Time to Pull the Plug on Hedge Funds?
Institutional investors will be sharpening their scalpels in 2012, cutting managers that failed to provide what they promised: absolute return.
Last year was the second-worst year for hedge fund performance in the 22 years that Hedge Fund Research Inc. has been tracking industry returns, and the patience that institutional investors had for subpar hedge fund performance is evaporating fast, said industry sources.
Industry insiders predict 2012 will be characterized by significant manager rotation within hedge fund portfolios.
“The hedge fund investment trend won't reverse, but many institutional investors will be carefully evaluating how individual managers and strategies contributed to their portfolios,” Anita Nemes, London-based managing director and global head of capital introduction in Deutsche Bank's Hedge Fund Capital Group, said in an interview.
“This assessment is precipitated by huge performance dispersion in 2011 in some strategies, like long/ short equity, but investors will be making their assessment over the longer time frame of the past few years,” Ms. Nemes added.
Last year was only the third since the HFRI Fund Weighted Composite index's inception in 1990 in which the index's return was negative, at -5.02%. The 2011 returns of hedge funds of funds were even worse, with the HFRI Fund of Funds Composite index producing a dismal -5.51%.
By comparison, the Standard & Poor's 500 index returned 2.1% in 2011; the Russell 3000 index, 1.03%; the Morgan Stanley Capital International All-Country World index, -6.69%; and the Barclays Capital U.S. Aggregate Total Return index, 7.84%.
“2011 was a good testing ground for hedge fund managers who professed to be able to manage risk. Those hedge funds that were not able to preserve capital are going to be under scrutiny,” alternative investment consultant Stephen L. Nesbitt said in an interview.
“The tide went out last year and you could see who didn't have any pants on. Managers complained that everything was correlated in 2011 and they couldn't be expected to perform. There always is an excuse,” said Mr. Nesbitt, who is CEO of Cliffwater LLC, Santa Monica, Calif.
With chief investment officers weary of excuses, Mr. Nesbitt said he expects “an above-average number of manager searches” in 2012, similar to the first half of 2009, when investors upgraded their manager rosters after the financial crisis in 2008. Mr. Nesbitt said Cliffwater's own clients likely will be among those making changes, but declined to disclose any names.
Deutsche Bank's Ms. Nemes said the biggest change for institutional hedge fund investors since 2008's financial market meltdown has been “so much more emphasis on bottom-up manager selection. And if you were not achieving your performance expectations, how you can effect a change going forward is through manager changes.”
“Fundamentally, institutional investors are not focused on changes to hedge fund portfolio construction as much as they are on assessing which managers will do best in the strategy weightings within their portfolios,” Ms. Nemes said. Part of that evaluation of hedge fund manager skill has to include assessment of the individual manager's ability to find investment opportunities regardless of market conditions, said Michael Rosen. As principal and CIO of Angeles Investment Advisors LLC, Santa Monica, Calif., Mr. Rosen advises institutional clients on hedge fund investments and manages the firm's $160 million hedge funds-of-funds strategy.
“You have to analyze the purpose of each hedge fund in your portfolio and what your expectation of that manager is. If a merger-arbitrage manager is sticking to his investment strategy and the market isn't favoring merger arb, then that manager may be meeting your expectations,” Mr. Rosen said.
Mr. Rosen said that in a manager-by-manager portfolio evaluation, the hedge funds he and his team are most focused on are those in which the manager's investment process has not worked and the manager seems “unsure about where to find opportunity. The question is not really so much about performance as it is about the lack of agility, the inability to see how they can make money.”
The $425 million Louisiana State Police Retirement System, Baton Rouge, is one fund that recently upgraded its hedge fund portfolio to improve performance (Pensions & Investments, Jan. 23). EnTrust Capital Management Inc. was hired in January to run $10 million in a hedge fund-of-funds strategy, replacing GAM, which was terminated for performance reasons in September.
Still, sources were unable to give specific examples of hedge fund and hedge fund-of-funds managers that have seen big redemptions or are among those most likely to be excised from institutional investors' portfolios.
But “drawdowns (negative performance) of a certain size will definitely put a hedge fund in the running” for replacement, said Donald A. Steinbrugge, managing member of third-party hedge fund marketing firm Agecroft Partners LLC, Richmond, Va.
