Tuesday, April 5, 2016

A Requiem For Hedge Funds?

Timothy W. Martin and Rob Copeland of the Wall Street Journal report, Investors Pull Cash From Hedge Funds as Returns Lag Market:
Marc Levine, chairman of the $16 billion Illinois State Board of Investment, had a provocative question this month during a board meeting about hedge funds.

“Why do I need you?” Mr. Levine asked. A lot of big investors are asking the same question.

Pension funds, insurers and university endowments helped pump up hedge funds to a record $3 trillion in assets over the last decade. But with results falling behind a more traditional mix of stocks and bonds for six straight years and the high-fee structure now politically sensitive in some states due to uneven results, many of them are pulling back.

From New Mexico to New York, big investors are dramatically reducing their commitments and opting for cheaper imitations. Investors globally asked for more money back from hedge funds than they contributed in the fourth quarter of 2015, according to HFR Inc.—the first net quarterly withdrawal in four years. They pulled an additional $15.3 billion in this year’s first two months, according to eVestment.

The exodus will soon include the Illinois fund overseen by Mr. Levine. Two days after he questioned whether hedge funds were necessary, the board that oversees investments for about 64,000 public employees agreed to yank $1 billion from them in favor of bigger bets on private-equity and low-cost stock funds. One of the investments that Illinois exited from, Mr. Levine said, includes exposure to hedge fund Pershing Square Capital. The New York fund was down more than 20% through last week largely because of a losing bet on drug maker Valeant Pharmaceuticals International Inc., according to people familiar with the matter.

A Pershing Square spokesman declined to comment on the Illinois exit or performance.

Plenty of big institutions are still keeping money in hedge funds, as managers promise protection from an economic downturn. But longtime investors are increasingly frustrated about losses that intensified when markets turned more volatile over the last year.

American International Group Inc. said last month it would cut the $11 billion it had earmarked for hedge funds in half. Citing poor performance by those investments, the insurer said it would reallocate the money to more straight-forward bonds and commercial mortgages managed internally instead.

Others are retreating because some of the investment strategies once available only at hedge funds can now be purchased at a fraction of the cost from other asset managers. These products, coined “liquid alternatives” or "multi-asset,” can make bets on low volatility or the direction of interest rates without using as much leverage, or borrowed money, to supercharge returns.

Hedge funds typically charge higher fees than other money managers, historically an annual 2% of assets under management and 20% of profits. Some new competitors say they offer similar techniques for less than 1% of assets and a zero cut of any profits.

Northern Trust Corp. , for example, charges a management fee of less than 1% for a new “engineered equity” product that it says is similar in approach to a hedge fund. It uses models—instead of traders—to bundle together stocks that limit volatility or market risk, said Mike Hunstad, head of quantitative research for the Chicago-based firm.

The proliferation of lower-price alternatives is one reason the Illinois Municipal Retirement Fund decided last month to end its $500 million hedge-fund program.

The commitment was expensive, said Dhvani Shah, the plan’s chief investment officer.

“So do I really want to scale up?” she said. "The answer is no.”

Overall, big investors pulled an additional $19.75 billion out of hedge funds in January, according to eVestment. That was the largest outflow for the year’s first month since 2009. Clients added $4.4 billion in February, but that was well below the $22.6 billion average for that month from 2010 to 2015, eVestment said.

It is too soon to know if those dismal showings will persist. Plenty of big investors still have huge sums committed to the industry.

Endowments and foundations, for example, cut their investments in hedge funds last year for the first time since Wilshire Trust Universe Comparison Service started tracking the data in 2001. Yet the asset class still accounted for 8.62% of their portfolios through Dec. 31, according to Wilshire.

Hedge-fund commitments as a percentage of U.S. public pension-plan portfolios have dropped from a peak of 2.31% in 2012 to 1.37% at the end of 2015, according to Wilshire.

One hedge-fund manager, TIG Advisors President Spiros Maliagros, said he believes investors will continue to seek out firms like his for the chance to do better than they would with mainstream investments. But he said the industry needs to be clearer that returns aim to diversify and ease the impact of market swings, not simply earn the highest payouts.

“It’s an expectation setting that I think we need to do a better job of,” he said.

The board that oversees Florida’s public pension money, the Florida State Board of Administration, has $3.9 billion invested in hedge funds and no plans to reduce the commitment.

“Our objectives have been met,” said Ash Williams, a former hedge-fund executive who now runs the Florida board.

Hedge-fund managers are seeking new ways to quiet any investor unease. Some are now pitching their own lower-cost products that bear little resemblance to the industry’s traditional offerings in price.

