Hedge Funds' Day of Reckoning?

Scott Deveau and Devin Banerjee of Bloomberg report, Hedge Funds May Lose 25% of Assets, Blackstone’s James Says:
The $2.9 trillion hedge-fund industry may lose about a quarter of its assets in the next year as performance slumps, said Tony James, Blackstone Group LP’s billionaire president.

“It’s kind of a day of reckoning that we face here,” James said Wednesday in an interview with Bloomberg TV Canada’s Pamela Ritchie at a conference in Toronto. “There will be a shrinkage in the industry and it will be painful. That’s going to be pretty painful for an awful lot of places.”

The hedge-fund industry is having its worst start to a year in performance and investor withdrawals since global markets reeled after the financial crisis. Third Point, the hedge-fund firm founded by Dan Loeb, last month said the industry is in the first stage of a “washout” after “catastrophic” results this year.

Hedge funds have lost 1.8 percent this year, according to Hedge Fund Research’s global index, the poorest performance since 2008. The industry had net outflows of $16.6 billion in the past two quarters, the most since 2009, according to HFR. In 2015, 979 funds closed, more than any year since 2009, according to the research firm.

Performance Concern

Blackstone is the largest allocator to hedge funds globally, and the New York-based firm also provides startup money to managers and buys equity stakes in hedge-fund firms. Results in its hedge-fund business are better than the industry average, James said, though performance generally remains a cause for concern.

“We’re definitely worried about what’s going to happen in the hedge-fund world right now,” he said, speaking at the Canadian Venture Capital and Private Equity Association’s annual conference.

Hedge-fund managers have been stymied by central bank stimulus worldwide, declining trading volumes and markets marked by wide swings in prices. Carlyle Group LP’s David Rubenstein said this month he was surprised that “so many macro people got it wrong.” Carlyle owns three hedge-fund firms and last week said Mitch Petrick, the head of the unit that houses the firms, stepped down.

James said hedge funds may be expected to under-perform the stock market during a bull run because they’re hedged to reduce volatility. Blackstone’s fund of hedge funds has about one-fifth of the volatility of the stock market and about 65 percent of the upside, he said.

“For a while that’s a good trade for them,” James said of investors in hedge funds. “But the longer that bull market goes, they fall further behind. Pretty soon, they don’t like that trade anymore.”

‘Unbelievable’ Compensation

James also called out hedge-fund managers for the fees they charge, which are typically 2 percent of assets annually and 20 percent of investment profits -- a structure he said “is hard to justify these days.” Billionaire Warren Buffett last month described such fees as “a compensation scheme that is unbelievable,” and Bill Gross of Janus Capital Group Inc. said on Twitter: “Hedge fund fees exposed for what they are: a giant ripoff.”

Tudor Investment Corp., one of the oldest and most expensive hedge funds, is trimming fees, according to a letter sent to clients this week. The $11.6 billion firm, run by billionaire Paul Tudor Jones, will reduce fees for a share class that contains most of its biggest fund’s money to 2.25 percent of assets and 25 percent of profits starting July 1. That’s down from 2.75 percent and 27 percent.

“We’re talking about three years of under-performance, the fact that investors pulled $1 billion of capital and already a 2-and-20 fee structure which is under duress,” Ilana Weinstein, the chief executive officer of IDW Group, which recruits investment professionals for hedge funds, said of Tudor. “Investors aren’t really excited about a slight discount for crappy performance.”

“There’s going to be a real weeding out of hedge funds,” she said Wednesday on Bloomberg TV.

Crowded Business

Blackstone in 2014 embarked on a new strategy to bring some traders in-house. The move has been enabled by a talent drain coming out of banks and other institutions, James said, where proprietary trading has been hampered by regulation after the financial crisis.

“We take these really remarkable talent and we can pick just a couple dozen out of thousands out there and put them in business,” he said. “They’re actually working for themselves yet we’re the ones who give them capital, tell them what they can and can’t do.”

His comments contrast with those made earlier this month by billionaire trader Steve Cohen, who said he’s “blown away by the lack of talent” in the industry.

Cohen, who spoke at the Milken Institute Global Conference in Beverly Hills, California, said the business has “gotten crowded” with too many managers following similar strategies. Hedge funds seem to think that by hiring skilled people, they can “magically” generate returns, he said.

Blackstone had $68.5 billion dedicated to hedge funds as of March 31, and the business produced $244 million in economic income, which includes realized and unrealized gains and losses, in the past year, down 35 percent from the previous 12 months. The alternative asset manager, run by James and CEO Steve Schwarzman, oversaw $344 billion in real estate, private equity holdings, credit assets and hedge funds at the end of the first quarter.

Peter Grauer, chairman of Bloomberg LP, the parent of Bloomberg News, is a non-executive director at Blackstone.
When Tony James talks about a solution to America's retirement crisis, peddling a "revolutionary retirement plan" which he conceived with Teresa Ghilarducci of the New School of Social Research, I tune off because it's another sham of a plan which will benefit Wall Street and do nothing to address America's looming retirement crisis.

