Dog Days For Hedge Funds?
The definition of a hedge fund, people used to joke, was a fee structure in search of an investor to fleece.
However, four years on from the financial crisis, and with so far little to show for it, hedge funds’ notoriously high fees are looking less and less definable, let alone defensible.
Some investors now hope that the industry’s totemic “two and 20” fee structure – 2 per cent of assets and 20 per cent of returns annually: a formula that has made many managers fantastically wealthy – may finally be beginning to crack.
Challenging fees is no easy task for investors, however.
Thanks to the crisis, they may well have more clout than ever before when it comes to negotiating with managers, but they are also themselves more desperate. In a time of ultra-low bond yields and high equity volatility, hedge funds are proving an irresistible draw.
And as such, investing in hedge funds still seems to be a game rigged in the managers’ – and not the investors’ – favour.
“With any industry in its development, margins start out high. Then, as an industry starts to mature, firms start to compete on price,” says Jeff Holland, managing director of Liongate Capital, which has $2bn invested in hedge funds. “The hedge fund industry, for whatever reasons, has so far been very good at avoiding that path. Managers have been very good at defending their margin.”
According to data from Hedge Fund Research this month, industry assets rose by $122bn in the first three months of 2012 – the largest quarterly inflow in more than two years – to stand at $2.375tn. Hedge funds now manage more money than ever before.
With those large inflows, however, a shift has taken place.
Institutions – pension funds, insurance companies and endowments – are now the single largest group of hedge fund investors, accounting for close to three-quarters of the industry’s assets.
By comparison, the wealthy individuals and private banks that once dominated hedge fund investing and brought with them a more handshake-oriented, take-my-money-and-shoot-the-lights-out attitude are becoming bit-part operators.
Glitzy penthouse offices with Tracey Emin paintings and Jeff Koons sculptures are out, and institution-friendly sobriety is in.
“There are increasing numbers of sophisticated institutional investors who are questioning managers on fees as a result of both regulatory and investment pressure,” says Erich Schlaikjer, co-founder of $5bn quant fund Cantab Capital Partners, which recently launched a new, low-fee fund.
“Australian superannuation funds, as an example, are unable to pay the industry standard fees of two and 20. Investors are also used to paying less for scalable strategies – for example, those investing in large-cap equities,” he says.
There is every indication the trend is set to continue. According to a recent comprehensive survey of hedge fund investors by Deutsche Bank, 66 per cent of pension funds increased their hedge fund allocations in 2012, compared with just 19 per cent of private banks. Furthermore, 94 per cent of pension funds said they would increase or maintain their hedge fund allocations in 2013 (click image below).
I've already covered hedge funds chopping fees in half. The institutionalization of the hedge fund industry will place enormous pressure on hedge funds to lower fees but the demand for hedge funds delivering uncorrelated returns is increasing, which is why we haven't seen a huge shift yet.
“There is now a lot of flexibility on the manager side,” says Anita Nemes, global head of capital introduction at Deutsche. “It is really the institutional investors that are driving fee changes – they are the ones that are negotiating.”
The Deutsche survey also showed that, while on average, wealthy individuals targeted returns of 10 per cent from their hedge funds annually, institutional investors target just 8 per cent.
Institutions look not just for managers promising the big gains on investments, but for those with returns that are uncorrelated to broader markets, or else are consistent, with as little volatility as possible.
And if the expected returns are lower, they believe, then the fees should be too.
“The reality is that while we say we don’t negotiate on fees, if a North American pension plan comes to us looking to invest $200m, then we’re going to sit down and have a talk,” says the head of marketing for one of Europe’s biggest hedge funds, who declined to be named because discussing fees publicly is too sensitive an issue. “Anyone who says otherwise is lying to you.”
In particular, it is hedge funds’ management fees – the “two” – that are coming under pressure.
And with good reason: the average hedge fund has returned just 9 per cent in the past five years, meaning investors have paid more in management fees alone to their managers since the crisis than they have received in profits.
