Small Hedge Funds Outdoing Elite Rivals?
The world’s top hedge funds did far less well than usual last year, as smaller rivals made more money for investors and the average return of the top 20 lagged behind those with a simple balanced portfolio.
Calculations by LCH Investments, the fund of hedge funds run by the Edmond de Rothschild group, found the 20 top hedge funds made $32.4bn for their investors last year, less than a fifth of the $172bn made by the industry as a whole. Over their history, the top 20 funds have generated almost half the total profits made by the industry, helping explain the stellar reputations of top names such as Ray Dalio, Seth Klarman and David Tepper.
The tough year for the hedge fund elite came as two top managers stepped down. Billionaire philanthropist George Soros retired from running other people’s money at the start of 2012, while John Arnold, a fellow billionaire, told investors in May he would be closing his Houston-based Centaurus Energy.I agree with Mr Sopher, the top 20 table showed the key to longer-term success was avoiding becoming too big. When you look into the rise and fall of hedge fund titans, you will almost always see that as assets under management mushroom, typically after a stellar year, performance dwindles in the subsequent years.
But the relatively poor year for the elite appears to be driven by the continued underperformance of “macro” hedge funds, which bet on interest rates, currencies and big market moves. Many of the world’s best-known investors are macro managers, led by Mr Soros and including Paul Tudor Jones, Louis Bacon, Ray Dalio and Alan Howard.
Rick Sopher, chairman of LCH, said the big winners in the past year had been stock pickers, with the biggest profits made by Lone Pine, Steve Mandel’s Connecticut-based fund.
Lone Pine’s returns were boosted by its long-only funds, which produced about two-thirds of last year’s $4.6bn of gains. They are counted by LCH as part of its hedge funds because they are run without the index benchmarks standard in long-only funds .
After Mr Mandel, the most money was made by Dallas-based Maverick Capital, another equity manager, who made $3.7bn. Like Mr Mandel, founder Lee Ainslie is a “Tiger cub”, a former protégé of hedge fund legend Julian Robertson at Tiger Capital.
Equity managers generally had a good performance last year, helped by rising markets and falling correlations between stocks, which helped those good at picking winners and losers. Their success follows what had been an awful 2011 for many, with Mr Ainslie recording his worst year and cutting back Maverick’s risk-taking as a result.
But Mr Sopher said the top 20 table showed the key to longer-term success was avoiding becoming too big. “When you look at the one thing that virtually all the managers on this list have in common, it’s that they have all either at some point or all the way through restricted capacity [how much money they will accept].”
Five of the funds on the list still run by their founders have made more money for clients than they currently run in assets, mostly because they chose to return money to customers.
Last summer, macro fund Moore Capital decided to shrink by a quarter, with Louis Bacon, its founder, saying it was trickier to make money in politically driven markets. Brevan Howard, a macro fund run from Geneva, has also begun returning capital after a couple of years of weak performance, while managers including Lone Pine, Viking and Eddie Lampert’s ESL Investments are known for being hard for investors to access.
The LCH table is closely watched by fund managers, as it tracks the amount of money actually made for customers rather than simple percentage returns. Percentage returns can be misleading because funds tend to do well early in their lives, then produce weaker returns as they grow bigger – meaning they do not make nearly so much in dollars as the long-run percentage figures suggest. The weakness of the dollar measure is that it is also influenced by customer behaviour, with flighty private clients tending to pull their money after a period of bad performance.
A pair of funds run by Mr Dalio’s Bridgewater Associates topped the LCH table for a second year, but the funds – the biggest in the world, with $76bn between them – had a poor year, making customers $1bn. Mr Soros’s closed Quantum fund retained the number two spot. John Paulson’s Paulson & Co, in third, had another poor year in its flagship fund but its other funds and the denomination of much of its assets in gold allowed it to scrape a profit for customers.
On average investors in the top hedge funds still run by their founders would have been slightly better off last year buying 10-year US Treasuries and a US tracker fund to create a balanced 60 per cent equity, 40 per cent bond portfolio at the start of the year. That would have generated 11 per cent, a little more than the average of the top funds.