AQR Capital Management is among the large hedge-fund firms that now offer cheaper alternatives to their main funds. The California Public Employees’ Retirement System, the nation’s largest public pension, has kept $578 million invested with AQR in a lower-cost product that relies on automated bets even as it announced an exit from all hedge funds in 2014.

“It’s been priced as if it was all super special,” said AQR Managing Principal Clifford Asness. “There is stuff still out there sold as magic, but there are simpler, cheaper options that accomplish much of the same thing.”
There most definitely are simpler, cheaper options than hedge funds. A couple of weeks ago, I visited the offices of OpenMind Capital here in Montreal where Karl Gauvin and Paul Turcotte gave me a presentation on their approach analyzing the volatility of volatility to deliver much better risk-adjusted results than the CBOE Put Writing Index (see their dynamic option writing strategy).

To my surprise, they met a few potential clients here in Quebec which were reluctant to even try this strategy fearing any put writing strategy is doomed to fail if another 2008 happens. This just goes to show you how ignorant many investors are in terms of put writing strategies (click on image):


The numbers are all there on the CBOE's website and I can guarantee you sophisticated hedge funds, pension funds and endowment funds are already implementing some form of a put writing strategy internally. I told Karl and Paul to "open their mind" (no pun or insult intended) and start approaching sophisticated investors outside Quebec. I also invited them to write a blog comment on their approach and strategies to educate less sophisticated investors on these strategies.

Anyways, back to a requiem for hedge funds. I recently discussed the bonfire of the hedge funds, going over why so many hedge funds closed shop in 2015 and how even top performers of last year -- like Citadel, Millennium and Blackstone's Senfina -- are struggling so far this year.

Moreover, a bunch of the top-performing hedge funds stumbled in March and hedge fund momentum trades blew up in Q1, suffering their worst losses since 2009 (I personally think this is a great opportunity to load up on biotech shares which got slaughtered in Q1).

In short, ultra low and negative rates are making this a brutal environment for all hedge funds, especially larger ones unable to cope with huge market volatility. And that's a structural change that isn't going to go away, especially if global deflation sets in.

Frustrated, many institutional investors are looking to illiquid alternatives like real estate, private equity and infrastructure. But they carry illiquidity risk which can sting over a shorter investment horizon (even if pensions typically hold these assets over a long investment horizon).

Institutional investors that refuse to give up on hedge funds are tightening the screws. Chris Flood of the Financial Times reports, Sovereign wealth funds push for higher hedge fund standards:
The International Forum of Sovereign Wealth Funds has signed an agreement with a large hedge fund association to push for better governance standards in the alternative investment industry.

The agreement is aimed at tackling issues in the hedge fund industry that have long concerned institutional investors, such as a lack of transparency around funds’ liquidity terms in stressed market conditions.

Many large investors, including sovereign wealth funds, were angered during the financial crisis when hedge funds imposed “gates” on their clients, preventing investors from pulling money out.

Alex Millar, head of sovereigns for Europe, the Middle East and Africa at Invesco Asset Management, the US fund house, said: “Some hedge fund investments turned out to be less liquid than expected. There was a discrepancy between the risks taken and the risks that were anticipated.”

The poor performance of many hedge funds since the financial crisis and their high fees remain sources of frustration among institutional investors.

The head of sovereign funds at a US investment bank, who did not wish to be named, added that there was room to improve the alignment of interests between long-term investors and hedge fund managers.

“Structuring long-term mandates in exchange for fee discounts and agreeing the appropriate performance targets and incentives between hedge fund managers and long-term asset owners is challenging,” he said.

To improve the relationship between sovereign funds and their hedge fund clients, the IFSWF has established a “mutual observer” agreement with the Hedge Fund Standards Board, an association that works with 120 hedge fund managers that collectively manage $800bn in assets.

Adrian Orr, chief executive of the New Zealand Superfund and chairman of the IFSWF, which represents a third of the world’s 90 sovereign funds, said: “This relationship will help ensure that sovereign wealth funds have a voice in the hedge fund standard-setting process.”
Is there room to improve alignment of interests between hedge funds and large institutional investors? You better believe it and it's about time these large sovereign wealth funds demand lower fees and better alignment of interests.

As far as large pension funds, most of them have given up on hedge funds but not the more sophisticated ones like the Ontario Teachers' Pension Plan. Last week, its CEO Ron Mock shared this with me when going over OTPP's 2015 results:
"2015 was a scratch year for external hedge funds and internal absolute return trading activities. In a volatile market like 2015, you wouldn't expect outperformance in these activities but they didn't dent the total portfolio either."
But Ron also told me Teachers' takes a 'total portfolio approach' and external hedge funds and internal alpha trading activities figure in prominently in this approach.