Janchor Partners, one of Asia’s most successful recent hedge fund launches, has a management fee which decreases as firmwide assets under management rise: incentivising the manager to concentrate on performance as a source of income, rather than asset gathering.
Even big, established blue-chip funds have not been averse to pressure.
In October, Caxton Associates, one of the world’s biggest macro hedge funds, cut its management and performance fee in a concession to the “tough investment backdrop” and changed investing “reality”. Caxton’s fees, though, started at three and 30. The company now charges 2.6 and 27.5.
“In a way, whether you are a hedge fund manager or in any other industry, the lesson is the same – quality commands a premium,” says Deutsche’s Ms Nemes.
But make no mistake, institutions are increasingly scrutinizing their hedge funds, and large pension funds are using their clout to lower fees. There is no way a pension fund writing tickets of $100 to $200 million to any hedge fund is paying the standard 2 & 20 fee. If they are, they're crazy.
Also, as I reported last Friday on teachers putting hedge funds in detention, the industry is being publicly maligned -- often without merit -- and needs a positive public relations campaign. In that comment, I also covered what a senior pension fund manager who invests in the world's best hedge funds stated to me:
He told me that part of their due diligence is to look at the internal rate of return (IRR) and how it has evolved as assets grow. In his own words: "It's important to track the dollar-weighted return of these funds. We ask them data going back since inception. If a manager can't provide us with their IRR, we don't even look at them. Also, if alpha is shrinking as assets mushroom, we flag it and review their performance."Yesterday, spoke with Julie Cays, CIO at CAAT, which I covered in my last comment. She told me CAAT invests in external managers including a few hedge funds because "it diversifies risk, operations, people, processes and philosophies. There are many benefits to investing with some of the sharpest minds in the industry."
This pension fund manager told me he read Simon Lack's book criticizing hedge funds, enjoyed many parts but he didn't agree with everything in the book. He thinks that hedge funds play an important part in an institutional portfolio and I agree. I'm also careful not to throw the baby out with bathwater when it comes to hedge funds as I think many commentators just do not understand their role in an institutional portfolio.
I agree, which is why smart institutions don't just invest in hedge funds and private equity funds, they leverage these relationships in key ways, bringing the information internally to better manage risks across public and private markets.
On that note, Pensions & Investments reports CalPERS continues to build out its hedge fund capability and seeks four additional investment professionals to join its six-person team, said Edigio “Ed” Robertiello, senior portfolio manager, absolute-return strategies, for the $258.3 billion fund. Would love to discuss some top candidates with Mr. Robertiello and share some other ideas with him.
Finally, looking ahead, Margie Lindsay of Risk.net reports, Falling correlations could give hedge funds bumper returns.
A fall in asset-to-asset correlations could mean a good year for many hedge fund strategies, even though volatility is expected to remain relatively low, according to research from AxiomaIndeed, if correlations remain low, hedge fund strategies could be in for a much better year. And if that's the case, hedge funds betting on market tumult will continue to struggle.
Despite negative factors such as US sequestration, the Cyprus euro crisis and continued weak job growth in Europe and the US, risk has fallen globally. Markets are generally strong and predicted risk largely continued the decline that started a year ago, according to Axioma's first quarter 2013 quarterly risk review.
A decline in correlations between individual assets within markets as well as between markets globally was also reported by Axioma, a risk management solutions provider to the largest investors.
In contrast to the relatively positive performance of US and European markets, forecasts for China, Japan and Australia bucked the trend. Risk increased during the quarter, especially at the short horizon. For example, FTSE Japan in yen is now one of the riskiest benchmarks covered by Axioma compared with only a year ago when it was one of the least risky. China's forecast risk in US dollar for the CSI 300 now exceeds that of the euro crisis countries.
All of the benchmarks tracked by Axioma showed far lower risk forecasts at the end of the first quarter of 2013 compared with the end of the same quarter in 2012. The exception was Japan where short-horizon risk ended the first quarter more than six percentage points higher than a year earlier.
