Hedge Fund Darwinism?
At least six hedge-fund firms announced plans to close in November and two more joined the list this week, underscoring the shakeout hitting the industry from uncertain markets, tighter regulation and what some fund managers say are investors with ever-shorter time horizons.Svea Herbst-Bayliss of Reuters also reports, Hedge fund Diamondback to close after clients pull out:
Some funds were hit by large requests from investors for cash, but others were just struggling to make money, fund managers and industry consultants say.
"If you look at the managers that have closed, there is not much commonality," said Michele Gesualdi, a fund manager at Kairos Partners, a fund of funds firm that invests in a range of hedge funds the same way that a mutual fund builds a portfolio out of many stocks. Recent shutdowns "demonstrate a tough time for the industry in general, regardless of strategy. Probably next year it will be even worse in terms of closures, but reduced competition should help performance improve."
Globally, 424 funds were liquidated in the first six months of 2012, 14% more than in the same period in 2011, according to data provider Hedge Fund Research. It hasn't yet published figures for the third quarter, but if the six-month pace holds, it would top the number of closures in both 2010 and 2011.
Many funds are struggling to do better than stocks and bonds. The average hedge fund was up 4.53% in the first 10 months of this year, on track to lag returns in major stock markets for the fourth year in a row, according to HFR. The Standard & Poor's 500-share index returned 14.28%, including dividends, in 10 months, while the Barclays Capital Government/Credit Bond Index rose 5.04%.
To be sure, investors—and almost all of them are big pensions and other institutional investors—don't appear to be giving up on the industry. Hedge funds manage a record $2.2 trillion at the end of the third quarter, up from $2 trillion at the end of 2011.
"Closures this year have been death by 1,000 cuts: a drip-drip of underperformance rather than a spectacular blowup," said Guy Wolf, a strategist at brokerage firm Marex Spectron. "The dominance of macroeconomic concerns and increased intervention from policy makers means that markets have become less fundamentally driven," with investors instead moving in and out of risky assets on the prevailing economic sentiment. "Many managers who have built their names, reputations and careers in a pre-2008 environment are struggling in this new paradigm, and the attrition rate will increase."
Among the fund managers that have said in recent weeks that they will shut down are Edoma Partners, Ridley Park Capital, OMG Capital, and, more recently Apson Capital, all in London. In the U.S., Grant Capital Partners, Weintraub Capital Management and Kleinheinz Capital Partners said last month that they would do the same.
On Thursday, U.S. hedge fund Diamondback Capital Management told investors that it would close and return money to investors. The company, which at its peak managed $6bn in assets, had been making money this year but faced redemption requests for Dec. 31 equal to 26% of its remaining assets and would shrink to $1.45bn. It also agreed in 2011 to pay the government more than $9m to resolve insider-trading allegations, while entering into a nonprosecution agreement with the Justice Department.
The decision to wind down the fund was based solely on the decline in assets under management and not related to any new regulatory situation, according to a person familiar with the situation.
Pierre-Henri Flamand, a former Goldman Sachs proprietary trader, set up Edoma two years ago to trade on mergers, takeovers, restructurings and initial public offerings, or what is know an event-driven strategy. But the dearth of deal activity hurt. He said he was shutting down Edoma's event-driven hedge fund "because I don't think I can make money in this environment."
Edoma's assets had fallen from more than $2bn at its peak to $855m, with further redemptions in the pipeline.
At Grant Capital, founder Geoff Grant decided that he didn't have an "edge" with his "global macro" strategy in today's markets. Such managers bet on big economic trends and policy decisions. But have found it difficult to time the frequent ups and downs of markets in which swings are often driven by announcements from politicians or central bankers.
A spokesman for OMG Capital, an equity trading boutique, said its "strategy doesn't work in the current environment," in which investors are swinging between liking and loathing riskier assets. OMG's strategy doesn't take a view on the direction of stock markets. An investor in Apson said the "lack of trends and low volatility across asset classes" had made it challenging for its equity strategy to make money.
More hedge fund closures are expected.
"In strategies where the average performance has been good, individual funds that have underperformed on a two-year basis and don't have critical mass will come under pressure," said Danny Caplan, Deutsche Bank's European head of global prime finance, which provides services to hedge-fund firms.
Recent closures have at least been orderly, a far cry from the spectacular blowups of hedge funds such as Long Term Capital Management in 1998, Amaranth Advisors in 2006 and Peloton Partners in 2008, all of which suffered huge losses and widespread investor redemptions before exiting the markets.
"Before it was death through blow-up or dramatic loss of assets. Now it's death through petering out," said Chris Jones, managing director and head of alternatives at consultant bfinance.
