Beaten Down Hedge Funds Fight Back?
Hedge fund managers pocketed 28.1 percent of profits generated by their funds over the past 18 years, new research from London's Imperial College found.
The research, commissioned by KPMG and hedge fund industry body the Alternative Investment Management Association, found investors' share of annual profits delivered by hedge funds from 1994-2011 was 71.9 percent.
It also found funds delivered an average annual return of 9.07 percent from 1994-2011, compared with 7.27 percent from global commodities, 7.18 percent from stocks, and 6.25 percent from global bonds.
"This research ... disproves common public misconceptions that hedge funds are expensive and do not deliver," said Rob Mirsky, head of hedge funds at KPMG in Britain.
The study, which assumed average hedge fund fees of 1.75 percent and performance fees of 17.5 percent, followed the publication in January of 'The Hedge Fund Mirage' by fund manager Simon Lack.
The book, which prompted a swift rebuttal from the hedge fund industry, said hedge fund managers themselves had earned 84 percent of returns delivered by their funds from 1998-2010.
The study found a relatively high level of correlation between hedge funds and global stocks, particularly during recessions.
The findings come after a 2011 in which funds lost money as markets fell on worries over the euro zone debt crisis and a first quarter of 2012 in which a market rebound has fuelled a resurgence in fund performance.
Correlations between hedge funds and global stocks were 0.87 during recessions and 0.77 outside recessions. A score of 1 indicates a perfect correlation.
The highest correlation was between equity hedge funds - one of the most popular strategies - and global stocks during recessions at 0.91.
You can read AIMA's study, The value of the hedge fund industry to investors, markets and the broader economy, by clicking here. Sam Jones of the FT also reports, Hedge fund industry fights criticism:
The hedge fund industry has never been bigger.
According to figures released last week, hedge funds now manage more than $2.13tn in assets on behalf of their clients. Gone too are the merely superwealthy: the majority of hedge fund investors are now pension funds, insurance companies or other sophisticated institutions.
But this does not mean that hedge funds are better. Last year was the second-worst year for hedge funds on record. The average fund manager lost 5.25 per cent in 2011, a drawdown only worsened in 2008. The post- crisis world has been unkind.
Indeed, for many, such numbers underscore an unpleasant truth: hedge funds are expensive follies
The criticism is not new, but in recent months, fuelled by the performance dip and a number of high-profile losers – John Paulson’s damaging 51 per cent loss, the industry’s worst ever in absolute terms, for example – it has been growing in volume.
Simon Lack, a former JPMorgan banker, has become one of the hedge fund industry’s most vocal critics thanks to his book, The Hedge Fund Mirage, which has enjoyed popularity beyond the rarefied hedge fund enclaves of Mayfair and Connecticut. Last year was the ninth consecutive year that a simple 60:40 stock and bonds portfolio outperformed the average hedge fund, according to Mr Lack.
Even the very notion of hedge funds as “alternatives” in any investor’s portfolio is beginning to come into question. Since 2008, the average hedge fund’s performance has very closely mirrored that of equity markets, apparently giving lie to the promise of de-correlated returns.
Faced with such challenges, the industry is keen to fight back.
The Alternative Investment Management Association is today set to release data, drawn up in conjunction with KPMG by academics at Imperial College, that it hopes will draw a line under the debate.
Hedge funds have, on average, returned 12.61 per cent annually, the research will show: 3.54 percentage points of which is skimmed off by managers as fees, leaving investors to pocket an average 9.07 per cent annual return.
The numbers are hardly of the sensational, shoot-the-moon, type that the hedge fund industry is perhaps best known for, but they are consistent, and they are better than most other asset classes, Aima says.
“This analysis covers 17 years and demonstrates that over that period hedge funds significantly outperformed traditional asset classes,” says chief executive Andrew Baker. “Of course, during that timeframe there will have been individual years when hedge funds were outperformed, but this research looks at the bigger picture.”
A 60:40 stock and bond portfolio may well have done better than hedge funds in recent years, but an equally split hedge fund, stock and bond portfolio would have done the best, the research notes.
According to Robert Kosowski, director at Imperial College’s Centre for Hedge Fund Research, the quality of the returns hedge funds deliver also stands out.
Data analysed by Mr Kosowski show an annual “alpha” – an industry buzzword that refers to the returns delivered by a manager’s skill rather than extraneous forces such as leverage or market direction – of slightly more than 4 percentage points.
Only 1.32 percentage points of hedge fund returns above a passive benchmark are, meanwhile, due to beta, or market risk factors, according to the research.
The question, as always, however, remains how such returns can be accessed. The average hedge fund does not exist in practice, and there are plenty of managers whose skills may not prove all that they seem.
“There are high-profile blow-ups or losers in just about every asset class you can invest in,” Robert Mirsky, head of hedge funds at KPMG, nevertheless points out. “Hedge funds are no better or no worse, from that point of view.”
