Hedge Funds Under Attack?
In less than seven days, hedge funds have been subject to a three-pronged attack by some of the biggest names in finance.
Steve Cohen, the billionaire trader whose former hedge fund had racked up average annual returns of 30 percent before pleading guilty to securities fraud three years ago, became the latest critic of the business, saying he’s astounded by its shortage of skilled people.
“Frankly, I’m blown away by the lack of talent,” Cohen said at the Milken Institute Global Conference in Beverly Hills, California, on Monday. “It’s not easy to find great people. We whittle down the funnel to maybe 2 to 4 percent of the candidates we’re interested in. Talent is really thin.”
‘Very Hard’
Cohen’s comments come after billionaire Warren Buffett said over the weekend that large investors should be frustrated with the fees they pay hedge funds, which fail to match the returns of index funds. Daniel Loeb, founder of hedge fund Third Point, said last week that industry performance this year was “catastrophic” and that funds were in the early stages of a “washout.”
Cohen, who had started his hedge fund SAC Capital Advisors in 1992, 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.
“It’s very hard to maximize returns and maximize assets,” said Cohen, who runs $11 billion Point72 Asset Management. It’s difficult to balance size with carefully managing an organization and delivering good risk-adjusted returns, he added.
Cohen rarely speaks publicly at industry events. He made the comments on a panel discussion with money managers Cliff Asness and Neil Chriss.
’Cost of Being Excellent’
SAC Capital agreed to return outside money to clients as part of a 2013 agreement with U.S. prosecutors targeting insider trading on Wall Street. The firm was renamed Point72 and now manages Cohen’s fortune. He wasn’t accused of wrongdoing.
Point72 President Doug Haynes said in October that there could be more closures and money pulled out of the hedge fund business as the “cost of being excellent” in the industry keeps rising.
Cohen said at the conference one of his biggest worries last year was that his firm might become the victim of an indiscriminate market selloff as other funds endured troubles and reduced risk. He said his worst fears were realized in February when his firm lost 8 percent. Global stocks fell about 1 percent that month.
Earlier Monday, hedge funds came under criticism at the conference on the heels of Buffett’s comments at his firm’s annual shareholder meeting on Saturday.
High Pay
Chris Ailman, who runs investments at the $187 billion California State Teachers’ Retirement System, said in a Bloomberg Television interview that the hedge fund industry’s fee model is “broken” and “off the table” for large institutional investors. Chriss, founder of hedge fund Hutchin Hill Capital, said investors will pull out of funds that aren’t giving them returns to justify the fees.
Jagdeep Singh Bachher, chief investment officer of the University of California’s $97.1 billion of endowment and pension assets, said paying high hedge fund fees for mediocre performance is “absurd.”
The only money managers worth high fees are those who have uncovered “unique situations” in financial markets, he said Monday at a meeting of the Board of Regents’ investment committee. The endowment said it’s consolidating managers in its $4.7 billion absolute return portfolio.
The $8.7 billion endowment lost 4.2 percent in the first nine months of the fiscal year through March 31, staff told trustees. Private equity gained 9.2 percent while absolute return was down 5.4 percent.
‘Giant Ripoff’
Janus Capital Group Inc.’s Bill Gross joined the chorus, tweeting Tuesday that “hedge fund fees exposed for what they are: a giant ripoff. Forget the 20 - it’s the 2 that sends investors to the poorhouse.”
Hedge fund managers are among the highest paid in the finance industry, traditionally charging clients 2 percent of assets as a management fee and taking 20 percent of profits generated. Buffett described the fee structure as “a compensation scheme that is unbelievable” to him.
Since the global financial crisis, some managers have cut fees in exchange for getting larger investments from clients and locking their money up for longer periods. Even so, New York City’s pension fund for civil employees voted last month to end investing in hedge funds, determining that they didn’t perform well enough to justify high fees.
American International Group Inc., the insurer burned by losses on hedge funds, is scaling back from those investments. It has submitted notices of redemption for $4.1 billion of those holdings through the end of the first quarter.
Worst StartSteve Cohen is right, there's a tremendous amount of competition in the hedge fund world and real talent is thin (or enjoying the freedom of blogging after a long stint at SAC Capital). But he's laying it on thick here for marketing reasons for his new fund which he will eventually manage (just like Ray Dalio does when he touts radical transparency and his Navy SEALs at Bridgewater).
Cohen said he was amazed that investors aren’t more demanding, while noting the irony of his remark since he now runs a family office. He said pension plans and endowments tend to follow trends instead of being forward thinking.