Paulson & Co. Inc. is a large, institutionally oriented hedge fund manager that got a lot of attention last year for disappointing returns. The hedge fund management company that produced a 159% return in 2007 from stellar subprime mortgage bets in its Paulson Advantage Plus Fund sustained a -35% return in the same fund in 2011. The company's oldest fund, the flagship Paulson Partners Fund, was down 10% in 2011, and Paulson Credit Opportunities Fund dipped 18%.
Net redemptions across all of Paulson & Co.'s hedge funds last year were less than in 2010, which in turn were less than 2009 redemptions, said a source with knowledge of the company, who asked not to be identified. The company's assets totaled $28 billion as of Dec. 31, but dropped to $23 billion on Jan. 1 when redemptions and performance were factored in, the source said.
Armel Leslie, a company spokesman, declined to comment.
But Agecroft's Mr. Steinbrugge predicted that “any drawdown of 30% or more just is not acceptable and will not be tolerated.”
He said as investors upgrade, they will be looking for hedge fund and funds-of-funds managers with strong risk controls that enabled them to produce positive returns last year despite extreme market volatility and high correlations between asset classes.
One institutional hedge fund manager — Bridgewater Associates LP — produced 15.3% in its Pure Alpha II fund in 2011. It had annualized returns of 14.6% for the 20 years ended Dec. 31.
The institutionally focused hedge fund Renaissance Institutional Equities Fund, managed by Renaissance Technologies Corp., also had strong performance — 35% — in 2011, although net inflows were “negligible,” according to a source who asked not to be identified.
Jonathan Gasthalter, a RenTech spokesman, declined to comment.
Institutional CIOs might need to move fast if they want to upgrade to 2011's best performers, Simon Ruddick, managing director and CEO of hedge fund consultant Albourne Partners Ltd., London, wrote in an e-mailed response to questions.
“Capacity is fast disappearing with those better-known funds that performed well in 2011, so opportunities to switch into them may well become limited. After way more talk than action, 2012 might see some shift to smaller funds,” he said.
With all due respect to Simon Ruddick, the last thing institutional investors should be doing is chasing hedge funds. Smart institutional investors realize they're getting eaten alive by hedge fund fees. And don't forget, the world's best hedge fund is actually a pension that doesn't invest in hedge funds, preferring to do it all internally at a fraction of the cost. But institutional investors keep pouring into hedge funds, chasing after them, foolishly believing that hedge funds will save them.
Let me repeat, the bulk of hedge funds are mediocre, hyped-up asset gatherers collecting 2 & 20 for delivering beta or even worse, sub-beta results. They absolutely stink. And most institutional investors that keep chasing after hedge funds don't have a clue of what they're doing. Most of these institutions are wasting time, money, and other resources chasing after a pipe dream.
How do I know? I used to invest in hedge funds, some of the best in the world. I went to those silly hedge fund conferences where I saw morons chasing after hedge fund managers. A bunch of horny imbeciles with hedge fund hard-ons chasing after pretty young sales ladies in short skirts peddling them hedge fund hype. The nonsense I've witnessed in the hedge fund industry is utterly scandalous.
John Authers of the FT is right, hedge funds have grown too big and need pruning:
Is there any such thing in the world of finance as a good idea that does not in time get taken too far, and flogged to destruction? I am beginning to doubt it.
If the financial world had any relative “winner” from the disaster of 2008, it was hedge funds. The long-feared collapse of a big hedge fund never took place. Banks turned out to create far more systemic risk. Some smart hedge fund managers actually saw the crisis coming and made money from it.
Managers like John Paulson, who made a huge bet against subprime mortgages, or David Einhorn, who aggressively sold short the shares of Lehman Brothers in a bet that they would go down, while publishing evidence that the investment bank’s accounts were fatally flawed, emerged from the crisis almost heroic – and very much richer.
Their lightly regulated business model, which allows them to borrow, to sell short, and to limit opportunities for investors retrieve their money, seemed superior to regulated funds.