More critically, perhaps, the Aima research comes as part of a broader drive at Imperial College to map, for the first time, an accurate “index” of hedge funds.
Traditional indices – of which there are several – are consistently criticised for overstating hedge fund returns.
Funds that implode or suffer negative performance may simply stop reporting figures to the databases, for example, flattering the picture of the industry as a whole, a phenomenon known as survivorship bias.
“Survivorship bias gets a lot of attention,” says Mr Kosowski.
“Some funds drop out because they have bad performance, but some funds also drop out because they have good performance,” he says. “The two actually cancel each other out.”
The hedge fund industry’s fiercest critics may not be silenced by such findings. But with most hedge funds already having made significant gains so far this year – and enthusiasm for hedge funds from big institutional investors remains undimmed – the industry may not actually need them to be.
Bloomberg reports Japanese pension funds plan to boost investments in alternative assets even after the fallout of AIJ Investment Advisors Co., which just confirms the insatiable institutional appetite for hedge funds and other alternative investments.
But as I mentioned last Friday in my comment on record hedge fund assets and food stamps, now more than ever, investors need to be vigilant on all hedge funds, including "superstar" managers. Far too many investors are falling for the 'placebo effect' of large hedge funds, erroneously believing that if they shove billions into large brand names, they'll fare better during the next downturn.
Nothing can be further from the truth. What is going on right now is hedge funds (and other funds) are riding the big beta wave in markets, a wave that has more upside as many investors are still caught in a stay-liquid-and-wait mode.
The real value of hedge funds will come when the next crisis hits and the large asset gathering marketing con artists running their Malakia Capital Management are exposed for what they truly are while true real alpha generators keep delivering real alpha, earning their performance fees.
Fed up with high fees, some institutions are chopping down hedge fund fees. Moreover, as Caroline Linanki, editor of Nrpn (Nordic region pensions and investment news) reports in the FT, a growing number of sophisticated investors are learning to harvest hedge fund return sources without high fees:
A growing understanding of the composition of hedge fund returns is letting investors capture the return streams of hedge funds through systematic exposure to persistent risk premia (returns above the expected risk-free rate of return). This provides investors with diversification away from equity market risk in a low-cost, liquid and transparent manner, but without the downsides of investing in a hedge fund.
For a long time, hedge fund returns were believed to derive purely from manager skill and clever investment decisions based on active management. However, the academic literature has identified that it is not so much skill as exposure to certain return sources that can explain the majority of returns in certain hedge fund styles.These alternative risk premia, the beta, or market components of many hedge fund strategies, can now be accessed through far more transparent structures than the typical black-box strategy that comes with hedge fund investing.
“There are a number of persistent risk premia that are uncorrelated to traditional beta,” says Yazann Romahi, executive director, global multi asset group at JPMorgan Asset Management. “A lot of these are typically exploited by hedge fund managers, but wrapped up in illiquid, expensive and opaque vehicles. But there’s nothing fundamentally illiquid about the underlying investments themselves or the underlying risk premia.”
The proponents of alternative risk-premia investing believe the attraction lies in the genuinely uncorrelated returns that it offers.
“The domination of equity market risk is a significant theme for institutional investors across the world and this is one way of reducing it in the portfolio,” says Antti Ilmanen, managing director at AQR Capital Management. “For many investors there is a huge correlation in portfolio returns and equity market movements. And diversifying into hedge funds doesn’t work. Over the last 10 years, the correlation of major hedge fund indices with global equities has been 0.77-0.88 per cent.”
Rather than trying to make money from active investment decisions, alternative beta is about systematic ways to capture the common risk factors behind hedge fund strategies. In other words, instead of timing or trying to forecast the market, it is about systematically harvesting the return sources over time.
PKA, the DKr160bn ($28bn) Danish administration company for five pension funds, and AP2, the SKr216.6bn ($32.1bn) Swedish national pension fund, are two of the pioneers in this area.
Both are in the process of implementing portfolios that look to capture alternative risk premia. The pension funds have been driven by the search to diversifying equity market risk but also share a fundamental scepticism about hedge funds.
PKA’s project to set up a portfolio of risk premia is an isolated equity project and is looking to both capture traditional and alternative risk premia in equity markets. AP2 has taken a different approach and is looking to implement a multi-asset class portfolio of alternative risk premia.
For AP2, capturing alternative risk premia is seen as a way to give the fund cheap exposure to valuable systematic risk factors rather than chasing expensive alpha.
“It’s not that we think alpha doesn’t exist. But it would be naïve to think that alpha would be cheap. By definition, there must be a shortage of pure alpha, so it will be expensive. And it’s also difficult to identify those managers and then knowing if the alpha will persist,” says Tomas Franzén, chief investment strategist at AP2.
The growing interest in alternative benchmarks and investing along risk premia in the long-only space is a related discussion. Both traditional and alternative betas are the result of exposure to systematic risks in capital markets, but alternative beta is more complex. While traditional risk premia can be captured by long-only investing, capturing alternative risk premia requires short-selling, leverage and the use of derivatives. However, long/short risk premia and factor indices are starting to emerge.