Adding to the trading challenges faced by hedge funds, many investors are demanding more frequent performance reporting, better liquidity and steadier returns, without adjusting their return expectations.
"Hedge-fund investing should be about finding a manager you believe in, understanding their investment philosophy and sticking with them over the long term, through periods of underperformance," said one hedge fund manager.
Investors are asking managers to think long term but then judging them over the short term, said Marex Spectron's Wolf. "It is not enough for managers to be confident that their long-term view is correct—they have to stay in business long enough to be able see their view play out. This is changing the way they invest".
Moreover, hedge funds, once essentially unregulated, are getting more attention, another factor dissuading their managers. In the U.S., regulations that took effect earlier this year require managers with more than $150m in assets must tell the Securities and Exchange Commission about their investors and employees, the assets they manage, potential conflicts of interest and their activities outside of fund advising.
Hedge fund Diamondback Capital Management, one of a handful of firms embroiled in a government insider trading investigation, told investors it would close down after nervous clients demanded the return of more than a quarter of its assets.The articles above don't shock me. Hedge funds were on the ropes last year and as smart money falls off a cliff, many funds are too weak to survive another annus horribilis.
Richard Schimel and Larry Sapanski, the firm's co-heads, broke the news to clients in a letter Thursday just three weeks after investors asked Diamondback to return $520 million, five times the amount top executives had expected.
As assets dwindled to $1.45 billion from about $5 billion two years ago, the firm's business model was in jeopardy and executives had to decide between closing the firm down or trying to engineer a second big restructuring within 18 months.
"Rather than continue to manage investor capital while undertaking to restructure the firm to manage this reduced level of assets, we have decided that the most prudent course is to wind down and terminate the funds and return investor capital," the two men wrote in the letter, a copy of which was obtained by Reuters.
Diamondback expects to lay off nearly all 133 employees. A small number will stay to manage the final liquidation, the people familiar with the matter said.
Founded by Schimel, Sapanski and a third partner, Chad Loweth, in 2005, Diamondback had been an industry darling.
Its three founders had all worked at Steven A. Cohen's successful SAC Capital Advisors, giving them the kind of pedigree that attracted some $6 billion of assets from marquee clients like the New Mexico's pension fund and Blackstone Group's powerful fund-of-funds unit.
BUCKING THE TREND
The fund's returns were strong with an average annual return of 9 percent since 2005, boasting gains even during the financial crisis when many hedge funds were in the red. There was only one down year - 2011.
But two years ago, the firm's fortunes plunged when federal agents raided its Stamford, Connecticut-based headquarters, shepherding employees into a conference room, taking their cell phones, and spending hours boxing up documents.
With Diamondback swept up in the government's fast-moving insider trading probe into how managers might be using illegally obtained tips to make million-dollar trades, many investors got cold feet and ran for the exits.
The probe had already led to the arrest of Galleon Group founder, Raj Rajaratnam, in 2009 and would later lead agents to Cohen's SAC, where seven former SAC Capital employees have now been implicated or charged. Last week, SAC told its clients it would likely face civil securities fraud charges.
Diamondback's founders and the firm were never accused of any wrongdoing, but many clients left, and the company gradually shrank.
In January, when Todd Newman, a former Diamondback portfolio manager, was arrested in Boston, the news turned worse for the firm. Although executives promptly fired him after he came under a cloud and cooperated with the government investigation, the fact that Newman's trial coincided with investor redemption notices that were due hurt the firm, a person familiar with the matter said.
So managers began selling assets and moving into cash in order to return the bulk of client money by mid-January.
Yahoo! Inc, Capital One Financial Corp and American International Group Inc were among the firm's biggest holdings at the end of the third quarter, according to securities filings.
CLOSING THE LOOP
Diamondback's liquidation now closes the last chapter of four firms that were surprised by FBI raids in November 2010, when the government's probe picked up speed.
The other firms - Level Global Investors, Loch Capital Management and Barai Capital - unraveled quickly. Diamondback, however, vowed to stay in business, helped by powerful investors like Blackstone Group's ongoing support.
But by November 15, the date for investors to decide whether they would stay or go, there was a tough decision to be made.
While Diamondback was delivering respectable returns of 7 percent after having returned an average of 9 percent a year since its founding in 2005, Newman's trial was playing out in a Manhattan court room.
Even though Diamondback's founders would not be prosecuted in the matter, there was a lot of headline risk. The firm had agreed to pay $9 million to settle civil charges that Newman, who made technology investments from Boston, and Jesse Tortora, a former Diamondback analyst, were making illegal trades.
Diamondback joins a large number of funds that have recently decided to get out of the business for a variety of reasons. John Kleinheinz is shutting Kleinheinz Capital because, he said, he wasn't having fun running the fund anymore, and Pierre-Henri Flamand, who set up Edoma Partners after leaving Goldman Sachs, said he could not make money in the current tough market environment.
