Are Smaller Hedge Funds Buckling?
Citadel LLC and CQS (U.K.) LLP are among global hedge funds providing refuge to managers in Asia as smaller firms struggle to raise money.
Agus Tandiono returned to Citadel, the $13 billion firm run by Kenneth Griffin, in January following the closure of a fund he managed, said a person with knowledge of the move. Sanjiv Bhatia joined CQS, which oversees $11.6 billion, after winding down his Hong Kong-based fund in December.
Asia-focused managers have struggled to gather capital as market volatility increased and clients became more selective following the global financial crisis and the Bernard Madoff scandal. Investors directed almost 80 percent of new capital to hedge funds overseeing more than $5 billion in the 15 months to March, according to Hedge Fund Research Inc.
“Unless you get to $100 million pretty early on, it’s very hard now to survive,” said Richard Johnston, Hong Kong-based Asia head of Albourne Partners Ltd., which advises investors on hedge funds and other alternative investments. “You’re better off working at a big multistrategy fund or platform manager.”
Of 308 Asian hedge funds started since 2009, 74 percent have failed to boost assets “significantly,” according to Eurekahedge Pte. Of those funds, 51 have been liquidated, according to the Singapore-based research firm, which tracks 1,314 hedge funds that focus on the region or are based in Asia and have a combined $128 billion in assets.
Competition for capital intensified in Asia as more hedge funds were set up to take advantage of the world’s fastest growing economies. Potential clients have held back after funds suffered two of their worst years in the past four years amid Europe’s sovereign debt crisis, concerns that the U.S. economic recovery is faltering and a slowdown in China.
“There is no doubt that the break-even level for funds has risen and startups need to manage their cash flows carefully whilst proving to potential investors that they have enough of an institutional infrastructure,” said Mark Wightman, global head of alternatives strategy at SunGard, a provider of trading systems for financial firms, in Singapore.
Direct allocations from institutions such as pensions and endowments now account for a larger share of the inflows into hedge funds, and they tend to prefer bigger and more established managers, said Max Gottschalk, co-founder of Gottex Fund Management Holdings Ltd. in Hong Kong, which allocates $7.6 billion to hedge funds.
Managers are further pressed to build and maintain large investment and operational teams, and systems to meet the more stringent demands of institutional investors, he said.
An estimated 775 hedge funds globally closed down last year, 4 percent more than in 2010, as institutional investors directed most of the new capital toward the largest managers, according to Chicago-based HFR data.
Tandiono started the first equity fund for Income Partners Asset Management Ltd. in July 2009, as the manager of debt and macro funds attempted to widen its offerings. The $25 million fund closed mid-2011 because “it was very difficult to raise money,” said Francis Tjia, a managing partner at the Hong Kong- based company, which has $1 billion in assets.
Tandiono, 40, first joined Citadel in early 2006 as an analyst and became the head of Asia equities later that year. He left in 2008 when the Chicago-based hedge fund reorganized in the region. Devon Spurgeon, a spokeswoman at Citadel, declined to comment. The person familiar with Tandiono’s hiring asked not to be identified because the information is private.
Bhatia, a former trader and risk manager at Goldman Sachs Group Inc. (GS) in London and Hong Kong, left Minneapolis-based Deephaven Capital Management LLC in July 2008 to start Isometric Investment Advisors Ltd. Bhatia, 41, said he closed the hedge fund in December after FRM Capital Advisors Ltd. in London, which accounted for about 80 percent of his fund’s assets, decided to invest its money elsewhere.
Investors added $18.3 billion of new capital to managers with at least $5 billion of assets in the first quarter, data from HFR show. Smaller managers with assets below that threshold suffered a combined outflow of almost $2 billion.
About 62 percent of the Asia hedge funds tracked by Eurekahedge oversee $50 million or less.
Still, some managers will seek to capitalize on reputations they built at global firms or within investment banks to establish their own funds, said Graham Seaton, Hong Kong-based Asia-Pacific head of prime brokerage at Bank of America Corp.’s Merrill Lynch & Co. unit.
“They may feel more able to generate alpha with smaller assets under management and more nimble strategy,” he said, referring to the excess return funds earn over performance benchmarks such as a stock index. “The other attraction is to have their own names on the door.”
