Hedge Fund Masters Flunking the Test?
Generating strong returns is getting so tough for hedge fund managers, supposedly the high-earning masters of any market, that some are shutting up shop and more look poised to follow.True, banks are closing proprietary trading desks, so there are few options left for hedge fund traders but try to perform better.
Years of choppy markets whipsawed by political risk have crippled performance and left many firms with little in the way of income earned by hefty fees.
Now, with an investor base increasingly ready to pull out, several are calling it quits.
Edoma Partners, one of the most talked about hedge fund launches since the financial crisis, said on Thursday it was closing just two years after it started, hit by poor performance and a flurry of investor redemptions.
Pierre Henri-Flamand, the ex-Goldman Sachs trader turned founder, blamed "unprecedented market conditions".
Other, more veteran managers, have also decided to exit.
Greg Coffey, one of the industry's best known figures, decided to retire early and liquidate one of his funds at Moore Capital, sources said earlier this month.
That followed Driss Ben-Brahim's decision to retire from GLG, the hedge fund he joined in 2008 and now owned by Man Group.
"It's been too long that hedge funds haven't delivered what they promised," said one investor, asking not to be named.
The average hedge fund has made its clients 4.86 percent this year, data from industry tracker Hedge Fund Research shows, far below the 12 or so percent investors would have got if they bought a fund tracking the S&P 500.
As many as 73 Asia-focused hedge funds shut down this year to end-September, although Europe has seen fewer closures.
Hedge funds market themselves for an ability to protect their clients' cash against market falls, and to make money in all trading environments.
Yet over the past three years, which includes several major equity market sell-offs, the average fund is up less than 4 percent while the S&P 500 is more than 30 percent ahead.
And without returns, managers do not get the lucrative performance fees - often a 20 percent cut - they crave.
"Maybe there is some fatigue at some levels. A number of classically driven fundamental managers have been frustrated by macro dominated markets for several years...," Fred Ingham, Head of International Hedge Fund Investments at Neuberger Berman, said, although he added that there were positive signs this may now be changing.
Hedge funds use management fees, an annual charge set at 1.5 or 2 percent of assets, to pay for salaries, rent in the upmarket districts of New York or London and their trading platforms.
If assets shrink, that business model can quickly come into question.
"The space is under pressure. If you are down 7 percent over two years, without a strong financial backing, it will be hard to hire and to make returns," Olivier Kintgen, chief investment officer at Europanel Research and Alternative Asset Management, said.
In an environment of rock-bottom rates, the hedge fund fee structure can also look outdated. Handing the manager 20 percent of double-digit gains is one thing, but losing a fifth of 4 or 5 percent made this year is harder to stomach.
According to hedge fund administrator SS&C GlobeOp's forward redemption indicator, client demands to pull money out of hedge funds rose to their highest level this year in September.
The monthly snapshot of clients giving notice to withdraw their cash as a percentage of SS&C GlobeOp's assets under administration measured 3.76 percent in September, up from 3.11 percent a year ago.
However, this is far below the all-time high in late 2008, when the GlobeOp Forward Redemption Indicator touched 19.27 percent.
Investors stress that with some managers still performing well, they are more likely to reallocate money within the industry to rivals rather that withdraw completely.
Others say that despite the poor performance and falling fees, for many hedge fund traders there is no option but to try and eke out better returns.
"I think a lot of managers will try and hang on. What's the alternative? There aren't many jobs in banks for them to go into," the hedge fund investor said.
And as the article states, some hedge funds are still performing well. Reuters reports, Och-Ziff profit tops view; Oz fund net returns 9.4 pct:
Och-Ziff Capital Management, one of only a handful of publicly traded hedge fund firms, on Friday reported quarterly earnings that beat Wall Street's forecasts, fueled by higher performance fees and lower taxes.Shares of Och-Ziff Capital Management (OZM) have rallied sharply in recent months and are set to move higher, especially if they can keep up this performance. They also pay out a nice dividend.
All four of Och-Ziff's funds are in the black for the year with most beating the average hedge funds' returns. Steady and strong returns boosted assets, as did fresh demand, the company said.
As of Nov. 1, the New York-based company said it had assets of $31.8 billion, and for the year-to-date through Oct. 31 its OZ Master fund had net returns of 9.4 percent.