At the same time, tougher regulations have also put a crimp in some traders' operations, industry experts said. And the government's insider trading case is expected to continue for some time at least.
Diamondback's founders are SAC Capital alumni. They know all about the perfect hedge fund predator and how tough and competitive this industry is. And now that Steve Cohen is on the hot seat, rich vultures are circulating to see if they can buy some of his prized art collection.
Have to laugh when I read media articles on how Steve Cohen treats his portfolio managers like stocks. So what? How is that any different from trading at Brevan Howard or other elite hedge funds? People that go work at these shops aren't naive, they know exactly what they're getting into. If they perform, they're richly rewarded and if they don't, they're out (the smart and lucky few take their winnings and leave while they're up to start their own fund).
That's why I won't shed a tear for Diamondback's founders, Steve Cohen or his portfolio managers. They made their fortunes during the good years of hedge funds. Unfortunately, those years are over. Some large investors have begun a crusade against external fees for private equity and hedge funds, and others will follow.
Of course, the hedge fund industry is far from dead, which is why I take media articles on the enormous unraveling of hedge funds with a shaker of salt. While few are belting homers, the hunt for yield is intense, pushing institutional investors back into structured credit.
Moreover, the industry is becoming increasingly more competitive. The Globe and Mail reports that some of the world’s top computer-driven hedge funds (CTAs) are buying exchange memberships to trade directly on the biggest commodities and financial futures markets, saving on the sizeable commissions normally paid to brokers:
Eager to improve returns and keep details of their “black box” trading strategies as secret as possible, so-called CTA (commodity trading advisor) funds are buying exchange membership seats for hundreds of thousands of dollars.No wonder bankers are jumping ship to hedge funds. They see the writing on the wall and think it's best to join their hedge fund customers or risk being left behind.
These include Winton Capital, one of the world’s largest with $29-billion of assets, and Cantab Capital with $4.5-billion.
Direct membership allows these funds, which can make hundreds of trades a day, to dodge broker commissions which often run into tens of thousands of dollars a week for the most active funds, one futures broker said.
Cambridge-based quantitative fund Cantab Capital said it spent in September more than $1-million on three seats at the Chicago Mercantile Exchange (CME), the world’s largest futures market, where it puts through at least half of its trades.
“We estimated what we have executed over the past year and worked out that we would make back the cost of the three seats in less than six months,” said founding partner Ewan Kirk.
“There is a lot of talk about trading costs at the moment and everybody should be focused on getting the lowest cost possible.”
Winton became a member of the CME last July, according to a notice on the CME Group’s website. Winton declined to comment.
Broker revenues have been boosted in recent years by the rapid growth of the CTA industry, which more than doubled in size between 2009 and 2011 to $188-billion, according to Hedge Fund Research.
But if more hedge funds were to take up exchange membership the largest futures brokers could lose tens of millions of dollars in commissions.
The world’s top futures brokers include Goldman Sachs , JP Morgan, Morgan Stanley, UBS and Newedge – owned by Societe Generale and Credit Agricole.
These firms declined to comment on the trend. A spokeswoman for the CME Group also declined to comment.
But while there are many excellent hedge funds, most of them are nothing more than glorified asset gatherers burning investors and eating them alive on fees. They lost the magic and are flunking the test. What worries me is there are still plenty of hyped up hipsters preying on ignorant institutional investors.
Tatiana over at MCM Capital Management tells me she's been busy flying to New York, London and Geneva, attending silly hedge fund conferences, wining and dining investors horny for hedge funds. Her cousin Yuri and his friend Igor are also busy "reverse engineering" portfolios of top hedge funds in my latest ultimate 13F guide, looking for long and short ideas.
Yes folks, believe it or not, even after 2008, the alternatives party continues but most of the underperformers and hipsters will crumble and die as hedge fund Darwinism crushes them.
Below, Simon Lack, founder of SL Advisors, talks about the performance of the hedge fund industry. He speaks on Bloomberg Television's "Money Moves." Listen to him carefully or you too will get burned investing in hedge funds.
Also, Tom Hill, a vice chairman at Blackstone, discusses hedge fund market conditions with Bloomberg's Cristina Alesci at the Blink Hedge Fund Summit, telling her hedge fund assets will hit $5 trillion in five years (this makes Tatiana at MCM Capital Management very happy).
Finally, Bloomberg's Scarlet Fu looks at the performance of small and large hedge funds. She cites PerTrac research which finds the average small fund outperforms the average large fund during long periods. Indeed, some smaller hedge funds are buckling but most typically best their larger rivals, which is why smart money is seeding alpha talent.