I agree with Richard Johnson of Albourne Partners, unless you get to $100 million pretty early on, it’s very hard now to survive. I would add that unless you have a good chunk of your own money to start operations, you'll struggle and close shop fairly quickly.
In this environment, good luck raising assets as a start-up or small hedge fund. Most pension funds are cutting risk across the board and only investing in "brand name" funds in their alternatives portfolio.
Most of the flows into large hedge funds are coming from pension funds dying for yield. Juliet Chung of the Wall Street Journal reports that hedge fund assets may rise to $5 trillion in the next five years:
The hedge-fund industry may more than double in size during the next five years, to more than $5 trillion in assets, as private fund firms broaden their offerings to compete with traditional money managers, according to a recent Citigroup Inc. C -4.87% survey.
The poll of investors, consultants and money managers predicted that hedge funds could lure $2 trillion in new money to investment vehicles long associated with mutual-fund companies and other institutional managers, including "long-only" funds that buy and hold stocks.
Pension funds and other large institutional investors may earmark an additional $1 trillion toward hedge funds as they grow more comfortable with the different risks posed by those strategies.
The predictions come as the hedge-fund industry evolves beyond its entrepreneurial, private roots to meet investor and regulator demands for greater transparency and more robust operations.
"You're not going to continue to hear the same emphasis on the star manager or the star trader" as managers look to attract large pools of money from investors, said Alan Pace, head of Citi Prime Finance business in the Americas, which wrote the report.
The unit processes trades for and lends securities to the bank's hedge-fund clients.
Many funds have had to adapt to draw money from a broader base of investors, a move necessitated by the financial crisis, said Sandy Kaul, Citi's U.S. head of business-advisory services.
More growth will come from institutional investors such as pension funds and endowments as they continue to rethink how they categorize their hedge-fund investments, the survey found.
Rather than bracket them into their "alternatives" bucket, some investors are including hedge-fund investments in broader buckets such as equity to "hedge," or protect against, downturns in the market.
Hedge-fund investments are "moving from being a side allocation for a bit of diversification to moving into the core part of the portfolio," Ms. Kaul said.
The survey is based on interviews with 73 people in the industry including institutional investors, hedge-fund managers and consultants.
Expectations for the industry's growth come even as hedge funds continue to struggle to meet investors' performance expectations
Hedge funds on average gained 2.54% this year through May, while stock-focused hedge funds on average were up 1.77%, with May losses eating into strong first-quarter gains by those funds, according to HFR, which tracks hedge fund returns.
By comparison, the Standard & Poor's 500-stock index rose 5.15% in the same period, including dividends.
The lackluster performance follows three years in a row in which hedge funds on average lagged behind the overall market—though hedge funds posted losses that were about half as large as the drop in the overall market in 2008.
Amanda Haynes-Dale, managing director of Pan Reliance Capital Advisors, a New York-based boutique fund of hedge funds, said she believed such industry growth was possible, but would depend on performance.
"Money comes in at the top and goes out at the bottom," she said. "It's human nature—it doesn't matter what the investment vehicle is."
In an environment of extreme volatility, most hedge funds are going to get killed. Only the very best will survive but institutional investors better be careful, because even top funds can experience a serious drawdown in this market.
None of this surprises me. I agree with Simon Lack, who I interviewed on my blog last month, most hedge funds are terrible and after fees, there is little left for investors to justify allocating to this space.
But even Simon Lack agrees there are excellent absolute return managers out there who earn their performance fees. And while many smaller funds are struggling to survive, others are thriving and beating their larger rivals.
The problem is that large institutional investors have all succumbed to the placebo effect of large hedge funds and in an environment of cover-your-ass politics, the herd all invests in brand names, finding refuge in doing what everyone else is doing.
To be fair, there are excellent large funds, some of which I mentioned in my tracking top funds Q1 activity, and more importantly, scale is an issue for large investors. If you're CPPIB or someone managing hundreds of billions, you're not going to waste your time investing in or seeding some small hedge fund or private equity fund.
There are ways to seed hedge funds and I've already mentioned that some of the world's best pension funds are seeding alpha managers, but they're doing it intelligently. My best advice to those who want to gain the economic incentives of seeding a hedge fund is to give some funds of funds another go, with a specific seeding mandate.