But when he talks hedge funds, private equity and real estate, I do listen carefully as he knows what he's talking about. Blackstone is an alternatives powerhouse and one of the largest allocators to hedge funds globally with $68.5 billion dedicated to hedge funds as at March 31, 2016.

The other global juggernaut when it comes to hedge funds is Man Group, one of the world’s largest independent alternative investment managers and a leader in liquid, high-alpha investment strategies with $78.6 billion assets under management (as at 31 March 2016).

Interestingly, while shares of Blackstone (BX) have recovered a bit from their lows, Man Group's shares hit an 18-month low recently as worries grew about a slump in AHL funds:
Citigroup downgraded Man from “buy” to “sell” on concerns about AHL, the trend-chasing funds that make up about a quarter of its assets under management and are estimated to provide more than half of the group’s earnings.

AHL Diversified is down nearly 14 per cent since mid-February and is about 15 per cent below the high water mark that it reached in March 2015, below which Man does not earn performance fees.

“Without AHL, performance fee generation looks challenged — there is little help elsewhere,” said Citi.

It forecast Man’s 2016 profit to slump 43 per cent, based on a 70 per cent reduction in performance fee revenue.
Not surprisingly, nearly four in ten Man Group investors voted against remuneration:
Shareholders at the hedge fund Man Group have hit out at the firm’s executive pay for the second year running, in the latest in a growing list of City rebellions about remuneration this year.

Around 37pc of the investors who participated cast their vote against Man Group’s remuneration report, which gave chief executive Manny Roman nearly $5.4m in pay and perks, up from $5.1m.

Mr Roman was awarded 83.3pc of his maximum bonus, which was not tied to profits but was based on targets such as integrating newly-acquired parts of the business, cutting costs and rejigging the firm’s reporting framework.

Ten percent of shareholders also voted against the reappointment of Phillip Colebatch, the non-executive director in charge of setting remuneration.

The board said it takes shareholder views into account when setting pay policies “in the light of the changing market place and Man Group's evolving strategy and development”.

“We will continue our efforts to engage with our shareholders and take account of their views in the coming year,” they said.

The protest vote comes a year after shareholders spoke up against Man’s pay policy. The firm’s first ever binding vote on future pay was passed and the board adopted the new targets, despite a 43pc vote against it in May 2015.

Man Group gave its chief executive Manny Roman a 10pc pay rise for the coming year, saying that he had not seen his $1m salary increase since he joined five years ago.
You will recall Mr. Roman was mentioned in my comment on the list of highest-paid pension fund CEOs where their compensation was outstripping his. Man Group's board rectified this "gross injustice" but the problem is Man Group isn't delivering the results that Canada's large pensions are delivering even if they have captive clients.

So when people ask me why is Mark Wiseman leaving CPPIB to go work at Blackrock,  I tell them because he's very good at what he does, led a team that has delivered great long and short-term results, and he seized the opportunity to go work at the world's largest asset manager.

Sure, he will be compensated well at Blackrock and make a lot more money than he did at CPPIB but only if he delivers on the bottom line. Blackrock isn't a charity, it's a private company focused on profits and Mark Wiseman knows he has to deliver or else he's out.

Anyways, back to hedge funds. Steve Cohen laments that he's "blown away by the lack of talent" but the problem may not be the lack of talent, but the lack of opportunities for emerging hedge fund managers who want to start their own shop.

There are important structural changes going on in the hedge fund industry that you all need to bear in mind:
  • The bifurcation of the industry continues unabated: This has been going on for years. The bulk of the money is going to large, well-known hedge funds which are tracked and recommended by pretty much every consultant. The big shops have big teams to take care of compliance, making it easier for them to address regulatory issues and garner huge assets from pensions and sovereign wealth funds. It shouldn't surprise anyone that Ray Dalio's Bridgewater Associates just passed the $100 billion mark in hedge fund assets, that he took home $1.4 billion last year or that Bridgewater will receive a $52 million economic assistance package from Connecticut to create jobs and expand its current locations in Westport, Wilton and Norwalk (unbelievable!). 
  • Crowding matters a lot more now: As the industry grows, more and more hedge fund managers are betraying their glory days with group think, engaging in the same strategies and trades and this crowding often leads to disastrous outcomes. Crowded trades are a direct consequence of too much money chasing limited opportunities which is why returns are suffering. This is why Goldman Sachs thinks hedge funds lost their magic and insurers are redeeming from them. Interestingly, according to bond manager Jeffrey Gundlach, Jim Chanos, founder of Kynikos Associates, is the best hedge fund manager because he’s permanently bearish and avoids the group think that led others in his industry to lose money last year (no doubt, Chanos is one of the great ones).
  •  Fees are going to come down hard: I don't care if you're Paul Tudor Jones, Ray Dalio, Jim Simons, Ken Griffin, or Steve Cohen, in a deflationary world -- and make no mistake, deflation isn't dead -- fees matter a lot more which is why 2 & 20 is dead and never coming back. Institutional investors are onto the hedge fund scam and are totally fed up of paying outrageous fees so they can enrich hedge fund billionaires that receive payouts fit for a king no matter how well they perform. And we're surprised that hedge funds are under attack or that people are openly discussing divorcing your hedge fund manager and asking why they still exist?
  • Deflation will roil hedge funds: This is especially true for the large shops which have become nothing more than glorified asset gatherers charging alpha fees for leveraged beta. They're going to be unable to cope with deflation, negative rates, huge volatility in public markets, and their returns are going to suffer considerably in the years ahead.
  • Big investors are starting to shun hedge funds: For all these reasons, large sophisticated investors are giving up on hedge funds and even private equity funds, preferring to invest huge assets directly in infrastructure, an asset class that offers stable returns over a long period, better matching their long dated liabilities. Why pay a few hedge fund hot shots 2 & 20 or even 1 & 15 when you can directly invest huge sums in infrastructure and have a better chance of delivering on your actuarial return target without the negative press that goes with hedge funds?
Cambridge Associates recently asked, Is the Hedge Fund Heyday Behind Us?, to which I can unequivocally reply: "You better believe it is!". Susana Rust of Pensions & Investments Europe reports, Fees make most hedge fund portfolios 'bad investments':
The vast majority of institutional investors’ hedge fund portfolios underperform simple investable benchmarks, with fees responsible for making most hedge fund portfolios “bad investments”, according to a study.

