Thursday, December 3, 2015

More Bad News For Hedge Funds?

Katherine Burton and Saijel Kishan of Bloomberg report, Hedge Funds Brace for Redemptions:
When BlueCrest Capital Management told investors Tuesday it would no longer oversee money for outsiders, one thing founder Michael Platt didn’t mention was that clients had already pulled billions of dollars this year.

Platt, who cited client demands and pressure on fees as a reason for his decision, isn’t alone in feeling the heat from investors. Firms including Och-Ziff Capital Management Group LLC and Mason Capital Management have seen cash flee this year, and others such as Fortress Investment Group LLC’s macro funds business shut down after redemptions and losses.

Hedge fund investors are losing patience even with marquee firms as many of them struggle this year, especially those that offer macro strategies or stock funds heavily weighted to rising shares. Some managers have lost money for two years running, while others such as David Einhorn’s Greenlight Capital are suffering declines that rival their worst year. After the weakest third-quarter inflows in six years, the industry could see outflows in the fourth quarter, said investors and bankers who watch the ebb and flow of hedge fund assets.

“The fourth quarter will be flat and possibly negative,” said Peter Laurelli, head of research at Evestment Alliance, which tracks hedge fund investments.

Hedge fund managers got off to a promising start in 2015, outpacing equity benchmarks including the Standard & Poor’s 500 Index. The second half of the year has proved more challenging as volatile markets create some of the steepest losses since the 2008 financial crisis for some of the most prominent managers in the business.

Ackman, Einhorn

The $2.87 trillion industry added $45.3 billion in net deposits in the first nine months of the year, according to Hedge Fund Research Inc. Only $5.6 billion came during the three months ended Sept. 30, the lowest third-quarter take since 2009, when a net $1.1 billion was deposited. If no money pours into funds in the current quarter, inflows in 2015 will be at least 40 percent below last year.

Among the most prominent losers in the second half is Bill Ackman, whose Pershing Square Capital Management is down more than 17 percent in 2015 through November. The firm has been hurt by its investment in Valeant Pharmaceuticals International Inc., whose shares have slumped 31 percent this year amid scrutiny over drug prices.

Einhorn’s Greenlight Capital has declined 21 percent this year, as positions such as SunEdison Inc., Consol Energy Inc. and Micron Technology Inc soured. Einhorn’s worst annual loss was in 2008, when his fund fell 23 percent.

Mason’s Slump

Others firms have been losing money for more than a year. Mason Capital, an event-driven fund based in New York, was down about 20 percent from the start of 2014 through this year’s third quarter, according to investors. Assets fell to about $5.6 billion from about $9 billion at the end of last year.

Fortress Investment Group LLC said in October it was closing its $2.3 billion macro business run by Michael Novogratz after posting losses for almost two years. Earlier that month, Bain Capital decided to shutter its Absolute Return Capital fund after more than three years of declines.

At BlueCrest, assets have shrunk by more than 40 percent this year to $7.9 billion, mostly from withdrawals after years of lackluster returns in what was once its biggest fund. New Jersey’s public pension plan decided to pull $284 million from one international fund as of June 30, citing “disappointing” returns just over a year after adding to its investment.

Hanging On

Och-Ziff, run by Dan Och, saw $4.2 billion leave its $30 billion multistrategy funds in the first nine months of 2015. Its biggest fund is little changed this year. The firm could face more withdrawals in 2016, depending on the outcome of an investigation by the U.S. Justice Department into whether it broke bribery laws in accepting an investment from the Libyan Investment Authority. Och-Ziff has told investors the matter is likely to be resolved next year, according to a person briefed on the matter.

Spokesmen at the firms declined to comment on flows and performance or didn’t return calls.

Some firms will be able to hang on to much of their cash regardless of performance. Certain investors in Ackman’s Pershing Square Capital Management can only take out one-eighth of their money every quarter, meaning it takes two years to exit completely. At the end of 2014, those restrictions applied to clients accounting for about a third of the firm’s $18 billion. About another third was permanent capital from a share sale last year.

