Drowning in High Water Hell?
The past few years have been “as miserable as I can remember”, says Johnny Boyer of Boyer Allen Investment Management, a British hedge fund focused on Asia. The fund, which looked after $1.9 billion at its peak, faced the prospect of spending the next few years trying to claw its way back to pre-crisis asset levels. Instead the founders decided to shut the fund and give investors their money back.
Others have also had enough. “I’ve been doing this for 15 years and I’ve never seen as many people give up as in the last three months,” says Luke Ellis of Man Group, a large listed fund. This trend is distinct from the round of closures in 2008. Then, managers were hit by investors’ redemptions and had no choice but to close; today many are electing to walk away.
For some managers, the markets have become too stressful. Running a hedge fund today is “three times as much work for a third of the fun,” says one. But many are motivated by economics. Hedge funds typically get paid a 2% management fee on assets to cover expenses and a 20% performance fee on the returns they achieve for investors. Most funds do not earn performance fees unless they outperform their peak level or “high-water mark”. At the end of 2011, 67% of hedge funds were below their high-water marks, according to Credit Suisse, and 13% have not earned a performance fee since 2007 or earlier.
Funds can survive off a management fee for a couple of years, but four is a long time to go hungry. Most managers were banking on a recovery in 2011 but the average hedge fund slid by 5.2%—much worse than the S&P 500, which returned 2%. Poor performance is causing changes in the way the industry markets itself. It also means many funds will have to wait even longer to earn a performance fee again. According to Morgan Stanley, 18% of hedge funds are more than 20% below their high-water marks.
Smaller funds have been more likely to close than their larger peers. That’s partly because it used to be possible to run a hedge fund with $75m under management. Today funds need at least double that amount because administrative and compliance costs are higher than ever. Larger funds also depend less on performance fees because their management fees bring in so much cash. John Paulson, a hedge-fund giant whose flagship fund was clobbered last year, has pledged to make up investors’ losses but his fund is so large that he can easily afford to carry on. That risks distorting the original point of hedge funds—that they are small, limber operations which come and go often (see chart above).
For investors, it is generally a good thing if underperforming managers are returning cash and not milking them for fees. But others worry that high-water marks could skew funds’ investing decisions. Managers who have not earned a performance fee in years could take bolder bets to get back into the black. Leverage levels have been creeping up. Some may prefer to go out with a bang, not a whimper.
Some are cranking up the risk but most hedge funds are dipping their toes, not their feet in stock market waters. The Economist also notes that facing difficult markets, hedgies are tweaking their marketing language, switching from alpha to smart beta:
In line with the rest of our industry we are making some changes to the language we use in our marketing and communications. We are writing this letter so we can explain these changes properly. Most importantly, Zilch Capital used to refer to itself as a “hedge fund” but 2008 made it embarrassingly clear we didn’t know how to hedge. At all. So like many others, we have embraced the title of “alternative asset manager”. It’s clunky but ambiguous enough to shield us from criticism next time around.
We know we used to promise “absolute returns” (ie, that you would make money regardless of market conditions) but this pledge has proved impossible to honour. Instead we’re going to give you “risk-adjusted” returns or, failing that, “relative” returns. In years like 2011, when we delivered much less than the S&P 500, you may find that we don’t talk about returns at all.
It is also time to move on from the concept of delivering “alpha”, the skill you’ve paid us such fat fees for. Upon reflection, we have decided that we’re actually much better at giving you “smart beta”. This term is already being touted at industry conferences and we hope shortly to be able to explain what it means. Like our peers we have also started talking a lot about how we are “multi-strategy” and “capital-structure agnostic”, and boasting about the benefits of our “unconstrained” investment approach. This is better than saying we don’t really understand what’s going on.
Some parts of the lexicon will not see style drift. We are still trying to keep alive “two and twenty”, the industry’s shorthand for 2% management fees and 20% performance fees. It is, we’re sure you’ll agree, important to keep up some traditions. Thank you for your continued partnership.
Zilch Capital LLC
OUCH! Even the Economist realizes that most hedge funds are a joke, glorified money outfits charging 2 & 20 for mediocre results. And the larger hedge funds aren't better than the smaller ones, they just have more staying power because they can collect 2% management fee on billions of dollars. Also, they benefit from the 'placebo effect' of large hedge funds.
The industry has grown way out of proportion. Instead of delivering absolute returns, most hedge funds are an absolute disgrace. But pension funds, sovereign wealth funds, endowment funds and other institutional investors keep plowing billions into hedge funds, foolishly believing that they will 'save them' from treacherous markets.
Just like most hedge funds are terrible, most institutional investors are clueless about hedge funds, relying on equally clueless consultants who typically shove their clients in large brand name hedge funds.
Even smart institutions that have been investing in hedge funds for years do stupid things. A couple of days ago I blasted Texas Teachers for buying a $250M equity stake in Bridgewater, and while others report that these "innovative partnerships" will drive returns, I remain skeptical.
Moreover, Texas Teachers just announced a new 5% allocation — $5.5 billion in current dollars — to directional hedge funds to bring the $109 billion fund up to its 9% hedge fund target. Good luck with that, sounds like they too are going to get a rude awakening on alternatives.
Meanwhile, smart hedge fund investors like APG are plowing more money into multi-strategy shops, especially in Asia where according to AsiaHedge’s survey, multi-strategy funds accounted for 60% of the total number of new funds in 2011, the first time they have outperformed other strategies. APG is also doing truly innovative things, like seeding hedge funds and managing their beta exposures in a much more intelligent way.
A few years ago, I wrote a comment warning the shakeout in the hedge fund industry will be brutal. I stand by this comment but completely underestimated the stupidity of most institutional investors who keep paying alpha fees for beta exposures. In this business, memories are short, most investors have forgotten about when the gates of hedge hell closed on them.
But now it's hedge funds that are reeling, drowning in high water marks. My advice? Unless you have deep and patient pockets backing you up, walk away, it's simply not worth it. When you see the head of Goldman's hedge fund group retiring, you know it's time to call it quits.
And if you're part of the few that made big bucks during the glory years of hedge funds, you can buy a minority stake in a professional baseball team and have fun watching the ball games, hoping your team wins the series again. Love those '86 Mets, those were the glory days!
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