And even though I don't believe the world's biggest hedge fund is in deep trouble, I do believe Bridgewater is experiencing growth challenges which will impact its performance. In that comment, I clearly stated my beliefs on the fees large hedge funds charge:
...there are good reasons to chop hedge fund fees in half, especially for these large quantitative CTAs and global macro funds. Why should Ray Dalio or anyone else managing over $100 billion get $2 billion in management fees? It's ridiculous and I think institutional investors should get together at their next ILPA meeting and have a serious discussion on fees for large hedge funds and private equity shops.Too many large hedge funds think that 2% management fee and 20% performance fee is something sacred, as if it's part of some hedge fund bible that all investors must adhere to. They're in for a rude awakening.
In my opinion, these large funds should charge no management fee (or negligible one of 25 basis points) and focus exclusively on performance. The "2 & 20" fee structure is fine for small, niche funds that have capacity constraints or funds just starting off and ramping up, but it's indefensible for funds managing billions as it transforms them into large, lazy asset gatherers, destroying alignment of interests with investors.
Now, one can argue that Bridgewater is becoming the next Pimco, a mega asset manager which successfully manages a lot more in assets. That's fine but then why charge 2 & 20?
While a few elite hedge funds like the perfect hedge fund predator are still getting away with charging hefty and outrageous fees, sophisticated institutions are using their size and clout to lower fees across hedge funds and private equity funds. Too many investors got burned with hedge funds in the last couple of years and they've had it with paying fees for less than stellar results.
One senior risk officer of a large Canadian pension fund told me last week: "We got rid and are getting rid of external managers charging outrageous fees for leveraged beta." And they're not alone. Large Canadian pensions are realizing they can save huge sums in fees and bolster internal capabilities, providing just as decent returns to their depositors.
Does this mean that hedge funds are dead? No, far from it, but hedge fund Darwinism will claim many more funds in the years ahead and it won't surprise me if some of them will be brand name funds which I regularly track every quarter.
As for funds of funds, predicted their extinction a little over four years ago. The very best of them, like Blackstone and a few others, will survive and thrive but they too are using their size and clout to lower fees and extract very generous terms from the hedge funds they're seeding or investing with. Some investors think it's time to give fund of funds another go which could make sense, especially for seeding new talent, but in general sophisticated institutions will forgo that extra layer of fees and just invest directly into funds.
And while it doesn't shock me that smaller funds outdid their larger elite rivals last year, be careful not to read too much into this. 'Abenomics' has revived global macro funds and some of them are now positioning themselves for other opportunities, like shorting the loonie, expecting less hawkish comments from the Bank of Canada which is worried about Canada's perfect storm (not time yet but there will come a time to make a killing shorting the Canadian dollar).
Also, go back to read a comment of mine from last year on whether small hedge funds are buckling:
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.
I recently spoke with Simon Lack and will arrange another interview for my blog. He's one of the few who understands that there is a lot of charlatanism in the hedge fund industry with many hedge fund hipsters peddling their form of 'MCM' Capital Management. As always, buyers beware!
Finally, while I still believe market timing is a loser's proposition, this is a stock picker's market and I see it every day. Just check out the 5-day chart of MGIC Investment Corp. (MTG), a company that provides mortgage insurance to lenders and government sponsored entities in the United States. It more than doubled in less than a week (click on image):
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Among the top institutional holders of the stock, you will find three elite hedge funds, Blue Ridge Capital, SABA Capital Management and Marathon Asset Management. I bet plenty more will jump in on this one and other mortgage insurers (be very careful as it's way overbought!!).
Below, Stan Druckenmiller, founder of Duquesne Capital Management LLC and one of the best performing hedge fund managers of the past three decades, discusses his concerns about entitlement spending, the economy, investment strategy, and tax policy. He speaks with Bloomberg Television's Stephanie Ruhle.
Once again, watch what they do, not what they say on Bloomberg and CNBC. You can track Mr Druckenmiller's family office holdings in my quarterly review of top funds or just click here to view his top holdings in equities (looks pretty bullish to me).
Also, Bloomberg's Stephanie Ruhle runs down the successful deals arranged by Guggenheim Partners as it eyes its next moves in global infrastructure and hedge funds. This will be the trend of the future in the alternatives industry as large players look to diversify and develop expertise in many areas (and gather lots of assets!!).
Lastly, master speed-painter D. Westry shows off his creative skills during the "Anderson's Viewers Got Talent" competition (h/t; Sam Noumoff). Watch this till the end, it will blow you away. Goes to show you, there are many talented individuals who have yet to be discovered.