Indeed, hedge funds soon repaired the damage. By the end of 2011, according to Hedge Fund Research of Chicago, the sector’s assets exceeded $2 trillion, greater than in 2007. In the last two years, a net 500 new hedge funds were created.
But it begins to look as though the sector has overplayed its hand. The release of Mitt Romney’s tax returns in the US illuminated what many did not realise – that wealth created by hedge funds is leniently taxed. Alternative asset managers suddenly face political attack.
Those proved right four years ago are now making mistakes. Mr Paulson took a loss of about $500m in the Chinese forestry group Sino-Forest last year as it fought short-sellers’ charges of fraud. As for Mr Einhorn, he had to pay a huge £7.2m fine to the UK’s Financial Services Authority this week, for market abuse.
The hedge fund industry as a whole is not looking so smart. According to HFR, the average hedge fund lost 5.02 per cent last year, only their third down year since 1990. Since August 2008, the eve of Lehman, hedge funds have almost exactly matched the S&P 500 stock index, and far underperformed bonds. Funds of hedge funds, with an extra layer of fees, have fared far worse, and are still 6.5 per cent below their level of August 2008.
They have some excuses. Correlations between securities and between asset classes are extremely high. That is bad news for hedge funds, many of whose strategies rely on correcting mispricing anomalies, selling short overpriced stocks and buying cheap ones. Such strategies fail if all stocks move together in response to the latest macro news.
But global macro funds collectively failed to exploit the twists and turns of the eurozone crisis. Some did. But most seemed to be flummoxed by the need to gauge political as well as financial risks.
Further, Mary Bartels of Bank of America Merrill Lynch shows that the correlation of several hedge fund strategies with the stock market reached record levels last year. That surely defeats their purpose, which is to provide a “hedge” - and implies that the sector is overcrowded, with too many players overexposed to the stock market.
Richard Bernstein, a New York investment advisor, points out acidly that treasury bonds offered true diversification, moving in the opposite direction to stocks. Hedge funds, despite their name, did not. “Traditional asset allocation has provided diversification, superior returns, liquidity and cheaper fees,” he said. “Alternatives have under-performed, are highly correlated to other asset classes, hinder liquidity, and charge high fees. This seems to be a comparison of a superior, less expensive product to an inferior, more expensive product.”
Many hedge fund strategies have a limit on how much money can be deployed, as there are only so many mispriced assets. When too much money makes the same bet, and copycats pile in, returns look ever more like the stock market itself. This is known in the industry as an “overcrowded trade”. It looks increasingly as though hedge funds owe their great performance in the decade before the crisis to cheap leverage, and cannot repeat the trick now that far more funds are trying to perform it.
Some hedge fund managers continue to use the freedom of their lightly regulated environment to reap fantastic returns each year. But many hedge funds are run by former traders using space on an investment bank trading floor, and using ideas spoon-fed to them by the research departments of investment banks.
For the sector as a whole, the picture is now familiar. Hedge funds have grown too big, they are copying each other, and they are tracking the market, but charging big fees for it. That is exactly what has already occurred in the world of mutual funds and unit trusts.
There are too many hedge funds. Those investors lucky enough to be able to invest in them should ask their fund managers whether they really need to exist.
Of course they need to exist. How else will they buy their Ferraris and yachts? And now that investment banks are scaling back bonuses, you're going to see a bunch of disgruntled prop traders who think they're the next Soros open up their hedge fund trying to get a piece of the action. Few will succeed, most will perish.
But their timing may be right. Reuters reports that stock gains turn hedge fund losers into winners:
Last year's hedge fund losers may be turning into winners again.
Several of the largest hedge funds that ended last year deep in the red, jumped to good starts in January, giving their wealthy investors reason to believe savvy traders are getting back their magic touch.
Lee Ainslie's Maverick Capital staged a dramatic rebound, leaping onto the list of top-20 performing funds in January thanks to a 5.89 percent gain in the first weeks of the year. In 2011, he lost 15 percent.
Even John Paulson shared good news with investors when he announced that his Advantage Plus Fund rose 5 percent last month after having been touted as the industry's biggest loser in 2011 with a 52 percent loss. By comparison, the benchmark S&P 500 index rose 4.4 percent in January.