Among the biggest winners is Millennium Management, run by Israel Englander. Its hedge fund pulled in a net $4.1 billion, bringing assets to $32.5 billion at the start of November, according to a person familiar with the firm.
There's nothing really new in this article. It's been a brutal year for many top hedge funds and I expect the latest shakeout in the hedge fund industry to continue. There will be winners but more losers and only the best of the best will survive. I'm not too worried about guys like Ken Griffin or Izzy Englender but I think a lot of other hotshots are going to get smoked in the next few years.

Now, "to redeem or not to redeem?," that is the question! The problem with redeeming AFTER a fund is down 20% or more is that you look like an idiot if the fund comes swinging back in the following year(s).

This is why I keep telling investors to understand and monitor all risks of investing in a hedge fund BEFORE and AFTER investing a dime in them, especially with these "marquee" funds that have tight redemption clauses that make it virtually impossible for you to redeem all your money within a quarter (thereby exposing you to potentially more losses and significant liquidity risk should you need that money to pay pension benefits).

Having said this, you need to carefully evaluate any decision to redeem from any fund, especially after a terrible year (most of the time, you should be redeeming after a stellar year). You need to put just as much effort (if not more) behind the decision to redeem as you did when you decided to invest in a hedge fund. In other words, don't panic and make hasty decisions you will regret, think and try to focus on why the fund is down and whether this is a cyclical setback or something more structural in nature.

There are no easy answers to when to redeem. Some investors follow strict rules like redeem from a hedge fund if it loses more than 5% on any given year while others are more patient and like to give a fund manager the opportunity to work through his or her losses. Most pensions fall into the latter camp and many end up regretting their decision to remain patient as they pay 2&20 in fees to some hedge fund guru losing 20% in a year (in a losing year the management fee bites and make sure they have a high-water mark so they make up all their losses before they start charging any performance fee again).

Whatever you decide, you should be grilling these hedge fund managers extremely hard regardless of whether they're outperforming or under-performing. When I used to sit down with a L/S Equity manager, a global macro fund or CTA, I was always prepared by analyzing their positions and asking very tough questions.

For example, Bill Ackman recently bought and sold options to increase his already enormous stake in Valeant Pharmaceuticals (VRX). Bloomberg reported the following on the transaction:
[..] he didn't buy stock: He went to two derivatives dealers, Nomura and UBS, and bought call options on Friday that give him any gains in value of Valeant's stock above the strike price of $95. He also sold those dealers put options, which put him on the hook for any losses in the value of the stock below the strike price of $60. And he sold other call options with a strike price of $165, capping his upside: If the stock gets above $165, he gives up any further gains. Then he did the same thing again on Monday, only with strike prices of $100, $70 and $130. The options he bought cost about $235 million, plus about $9 million of hedging costs ; the options he sold brought in about $169 million.
Basically, Ackman is betting that Valeant shares will trade above $95 and below $165 over the next year (I presume it's a year) and if for any reason Valeant shares drop below $60, he'll be losing huge on his stock and option positions in Valeant.

I hope for Ackman's sake and more importantly, his investors' sake that he turns out to be right on his bullish Valeant positions but I'd be very concerned about any hedge fund manager taking such concentrated bets no matter how stellar his or her past track record is.

At least David Einhorn sold a chunk of his holdings in both SunEdison (SUNE) and Micron (MU) by the start of October. But SunEdison’s stock fell by more than 56% in November and still seems to have further dented Einhorn’s returns. Still, Einhorn's portfolio is a lot more diversified than Ackman's and even though I have concerns (like his bullish Consol Energy position), I'm pretty sure he will bounce back from this setback. (Update: Einhorn is also losing money on shorts like Keurig Green Mountain which just got acquired for $92 a share, representing a huge premium).

Of course, an investor's job isn't to second guess a hedge fund manager on individual positions but to ask tough questions on the entire portfolio and risk management. Even the best hedge funds go through dry spells and tough periods but the key is to understand why and to gauge whether they have the right processes and personnel to come back from these setbacks.

And it's not all bad news for hedge funds. Inyoung Hwang of Bloomberg reports that long-short hedge funds, which place bullish and bearish wagers on individual stocks, are on track to top the Standard & Poor’s 500 Index for the first time since the 2008 financial crisis, according to an index by Credit Suisse Group AG:
While the S&P 500 has struggled to hang onto its gains all year, long-short fund managers were able to differentiate by wagering on winning industry groups within technology, according to Mark Connors, Credit Suisse’s global head of risk advisory. This year’s long-short returns are poised to top every other strategy tracked by the firm.