An important distinction is the difference between hedge fund replication and alternative beta strategies. While the latter is a bottom-up collection of strategies, hedge fund replication has come to mean top-down replication of hedge fund indices.
“I think the industry has been sent off on a tangent because of the hedge fund replicators. Ironically they delayed the growth of the industry,” says Mr Romahi. “We’re not replicating indices. Our aim is to take out the traditional beta and concentrate on the factor exposure. What’s important is whether we can use the common-factor risk exposures in hedge funds and invest like they do. It’s a subtle but very important difference.”
And crucially, as Mr Ilmanen points out, hedge fund replication strategies will replicate the high correlation with equity markets. “We should instead try to do what’s good in hedge funds – which is the alternative beta part – and come up with a combination of alternative beta strategies that doesn’t have 0.8 correlation but 0.2 correlation to equity markets,” says Mr Ilmanen. However, not all investors are convinced of the existence or persistence of alternative risk premia. One of them is the €31.9bn Finnish pension company Varma, the Nordic region’s largest hedge fund investor with 11 per cent of assets allocated to the asset class.
“We’ve been following the development of the alternative beta space for years,” says Jarkko Matilainen, director of hedge funds at Varma. “There are three strategies where we can easiest argue that there is some alternative beta and where I think it’s applicable: merger arbitrage, convertible arbitrage and trend-following strategies.
“I have difficulty buying the argument that other strategies are capturing alternative beta,” he says.
He is also not convinced that having a systematic exposure to these risk premia is the best approach.
“For me, it’s simple. I don’t want to be invested in convertible arbitrage or merger arbitrage all the time, only when the risk premia is high. Those strategies are quite commoditised and I’m not sure if there’s any risk premia left or if there is enough all the time. You should look to time it rather than participate the whole time. We have outsourced a large part of the timing decisions to the multi-strategy hedge fund that we are invested in,” he says.
But Mr Matilainen does not close the door completely on Varma’s prospects of using alternative beta strategies.
“If alternative beta can be replicated in a reasonable and rational manner then maybe it would be interesting for us. It could also be used as a liquid way to gain exposure if we wanted to make quick changes in strategies,” he says.
Widespread adoption of alternative beta investing would be likely to pose a threat to the traditional hedge fund model. If a significant part of hedge fund returns is beta and not skill, can the industry really justify the existing high fees?
Mr Franzén is clear. “Hedge funds have a fee structure appropriate for true alpha generation while most returns come from systematic risks. We want to get paid for taking systematic risk, not pay for it,” he says.
Mr Ilmanen says an increased understanding of alternative beta is offering investors a weapon when trying to negotiate better fees.
“It’s easier for the hedge funds to charge 2 and 20 when it’s all mystical and magical. When you explain and demystify the returns, it pretty much leads you to lower fees and that’s not in the interest of the industry,” he says.
Mr Franzén agrees: “There are various stakeholders within this discussion and parts of the asset management industry do not want to hear about this. In the end, it comes down to evaluating a business model. If everyone started arguing along these lines, large parts of the hedge fund industry would have problems with their business model.”
I'm not a big believer that "alternative beta" is the way to go. Let's be brutally honest, even if you can capture some of the risk premia in some hedge fund strategies, what exactly are you capturing?
Also, no matter how good you are, you'll never come close to beating top multi-strategy hedge funds which are the best of the best at dynamically allocating across alpha strategies. Investors chasing 'smart beta' should read this previous comment of mine.
Sophisticated Canadian, Dutch and Danish pension funds are properly compensating their managers to deliver internal alpha across public and private markets. They will only go to outside managers and pay fees for alpha they can't replicate internally. And the very best pension plans like ATP and HOOPP hardly use external funds and don't need to bother with "alternative beta" because they have mastered the intelligent use of derivatives to manage their assets and liabilities.
Other top global pension plans like Ontario Teachers' delivered stellar results in 2011 by producing alpha through internal and external managers. And some top global pension funds, like APG, changing without regret, are adopting innovative internal and external strategies like seeding top alpha managers.
I cannot overemphasize the importance of seeding alpha managers in this environment. If done properly, using selective fund of funds, institutions will get better terms (not just lower fees) and a better alignment of interest as smaller hedge fund managers typically outperform their much larger rivals.
Will end my comment by making another shameless plug for Quebec's absolute return funds and ask you to please read that post carefully, including the update at the end. If you require more information, contact me directly at LKolivakis@gmail.com.
Below, Ken Heinz, president of Hedge Fund Research Inc., talks about the performance of global hedge funds. He speaks with Linzie Janis on Bloomberg Television's "The Pulse." And Philip Vasan, head of prime services at Credit Suisse Group AG, talks about the outlook for hedge funds and global markets. He speaks with Erik Schatzker, Stephanie Ruhle and Scarlet Fu on Bloomberg Television's "InsideTrack."