The study, carried out by Canadian research company CEM Benchmarking, was commissioned by 27 large institutional investors from Denmark, the Netherlands, Sweden and the UK, among others.

The study found that most hedge fund portfolios “look surprisingly like simple stock/bond portfolios”, according to Alexander Beath, senior research analyst and lead author of the study.

“Worse,” he added, “what little alpha is generated goes to the hedge fund managers and then some.”

According to CEM Benchmarking, the study found that institutional investors’ hedge fund portfolios have over 15 years outperformed simple stock/bond portfolios by 0.97% before fees but that “fees have made most hedge fund portfolios bad investments with net alpha of -1.88”.

The company analysed the realised hedge fund portfolio returns of more than 300 large global investors.

Half of these have invested with hedge funds for five years or more, with analysis of these return histories showing that, “for most funds, the performance can be replicated at much lower cost by simple equity/debt blends”.

The average correlation to simple stock/bond portfolios was 84% and more than 90% for more than half of funds, according to CEM Benchmarking.

“These results would not be disappointing except for the fact 70% of funds underperformed the simple benchmarks,” it said, “and the average fund underperformed by -1.88%.”

Thirty percent of the surveyed institutional investors had hedge fund portfolio returns that beat the benchmark, and they had the following features in common, according to CEM Benchmarking:
  • Funds with long histories investing in hedge funds tend to outperform those with short histories
  • Funds with lower correlation to equity/debt blends tend to outperform those with high correlations
  • Funds with low cost implementation tend to outperform those with high cost implementation
CEM Benchmarking said most institutional investors benchmarked their hedge fund portfolios against speciality hedge fund indices or cash-based benchmarks, and that both styles were “flawed”.

Speciality hedge fund indices suffer from survival biases, it said, while cash-based benchmarks show no correlation to hedge fund returns.

Neither of these types of indices is investable or representative of a low-cost viable alternative, it noted.
These findings hardly surprise me as most hedge funds stink and are charging alpha fees for leveraged beta. There are excellent funds but it's becoming increasingly more difficult to find them and even more difficult to get the right alignment of interests when you do find them.

Finally, I want all you hedge funds and institutions allocating to hedge funds to read a comment from Ben Carlson of the A Wealth of Common Sense blog, How Should Alternatives Be Benchmarked? as well as one from my friends over at Phocion Investments, Managers Distinguish Themselves by Implementing Sound Risk Practices. If you're a hedge fund looking to beef up your risk practices and improve your performance or if you're an institution that needs customized operational due diligence on your hedge fund investments, I recommend you contact them here. They are nice, smart guys with years of experience working at large pension funds who will help you.

Let me end by plugging my blog too. I work very hard on a blog that offers me very little in terms of remuneration but a lot in terms of talking and meeting interesting people. I will ask many of you who regularly read this blog to please kindly subscribe or donate via PayPal at the top right-hand side and show your appreciation for the hard work that goes into these daily comments.

I thank all my supporters and wish my American readers a great Memorial Day weekend.

Below, Bloomberg's Scott Deveau discusses why Blackstone's Tony James isn't particularly gun-ho on Canada or Canadian real estate (stay away from Canadian real estate!) and why hedge fund assets will shrink markedly over the next year.

Second, CNBC reports that Wall Street's "billionaires club" is only growing even after some of the biggest hedge funds struggled in 2015.

Third, CNBC's Kate Kelly reports that Tudor Investment Corp is cutting its hedge fund fees. Tudor can cut those fees a lot more and there will be many more hedge funds following suit in the years ahead. Kelly also takes a look at this year's ranking of the world's largest hedge funds.

Lastly, to all you glorified hedge fund asset gatherers charging alpha fees for leveraged beta, Tom Lee of Fundstrat Global Advisors has some good news for you, he thinks the recent rally in high yield is bullish for stocks. Hope he's right but in case he's wrong, you'd better hedge to limit downside risk!