“Macro factors still weigh on markets, but instead of everything lifting as in 2013 and 2014, you’ve had some segmentation by sectors this year,” said New York-based Connors. “Equity long-short funds picked up on that.”
Also, Lawrence Delevingne of Reuters reports that a small group of hedge fund managers have beat their struggling peers and the anemic stock market by betting against stocks:
John Burbank’s Passport Capital, Lee Ainslie’s Maverick Capital, Paul Hudson’s Glade Brook Capital Partners and Adam Bernstein’s Pagoda Asset Management have made bets that individual stocks would fall, known as short trades, that have driven their funds’ performance in recent months.

The average stock-picking hedge fund, as represented by the Absolute Return U.S. Equity Index, gained just 0.04 per cent from the beginning of January through October. That’s less than the Standard & Poor’s 500 index’s gain of 2.7 per cent, including dividends, over the same period following sharp sell-offs in August and September. Virtually all stock hedge funds bet that some stocks will rise and others will fall, but most are net owners of stock, meaning they do best when shares rise.

The main fund managed by $4.4-billion Passport is up 12.8 per cent through October thanks to a slew of profitable short bets, according to performance information and an Oct. 30 letter to investors seen by Reuters. Specific bets were not named, but Passport’s third-quarter gain of 6.7 per cent by its Global fund was driven by shorts on stocks in the basic materials sector, the letter said. The fund also made money betting against energy stocks and shorting crude oil directly. A spokesman for Passport declined to comment.

Shorts have also boosted $10-billion Maverick, whose main hedge fund is up about 16 per cent this year through October, according to investor materials seen by Reuters.

“Our short investments were profitable in every industry sector and each region in which we invest,” Ainslie wrote in a letter to investors summarizing the third quarter, when the fund gained 2.7 per cent.

More information on the shorts was not disclosed, but Maverick had its largest long bets on technology, media, and consumer stocks at the end of the third quarter, according to a recent public filing, including Liberty Global, Aramark and Google. The letter also noted that the fund took a relatively conservative posture toward market risk earlier in the year, a move that paid off in recent months.

Glade Brook, which invests in technology, media, telecommunications and consumer sector stocks, also gained from short bets.

The firm’s hedge fund’s 2.7-per-cent return over the third quarter was driven by betting against unnamed traditional retailers, especially those hurt by growing competition online, and old-line media companies hurt by the types of companies it is long, such as Facebook and Google parent Alphabet Inc, according to an investor letter seen by Reuters.

The hedge fund is up about 12 per cent net this year, according to a person familiar with the situation, with longs and shorts contributing roughly the same amount to performance. The largest single winner is a long bet on online travel agency Expedia Inc, according to the person. Glade Brook manages slightly more than $1-billion, according to the letter, with $314-million in its hedge fund strategy (The majority is in private equity funds that bet on fast-growing technology companies such as Uber and Snapchat).

A final example is Pagoda. The $211-million firm, launched in September 2014 by veterans of Highbridge Capital Management, saw its main fund gain 14.5 per-cent trough October, according to a person familiar with the situation. The fund gained 5.1 per cent in the third quarter thanks to shorts on undisclosed companies in leisure and retail sectors, among others, according to a letter sent to clients seen by Reuters.

One well-known manager who has added to his shorts is Dan Loeb of Third Point.

“The environment for short selling is also attractive,” he wrote in a recent investor letter, “and we have more single short names than long positions in our book today.”

A spokesman for Third Point declined to comment. Its main fund has returned virtually zero for the year after gaining 4.7 per cent in October, according to a performance update seen by Reuters.
There were tons of opportunities to short stocks in all sectors in 2015.  My short-selling focus has been on energy, commodities and emerging markets but there were plenty of stocks in retail, biotech and many other sectors that got clobbered in 2015.

The problem is most L/S Equity hedge funds are terrible at shorting stocks and I've seen this firsthand when I was investing in them. Most of them are net long and it's rare that you'll see a L/S Equity fund deliver alpha in both their long and short positions (to be fair, shorting stocks is a lot more difficult especially in an environment where central banks are backstopping equities).