A strong performance at Och-Ziff's main funds is leading analysts to expect the company to earn more in incentive fees, the money paid to hedge fund managers when their funds do well.
Additional flows and the year-to-date returns of "9.45 percent for the Master Fund (is) putting (Och-Ziff) in solid position for strong performance fee generation into year-end," Jefferies analyst Dan Fannon wrote in a report.
The company, which has long been a favorite with pension funds, is in discussions to manage money for other big name clients, Daniel Och, the company's chairman and chief executive officer, said on a conference call.
For the third quarter, Och-Ziff reported distributable earnings of $61.7 million, or 14 cents per adjusted Class A share, beating Wall Street's 13 cent per share forecast. The result excludes costs associated with a reorganization in connection with its November 2007 initial public offering. A year before the company earned $49.9 million, or 12 cents a share.
Och-Ziff reported a net loss of $127.5 million, or 89 cents per share, largely due to expenses associated with the IPO-related reorganization.
The company will pay a third-quarter dividend of 12 cents a share, down from 13 cents a share for the second quarter, when incentive income was higher.
Och-Ziff's stock price was nearly flat at $10.03 in midday trading.
Other hedge funds are doing well too. In particular, funds investing in structured credit are posting very strong returns. Mary Childs of Bloomberg reports, BlueMountain to Saba Searching for Yield in Bond Exotica:
BlueMountain Capital Management LLC and Saba Capital Management LP are leading investors into the debt market’s darker corners to boost returns, buying securities from collateralized loan obligations to bonds that seldom trade.
BlueMountain, the $11 billion hedge fund firm in New York, raised twice the amount it anticipated this month from pension managers for a credit fund that buys CLOs, asset-backed securities and less liquid corporate bonds. Saba, founded by Boaz Weinstein, says CLOs are cheap compared with the underlying loans, while Citigroup Inc. sees banks “getting increasingly involved” in the securities for higher returns on capital.
Investors are casting a wider net as they face a fifth year of near-zero interest rates and bond yields at record lows amid Federal Reserve efforts to lift the economy and lower unemployment. Even the lowest-rated portions of CLOs, which were shunned after the financial crisis, are making a comeback.
“The corporate market has compressed so much, people are looking everywhere,” said Ashish Shah, head of global credit investments at New York-based AllianceBernstein LP, which oversees $230 billion in fixed-income assets. Investors such as him have “become more open” to assets like CLOs because they “haven’t compressed as much as comparable credit,” he said. “They represent remaining parts of value in the market.”
Issuance Triples
CLO issuance has more than tripled this year to a more than five-year high of $36 billion, data compiled by Bloomberg and Morgan Stanley show. The instruments, which peaked at $91.1 billion of sales in 2007, are a type of collateralized debt obligation that pool high-yield, high-risk loans and slice them into securities of varying risk and return.
JPMorgan Chase & Co. expects $45 billion of CLOs will be sold in 2012, and as much as $70 billion next year, analysts led by Rishad Ahluwalia said in a report dated Oct. 19.
“During hot markets, bankers will typically slowly start pushing the envelope little by little, introducing either lower credit quality or increasingly esoteric structures to get a sense of the market’s acceptance,” Adrian Miller, director of global market strategy at GMP Securities LLC in New York, said in a telephone interview. “There’s still room to go with structured credit.”
The article goes on to explain how some pension funds are jumping on board, investing in funds that specialize in CLOs, but others are still cautious, especially after 2008:
JPMorgan predicts that relative yields on top-rated portions of CLOs will drop to 125 basis points more than the London interbank offered rate by the end of the year, compared with coupons on new deals last week of as much as 143 basis points over the benchmark, analysts Ahluwalia and Maggie Wang wrote in the Oct. 19 report. Spreads will continue to narrow to 100 by the middle of 2013, they said.
“Some CLOs issued before 2008 are still undervalued comparing to the underlying assets,” James Wang, a money manager at Saba in New York, said in a telephone interview. Wang said he likes debt from older CLOs, which “are more stable because they are short-dated” and “have relatively low volatility compared to the average CLO.”
BlueMountain raised $1.5 billion, double its target, for its Credit Opportunities Master Fund I that invests in structured corporate credit including CLOs, asset-backed securities and less liquid corporate credit. Investors were primarily pension funds in the U.S., Canada, Japan, and Europe, Stephen Siderow, the fund’s president and co-founder, said in an interview last week with Deirdre Bolton on Bloomberg Television’s “Money Moves.”
