funds.

The problem is nobody listens to me. They prefer paying big bucks to their useless investment consultants who shove them in the same brand name funds and that's why they're going to get killed picking hedge funds in this deflationary environment.

Listen to me carefully, stop trying to be a pension fund hero picking the best hedge funds, you're going to get your head handed to you. I'm not being a cynical jerk here, I'm telling you the brutal truth as I don't want to see public pension funds being eaten alive by hedge fund fees.

Of course, nobody's going to listen to me, especially not U.S. public pension funds chasing their rate-of-return fantasy. They don't realize it yet but this latest shakeout in the hedge fund industry is just getting underway and it will be brutal, perhaps even more brutal than the one following the great recession.

This isn't the time to fall back in love with your superstar hedge fund managers. This is the time to grill them very hard, no matter how well they're performing. I don't care if it's Ray Dalio, Bill Ackman, David Einhorn, Carl Icahn, or even Ken Griffin, you'd better be asking some really tough questions to all your hedge funds no matter how rich and famous their managers are.

For example, there are a lot of top hedge funds getting killed on their positions in Valeant Pharmaceuticals (VRX). At this writing, shares of Valeant are down 40% on huge volume after short seller Citron Research published a report alleging that the company has engaged in a series of sham transactions to inflate its drug sales (click on image):

Over the last two months, shares of Valeant are getting crushed, down 66% from their early August highs (click on image):


This is bad news for Pershing Square and many other top hedge funds that hold big positions in this company (click on image):


But notice how ValueAct cut its holdings in Q2, which would have immediately raised my antennas and I would have been asking some very tough questions to them and other hedge funds regarding this company, especially a hedge fund like Pershing Square which has a very concentrated $12 billion equity portfolio made up of just seven stocks with Valeant being its top holding (click on image):


There's something else that bothers me. I trade biotechs and I loaded up on some of them during the last selloff. I follow top funds to gain some insights but this sector is extremely volatile and there's a lot of hype here, just like in the subprime unicorn boom in tech.

All this to say, where's the risk management here? I hope these elite hedge funds used derivatives to actually hedge some of the losses in the huge positions they're taking in single names like Valeant or SunEdison (SUNE). These overpaid hedge fund gurus are managing billions from institutions and I'm shocked at how poorly they're doing in actually hedging their big positions.

Anyways, as I stated above, the latest shakeout in the hedge fund industry is just getting underway and it will be brutal. In fact, Madison Marriage of the Finacial Times reports, Hedge fund performance fees decline sharply:
The income hedge funds receive from performance fees has fallen drastically this year, dropping more in the first half of 2015 than in the previous seven years combined.

The fear is the drop in performance fees, coupled with weak returns across the hedge fund industry, could force both new and established funds into closure.

According to Eurekahedge, the data provider, new hedge funds are charging average performance fees of 14.7 per cent, a sharp drop on the 17.1 per cent typically charged in 2014.

Several high-profile hedge funds, including Fortress’s $2bn macro fund and Renaissance Technology’s $1bn computer-driven fund, have already been wound down this year after delivering poor returns to investors.

Jean Keller, chief executive of Argos, the Swiss hedge fund company, said: “The firms that cannot generate returns and demonstrate true investment talent will disappear. The fact that, overall, the industry has not delivered this year and more generally since 2008 will be an enormous challenge.”

Preqin, the data provider, last week predicted this would be the worst year for performance across the hedge fund industry since 2011 as managers struggle to respond to uncertainty over Chinese monetary policy and US interest rate rises.
Mohammad Hassan, senior analyst at Eurekahedge, said: “With increasing competition in the industry, regulatory costs and the current market uncertainty, lower fees could lead to an early demise for otherwise good hedge fund investment models.

“If things deteriorate then you could see closures spike over the next year. Smaller funds will be more at risk, given their business model places a larger reliance on performance fees.”

The drop in performance fees has been sharpest among the popular long/short equity category of hedge funds, according Eurekahedge.

The data provider added that the emergence of mainstream funds offering hedge fund-like strategies has contributed to the decline in performance fees, which have hovered between 17 and 18 per cent since 2009, after falling from 18.8 per cent in 2007.

Troy Gayeski, a partner at SkyBridge, the US fund of hedge funds company, expects more fee reductions in light of weak returns across the industry this year.

“2011 was the watershed year when high-quality managers in attractive strategies began to offer meaningful fee discounts. The trend to lower fees has been firmly in place since then, but this year’s performance will further accelerate that trend,” he said.

Fixed management fees have climbed over the past four years, from 1.6 per cent in 2011 to 1.7 per cent today, but that only matches the average management fee level in 2007.

David Walker, director of European institutional research at Cerulli Associates, the research firm, agreed that smaller hedge funds are particularly at risk.

He said: “A 2.5 per cent average loss by mid-October means many managers will be relying on their [management] fee to finance their operations and pay their staff. This will be painful for smaller hedge funds whose assets alone struggle to generate significant fees.”

However, Michaël Malquarti, co-fund manager at Altin, the Anglo-Swiss fund of hedge funds company, welcomed the reduction in fees. “Launching a hedge fund is always a risky business and will always remain so. It might just be a bit tougher to get rich very quickly, which is not a bad thing.”
If you ask me, investors need to beware of small and large hedge funds in this deflationary environment where returns will be a lot lower even if central banks are busy figuring out new ways to save the world.

It's also clear to me that a lot of hedge funds betting big on a global recovery continue to underestimate the effects of China's Big Bang and the Fed's growing deflation problem.

Let me be clear, I'm not in the camp that says there's a looming catastrophe ahead or that you should follow Harvard and load up on short-sellers, but some of these hedge funds taking huge risks with other people's money are going to get eviscerated in these Risk On/ Risk Off markets dominated by algos and high-frequency traders.

Below, Daniel Stern, Reservoir Capital co-CEO, and Barry Sternlicht, Starwood Capital CEO, discuss the challenges facing hedge funds. I'd love to talk to Stern about a handful of very talented emerging hedge fund managers here in Canada that are well worth seeding.

Also, hedge funds are getting hurt after Citron Research released a report bringing Valeant's business practices into question. CNBC's Kate Kelly reports on which hedge funds are getting whacked by Valeant and why it pays to short some hedge fund hotels.

Update: Shares of Valeant (VRX) bounced big off their lows but still closed down 19% on huge volume today. Ackman is down more than $1 billion on his big Valeant bet but he reportedly bought 2 million more shares today. The company categorically denied Citron's claims but something really smells awful here. Either Citron is way off or Pershing Square is out to lunch. Either way, this stock is being manipulated by these big funds and even though it's oversold, I wouldn't touch it until the dust settles. Be careful here, there's a reason why Jim Chanos is short Valeant and making a killing in the process.


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