"We've finally reached the point where we are getting over the hangover of the global financial crisis and the European crisis," says Melissa Brown, senior director of applied research at Axioma (pictured). "Markets have been doing well in general. They've been going up relatively slowly. Investors seem to be gathering a little more confidence in equity markets. All of that comes together to drive equity risk lower. In addition it's something that feeds on itself as risk goes down," she notes.
"With volatility down, you're more likely to get more flows into the equity markets which in turn are likely to keep equity volatility down. There's still plenty to worry about if you want to worry but a lot of the headline concerns are already reflected in equity prices," Brown adds.
Another trend picked up by Axioma is low volatility investing. "We have seen a lot of interest in strategies that seek to be overweight or to buy lower volatility stocks. That kind of strategy, while it still did okay in the last 12 months, did worse than it usually does [in the first quarter]," she says. Low volatility trends are not working as well as previously while the trend towards momentum is "quite profitable", according to Brown.
Brown's research also shows that currency risk has risen, particularly in European currencies. "European currencies, the Japanese yen and the [South] Korean won have all seen a sharp increase in their volatility. Most other currencies have not." This is a trend she says is worth watching.
Another theme emerging in the first quarter of 2013 is a decline in correlations. As correlations fell, investors became better diversified, resulting in steadier returns. Asset-to-asset correlations fell to lows not seen in most markets for over five years.
This seems to have had an unusually large impact. "In almost all the markets we look at, correlations have gone very low. They are at five-plus-year lows as of the end of the first quarter," says Brown. "That's a big trend in terms of what it means for manager returns, particularly long/short returns."
The trend towards lower asset-to-asset correlations is a result of fewer concerns about markets in general, believes Brown. "We've gotten away from some of these overriding, overarching concerns about markets in general. We're seeing more differentiation in results from individual companies. We're seeing that's what drives these correlations down."
So far in the first month of the second quarter, Brown confirms there has been a small increase in correlations. "It hasn't been dramatic and it hasn't been across all markets. We've seen that increase in the US and in Europe in particular but not so much in Asia," she says, adding, "We expect the correlations will settle back down again."
Brown also confirms there has been a slight increase in risk at the start of the second quarter, particularly in the US and Europe. However, figures show the opposite happening in China and Japan.
"Risk is coming down in China. Japan had a very sharp increase in risk in early April but that has also died down. We are seeing different results in different markets. The theory is that we're no longer seeing one thing, one topic driving global markets. What's driving Asian markets is what's going on in Asia and concerns about economic growth slowing in China, We've seen risk in the yen go up quite a bit. Logically that should affect Asian markets and perhaps other markets less."
This decoupling of the Chinese and Japanese markets from the global scene is expected to continue "because you have different economic issues, different actions by central banks", affecting responses by investors. If this divergence of policy action continues, Brown predicts markets are likely to see "continued decoupling".
"In terms of diversification across portfolio, I think [decoupling is] good for global portfolio managers because they are getting better diversification when some markets behave differently from other markets."
Moving into the second quarter, Brown expects the "unusual calmness" of markets to continue for a while but with more volatility creeping into equity markets overall. "We're still looking at volatility that is dramatically below what we saw in 2008-2010. While the volatility may be slightly higher than in quarter one [in quarter two], most markets' volatility hasn't even reached the level it was at the end of 2012."
There may be a slight increase in risk in the second quarter, too, although Brown does not believe it will reach the levels experienced over the past few years.
If correlations remain low, either between equities within a specific market or between markets, hedge fund strategies could be in for a much better year in terms of performance. Research by Axioma has shown that "when correlations are very high, that's typically very bad for hedge fund strategies. They tend to do much better when correlations are low".
However, lower volatility may inhibit outperformance by managers. "The lower volatility may dampen the ability of the really good hedge funds to create outsized returns. But I still think they can create good solid and steady returns this year."
Below, Ilana Weinstein, founder and chief executive officer of IDW Group, talks about compensation and employment in the financial industry. She speaks with Tom Keene and Sara Eisen on Bloomberg Television's "Surveillance." Ralph Schlosstein, president and chief executive officer of Evercore Partners Inc., also speaks. I like Ms. Weinstein, listen to her carefully, she knows what she's talking about.