But most prominently, the relatively small Henderson European Absolute Return fund, with about $116 million in assets, currently claims top honors as the year's most profitable fund with a 14 percent gain through late January, HSBC data show.
Last year that fund, known for its manager's contrarian stock picks, ranked second highest on the list of the year's biggest losers with a 42 percent decline.
Fortress Investment Group, one of a handful of publicly traded asset managers, also started 2012 with solid gains after several of its portfolios struggled in 2011.
Its Fortress Macro Fund rose 3.82 percent through January, while the Fortress Asia Macro Fund gained 2.21 percent, according to an SEC regulatory filing Monday. The firm's commodities fund dipped slightly, down 0.43 percent.
One month clearly does not make a year, but for last year's big losers, the January rebound could be a sign their fortunes are changing because the stock markets are doing better and they have made adjustments to their portfolios, investors said.
In fact, much of the $2 trillion hedge fund industry is looking for a revival this year, after funds, on average, posted a 5 percent decline in 2011.
"January can be characterized as having been generally strong across the board," said Paul Zummo, co-head and chief investment officer at JP Morgan Alternative Asset Management.
Similarly, Dan Loeb's Third Point Ultra fund is on the list of winners with a 5.8 percent gain in January after having dipped 2.3 percent last year, and David Tepper who finished 2011 down in the low single digits, turned the corner with a gain in the low single digits in January, people familiar with their numbers said.
While welcome, January's turnaround does not come as much of a surprise for the hedge fund industry considering the stock market's strong start to the year, investors and managers said.
So-called long-short equity funds turned in some of the industry's best returns, with an increase of 2.62 percent in January, analysts at Bank of America Merrill Lynch found. Last year, these types of funds which invest more than a trillion dollars in the stock market, lost about 19 percent.
Adjusting positions helped. After many hedge funds stumbled last year from too many managers chasing the same opportunities, crowding into big stocks like Bank of America, the appetite has shifted this year to small cap stocks, Merrill Lynch analysts said. But at the same time, Bank of America is up 35 percent amid slightly better economic numbers and hopes that Europe's financial crisis can be sorted out.
"Hedge fund managers tend to do better in environments that are not as driven by macroeconomic and politically driven fundamentals," JP Morgan's Zummo said.
Last year's winners are also benefiting from more favorable conditions. Steven A. Cohen's SAC Capital Advisors gained about 2 percent in January after rising 8 percent last year, and Kenneth Griffin's flagship funds at Citadel, climbed 3 percent in January after a 20 percent increase last year.
Not everyone has called an all-clear on the troubles that wrecked last year's returns.
"It is no time to put on our party hats," said one executive at a mid-sized hedge fund who can not be quoted publicly and worried that Greece's debt problems will still make investing tough because many fund managers are exposed to European banks who are in turn exposed to Greece.
My take on all this? I saw it coming last year when I wrote my comment on hedge funds being on the ropes. It's all about beta, not alpha! They all piled into risk assets early in 2012 and they'll keep piling into them hoping to shoot the lights out this year to save their skin and crank up their marketing machine.
Bottom line: With few exceptions, the hedge fund industry is a joke, bunch of momentum driven beta chasers, but the real joke is on pensioners whose contributions enrich these hyped-up money managers.
In the weeks ahead, I am going to use publicly available 13-F filings to show you exactly where "elite" hedge funds (many of which are closed) have been making their money and where they're placing their bets in the stock market (bulk of money still goes to L/S equity hedge funds).
If pensions had half a brain, they'd pull the plug on hedge funds and use the information I provide them on this blog to beat hedgies at their own game at a fraction of the cost.
I'm also very concerned about the concentration of money going to a few well known hedge funds. This is a recipe for disaster because when the next major shock occurs, these mammoth funds could get whacked hard. This is why some of the smarter institutions are going against the current and carefully seeding new hedge funds.
Below, Tony James, president of Blackstone Group LP, talks about criticism of private-equity firms and impact on the industry. James, speaking with Erik Schatzker and Stephanie Ruhle on Bloomberg Television's "InsideTrack," also discusses investment strategy. Blackstone is one of the best alternatives shops in the world, investing in private equity and hedge funds.