Finally, Forbes mentions the creation of a new ETF (symbol: GURU) which tracks the top holdings of top hedge funds:
Want to buy like the best hedge fund managers? A new exchange-traded fund, Top Guru Holdings Index (GURU, $15.48), offers a simplified way to become an at-home version of say, Greenlight Capital’s David Einhorn.
Unlike other ETFs using hedge fund-like strategies, Guru sticks to stocks—mostly U.S. equities, with 20% of assets going outside the States. A portfolio of some 50 stocks are selected by screening for hedge funds with more than $500 million in assets; significant allocation to U.S. equities; a top holding that’s at least 5% of total assets and low turnover. “Any fund that’s out to hold for seconds or minutes is irrelevant to our investors, so we filtered those out,” says Bruno del Ama, CEO of Global X Funds (assets: $1.5 billion), which built the ETF.
Each hedge fund’s top holding goes into the portfolio. In effect, Global X built a basket of “high-conviction ideas,” as del Ama puts it, from some of the best living investors. When Global X first constituted the ETF earlier this year, the screen found 68 hedge funds that fit the bill: big names like Paulson & Co. and Pershing Square Capital Management, as well as, yes, Greenlight. Some held the same top holding, so Guru ended up with 51 different stocks to start, and about 2% went into each. The ETF’s top holding is home-loan lender Nationstar Mortgage Holdings. It’s a wide-mix, though, that includes names like Apple, Kraft, JPMorgan Chase and Google too.
The ETF began trading last Tuesday, and finished the week up 2.5%.
Since hedge fund managers must release quarterly Securities and Exchange Commission fillings, as does any institutional money manager with more than $100 million in assets, Global X plans to rebalance Guru after each quarter, running the screen anew using the fresh data. “The fact that you have complete transparency to what John Paulson or what Bill Ackman or David Einhorn, it’s pretty amazing, right?,” says del Ama. “Because of U.S. regulatory requirements you have a huge amount of transparency of the best ideas from the best investors.”
To be sure, it’s not complete transparency. The 13-F fillings require only long positions to be reported, and it’s not as current as you might think. It’s actually a 45-day lag.
Global X faces a crowded field. There are many ETFs hoping to duplicate the success of the hedge fund industry. Many try to mimic specific investing methods, like global macro or fixed-income arbitrage. Guru separates itself from the others through its simplistic and transparent approach to owning hedge fund-favored stocks. Its costs, a 0.75% expense ratio, are in-line with competitors.
ProShares and IndexIQ offer some of the most competing ETFs, like Hedge Replication (HDG, $38.22) and Hedge Multi-Strategy Tracker (QAI, $27.26). What’s more, another ETF devoted strictly to copying hedge funds’ equities holdings launched last week too. However, AlphaClone Alternative Alpha ETF (ALFA, $25.07) offers no insight on its holdings, and tries to take the idea a step further; depending on market volatility, the ETF will split its assets evenly between long and short positions. It’s more expensive than Guru, with a .95% expense ratio.
It’s easy to understand why investors out to become Paulson 2.o are interested. Only accredited investors can buy hedge funds, and many such funds contain illiquid assets. ETFs, of course, are a very liquid investment. Grandpa can buy them through his retail brokerage account. And ETF fees are much less than what a hedge fund manager might charge.
Global X contracted another index provider, Structured Solutions, to run a roughly three-year backtest—from February 2009 to January 2012—using a basket of stocks similar to Guru’s current one. The test found Guru would have returned some 31%, while the S&P 500 returned 22%. Guru also stayed a touch less volatile, too. Del Ama declined to talk about the specifics of the backtest, citing SEC restrictions.
For sure, though, such a return would be a fine start for an Armchair Einhorn.
There you go, for those of you who do not want to pay 2 & 20 to some silly hedge fund, just park your money into GURU and you'll probably come out ahead over the long-run. Of course, in these schizoid markets dominated by macro and political events, even the best "GURUs" are finding it hard to deliver top results, so tread carefully.
Below, Bloomberg's Erik Schatzker reports that the financial crisis wiped out 18 years of gains for the median U.S. household net worth, with a nearly 39 percent plunge from 2007 to 2010 that was led by the collapse in home prices, a Federal Reserve study showed. He speaks on Bloomberg Television's "Inside Track."