Let me end my comment on a more positive note for hedge funds. Stephanie Yang of CNBC reports, Surprise! Hedge funds aren't that bad at picking stocks:
2015 is turning out to be one of the worst years on record for hedge funds. But for those losing faith in their stock-picking capabilities, one research paper provides a comforting conclusion — hedge funds may not be so bad at it after all.

According to the Hedge Fund Research HFRI Fund Weighted Composite Index, hedge funds have seen returns this year through October of about 0.03 percent. This puts 2015 on track for the fourth-worst year of returns for hedge funds, after 2002, 2011 and 2008.

But Jonathan Rhinesmith, doctoral candidate in economics at Harvard University, said the biggest buys for hedge funds have a tendency to go up, and stay up.

"My research has found that at least historically, hedge funds have actually done pretty well, especially when you make that comparison to a monkey throwing darts," Rhinesmith said, referring to the trope implying that a portfolio of stocks chosen by a monkey randomly throwing darts at a paper would outperform a fund manager's personal picks.

Rhinesmith's paper, "Conviction and volume: Measuring the information content of hedge fund trading," analyzes $4.3 trillion in purchases of equity positions. Based on filings with the Securities and Exchange Commission, he found that the stocks that hedge funds took the biggest positions in tend to increase in price the most, and maintain higher prices even as firms exit large trades.

Since these stock picks outperform overall in the longer term, gains from hedge funds positions shouldn't be solely attributable to temporary price pressure due to the large trade itself, Rhinesmith said.

"Hedge funds do in fact predict future stock returns when they take up a lot of volume in stocks. And not only that, but the the returns that they predict don't revert," he said in an interview with CNBC's "Trading Nation." "By that measure, hedge funds are actually pretty informed. Furthermore, they even predict earnings returns in stocks."

In another paper, Rhinesmith takes a look at "doubling down," in which fund managers take another large stake in an existing position even after the stock has underperformed. He found that the greater the losses before doubling down, the more that position tended to outperform. This could indicate that when a hedge fund has a great deal of conviction on a stock, that stock will actually tend to do well, which is more evidence that hedge funds hold relevant information of a stock's value.

Despite that relevant knowledge, this rarely happens, Rhinesmith writes, because investment managers are reluctant to add to losing positions and risk their careers.

Unfortunately for other investors, those looking to follow in a hedge fund's footsteps may not find much outperformance. According to Rhinesmith, trades executed based on filings that list a fund's holdings will likely be late to the game.

"By the time these filings are made publicly available, hedge funds have actually already moved prices so much that there's not as much juice in the trade," he said.

The bright side, however, is that this implies that hedge fund purchases bring share prices closer to their "fundamental value," meaning that hedge funds end up improving the pricing of stocks bought and sold by less-informed investors.
This is why I track top funds' quarterly activity very closely but keep warning you to never blindly buy or sell any stock based on what some hedge fund hotshot bought or sold. If you read the research above, you'd conclude Ackman is doing the right thing adding to his already huge Valeant position (I sure hope so for him and his investors).

Below, in the wake of BlueCrest Capital Management's decision to return all outside client money and become a private partnership, Bloomberg's Simone Foxman examines the challenges facing the hedge fund industry. She speaks on "Bloomberg Markets."

In an article in the Telegraph, BlueCrest said that while it had delivered $22bn in trading profits since its launch 15 years ago, “ongoing secular changes in the industry, including trends in fee levels, the cost of hiring the best trading talent, and the challenges in tailoring investment products to meet the individual needs of a large number of investors, have weighed on hedge fund profitability”.

However, the company plans to keep hiring traders to run its remaining funds worth several billion dollars and I think Michael Platt is doing the right thing here returning outside capital to focus on improving profits as a staff-owned firm (would love to recommend him some Canadian talent I like a lot).

Also, hedge fund investors are losing patience even with marquee firms as many of them struggle this year, especially those that offer macro strategies or stock funds heavily weighted to rising shares. Bloomberg's Katherine Burton has more on the state of hedge funds. She speaks on "Bloomberg Markets."

Lastly, a new study suggests that hedge funds are actually decent at picking stocks. The author of that study, Harvard Ph.D. candidate Jonathan Rhinesmith, discusses with CNBC's Brian Sullivan.

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