Attracting Pensions
“We actually don’t think you have to take on that much more risk to enhance your return,” Bryce Markus, a money manager at BlueMountain, said in a telephone interview yesterday. “You need to forego liquidity and possibly accept complexity but not necessarily greater market risk. For longer- duration capital we think these types of assets make a ton of sense.”
Pension managers were particularly attracted to the fund because they traditionally have had long-dated liabilities and shorter-dated, more liquid portfolios, said Markus, a managing principal at the firm.
“We are seeing more and more pension funds embrace that type of investing, where they see significant returns from moving into longer-dated, less liquid investments,” he said.
BlueMountain also bought a portfolio of assets from synthetic collateralized debt obligations, backed by derivatives bets on the creditworthiness of borrowers, from Credit Agricole SA (ACA), Siderow said last week in the Bloomberg Television interview.
Likely Tempered
“There will be more of those types of transactions” as U.S. and European banks cut risk and raise capital to comply with more stringent global capital requirements and the Dodd- Frank Act in the U.S., he said.
The Fed’s resolve to hold interest rates at about zero for another three years has pushed yields on corporate debt to the lowest ever. Bonds with maturities from one to three years have returned 4.1 percent this year, compared with 11.7 percent for debt with seven- to 10-year maturities, according to Bank of America Merrill Lynch index data.
The move back into structured credit is likely to be tempered by the outsized losses they left investors with during the crisis four years ago, said Noel Hebert, chief investment officer at Bethlehem, Pennsylvania-based Concannon Wealth Management LLC, which oversees about $250 million.
Institutional investors “won’t soon wade back into that pool regardless of yield -- too much career risk,” he said. “The one unforgivable sin is to get pinged by them again,” so it’s more hedge funds or more aggressive fund managers that are investing now, he said.
‘Terrible’ Cycle
As opportunities in older CLOs diminish amid spread- tightening and maturities of existing bonds, investors are migrating toward new deals, said Robert Cohen, a senior credit analyst at Los Angeles-based DoubleLine Capital LP, which oversees $45 billion in assets.
“The CLO structures have worked and they’ve survived a terrible credit cycle,” he said. “As those prices tighten up with the rest of the market, it makes people think about investing in new deals, plus a new deal has the benefit of new collateral and fresh portfolio quality and coverage tests as well,” Cohen said.
Yields on the top-rated tranches widened to as much as 725 basis points seven months after the September 2008 collapse of Lehman Brothers Holdings Inc., Morgan Stanley data show. Spreads on benchmark U.S. CLO portions rated AAA trade at 130 basis points, JPMorgan said in the Oct. 19 note.
‘Cheapest’ AssetsI've already discussed how the hunt for yield is pushing funds back into CLOs. Keep an eye on Blue Mountain, Saba and other funds investing in structured credit but be warned, as more money enters the space, yields will be compressed. Moreover, if economic conditions significantly deteriorate, these funds will likely experience sizable losses (however, as I predicted, the US economy is improving).
“CLO AAAs are one of the cheapest highly-rated assets” with “negligible credit risk,” the JPMorgan strategists wrote last week.
Some funds that buy speculative-grade debt are allocating money to lower-ranking investment-grade portions of CLOs “because they’re getting similar or higher yield and they’re getting the fact that CLO A has subordination below it to protect them from some default losses,” which explains some of the rally in that slice, Citigroup analyst Ratul Roy said in a telephone interview.
In the past, “there was limited equity capital available so managers needed to bring most or all of the equity do get a deal done,” DoubleLine’s Cohen said. “Now managers are able to get deals done with substantially less, with third party capital, so that’s helping to drive new issuance.”
As you can see, while some hedge fund 'masters' are closing shop, others are doing fine. The very best managers will adapt and thrive, but most hyped up hedge fund hipsters will fail and vanish.
Below, Stephen Siderow, co-founder of BlueMountain Capital Management LLC, talks about investing in corporate structured debt and his strategy for the asset class. And Bloomberg's Nathaniel Baker talks about the European debt crisis and hedge funds. They both speak with Deirdre Bolton on Bloomberg Television's "Money Moves."