I'm not too worried about Ontario Teachers' when it comes to external hedge funds. Ron Mock has mentored Jonathan Hausman who is responsible for the Fund's global hedge fund portfolio, as well as its internal global macro and systematic trading strategies. And Jonathan has an unbelievable team made up of people like Daniel MacDonald (best hedge fund portfolio manager I ever met) to help him oversee that portfolio during these tough times.

But other large pension funds have followed CalPERS and exited hedge funds altogether. Still, it's far from being a lost cause for hedge funds. Lea Huhtala of the Financial Times reports, Finland’s state pension scheme to boost hedge fund assets:
Finland’s state pension scheme plans to invest another $500m in hedge funds this year despite persistent concerns over performance and high fees within the sector.

The move will be welcome news for the hedge fund industry, which has had to contend with a number of large investors either scrapping or scaling back their allocations.

Railpen, one of the UK’s largest pension schemes, finished a drawn-out reduction of its hedge funds assets last year, and now has just a 2 per cent exposure to hedge funds.

Europe’s second-largest public pension fund, PFZW, cut its entire €4.2bn hedge fund allocation last year.

VER, Finland’s state pension fund, intends to increase its allocations to hedge funds and other complex strategies to 6 per cent of its total $20bn portfolio. This is despite its existing hedge fund assets returning only 2.5 per cent in 2015 while its overall portfolio returned 4.9 per cent.

The pension fund currently allocates 3 per cent of its assets to hedge funds.

Timo Viherkenttä, VER’s chief executive, said: “We are aiming for a higher return than 2.5 per cent, but considering where the overall hedge fund market is now, the return was not too bad.”

A typical hedge fund charges investors a fixed management fee of 2 per cent and a further 20 per cent performance fee on returns the hedge fund manager generates.

According to figures released by State Street, the financial services provider, in February, nearly half of global pension funds plan to increase their exposure to single-strategy hedge funds over the next three years.

Nordic investors showed the most interest. Nearly 63 per cent of the Nordic pension funds surveyed planned to increase their single-manager hedge fund allocations in the next three years.

However, the survey showed investors have become more demanding. Ian Mills, a partner at LCP, the pension fund consultancy, said: “Investors are much more selective about the funds they are investing in. If you are going to pay 2 per cent per annum management fees and 20 per cent for performance, then you really want the best.”
Much more selective? They typically follow the advice of useless investment consultants that shove them in the hottest hedge funds they should be avoiding (don't get me started on this nonsense).

When I read articles on how Bill Ackman's Pershing Square is down 25% so far this year, I cringe in horror thinking of how many public pensions are invested with this fund and are now praying Valeant Pharmaceuticals (VRX) won't turn out be the Canadian pharmaceutical equivalent of Nortel.

And like I said before, it's easy to beat up on a high profile hedge fund honcho like Bill Ackman but he's not alone. Fortune's Nathan Vardi reports, Jeffrey Ubben’s ValueAct Capital, another big Valeant investor, has been sued by the U.S. government for violating pre-merger reporting requirements in connection with the hedge fund’s purchase of $2.5 billion of Halliburton (HAL) and Baker Hughes (BHI) shares.

[Update: Even Ray Dalio's Pure Alpha fund is down almost 7% so far this year, which goes to show you how tough it is out there, even for a 'radically transparent' shop like Bridgewater.]

So, is it a requiem for hedge funds? Of course not. As long as large institutional investors search for 'uncorrelated yield', top hedge funds will continue to do well.

But the landscape for the hedge fund industry is irrevocably changing and in a deflationary world where ultra low rates and the new negative normal reign, institutional investors will be demanding much lower fees and much better alignment of interests from all their hedge funds.

As I warned all of you last October, the shakeout in the hedge fund industry is far from over. You can listen to all the excuses in the world, but I'm telling you, the deflation tsunami is coming, and this means ultra low or negative rates and huge volatility are here to stay. That alone will clobber many large hedge funds unable to cope with unprecedented volatility (makes you wonder which hedge funds are loading up on bonds).

Below, discussing the rocky start of the year for hedge funds with Don Steinbrugge, Agecroft Partners Managing Partner. Listen to Don, he knows what he's talking about when it comes to hedge funds.

And Kelvin Tay from UBS Wealth Management says hedge funds are largely uncorrelated to other asset classes and offer higher returns for risks. Interesting discussion but take all this talk of hedge funds offering 'uncorrelated returns' with a shaker of salt (most are charging alpha fees for leveraged beta).

Lastly, Mozart's Requiem Mass in D Minor, his final masterpiece which was commissioned in mid 1791 by the Austrian Count Franz von Walsegg as a tribute to the passing of his young wife Anna. 



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