The $2.9 trillion hedge fund business is having its worst start to a year in terms of returns and client withdrawals since 2009, when financial markets were reeling from the global financial crisis. Managers including Bill Ackman, John Paulson and Crispin Odey posted declines of at least 15 percent in the first three months in some of their funds.
Loeb said in a quarterly letter that most money managers were “caught offsides at some or multiple points” since August. That month, China’s surprise currency devaluation sent shock waves across markets.
Cohen said most people at his Stamford, Connecticut-based firm are not very good at timing when to invest or exit markets, though they are adept at picking stocks. He said external hires account for 20 percent of headcount at Point72, which prefers to groom analysts and money managers internally.
The Point72 founder said there are parts of the world where there are opportunities to generate more alpha, which are profits above a benchmark index, than in the U.S. His firm has offices in cities including Hong Kong and London.
Cohen, who under a settlement with regulators could manage outside capital again as soon as 2018, said he didn’t see the crowding problem in the hedge fund business easing any time soon.
“This industry has been around in a real way for 25, 30 years and excess profits get competed away in one way or another,” he said. “More people are going to enter the business and drive it down. It’s starting to happen now and will probably continue to happen. That’s a normal industry cycle.”
Interestingly, one of my buddies in Montreal who left the pension industry and got a Masters of Science in Predictive Analytics from Northwestern University now works in the insurance industry and tells me he sees SAC and other top hedge fund recruiters at data analytics conferences along with those from Google and Amazon. He already has a Masters in Finance and a CFA but tells me straight out: "Top hedge funds don't care about these qualifications, they are looking for specific qualifications and don't really like traditional finance types."
Anyways, back to Steve Cohen's remarks. I was utterly shocked to learn his personal fund was down 8% in February but it shows you how brutal this environment is even for the perfect hedge fund predator. When you see top multi strategy funds like Cohen's, Ken Griffin's Citadel and Izzy Englander's Millennium losing big in one month, you know it's beyond brutal out there for top hedge funds.
What are some of the structural issues plaguing these top hedge funds? One of them most definitely is crowding. Cohen said hedge fund crowding caused his fund's major February loss:
Billionaire investor Steven Cohen said that too many hedge funds placing the same types of bets contributed to sharp losses for his $11 billion Point72 Asset Management earlier this year.In a world of ultra low and negative rates, hedge fund superstars can kiss those 20, 25 and 30 percent returns of the past goodbye, it's never going to happen. They too have to prepare for lower returns which is why pensions need to brace for the new normal of lower neutral rates and squeeze hedge funds hard on fees.
"One of my biggest worries is that there are so many players out there trying to do similar strategies," Cohen said Monday, speaking at the Milken Institute Global Conference in Los Angeles.
"If one of these highly levered players had a rough run and took down risk, would we be collateral damage?" Cohen said. "In February we drew down 8 percent which for us is a lot. My worst fears were realized."
Point72 has rebounded to a return of approximately zero for the year, according to a person familiar with the situation.
Cohen also commented on the hedge fund industry's relatively large size and meager recent returns, saying that both investors and their clients were willing to tolerate lower performance.
"When this business started, guys took pride in the returns that they generated. Guys would make 20, 25, 30 percent," said Cohen, known for generating similar returns himself. "Now it's about trying to figure the intersection between assets under management and what investors would be willing to accept."
That brings me to the other structural factor plaguing mostly large, well-known hedge funds. If the deflation tsunami I've been warning about comes true, and ultra low or negative rates are here to stay, this means these large hedge funds are going to have to deal with unimaginable volatility in public markets. This is the type of volatility that has confounded the best of them in the past and size is an issue when you're trying to deliver great risk-adjusted returns in this environment.
Let me be more blunt. I think a lot of hedge funds are getting way too big for their own good and more importantly, for that of their investors. When Cohen says "now it's about trying to figure the intersection between assets under management and what investors would be willing to accept," he's absolutely right.
What he neglects to say is that many of the bigger hedge funds deliberately focus a lot more on growing assets under management than their risk-adjusted returns and that's what frustrates their investors which dole out 2 & 20 or 1.5 and 20 in management and performance fees (in his heyday, Cohen was charging 3 & 50 to his investors). It's that 2% management fee on multibillions which really stings when managers are underperforming.
Earlier this week we learned AIG, burned by losses on hedge funds, submitted notices of redemption for $4.1 billion of those holdings through the end of the first quarter. Last month, New York City's largest pension followed CalPERS and shut down its hedge fund program, telling managers to sell their summer homes and pay back all those hefty fees.
And to add insult upon injury, the Oracle of Omaha launched an epic rant against Wall Street tearing into hedge funds, their fees and the entire investment consulting and pension industry to pieces:
Just before lunch at the Berkshire Hathaway annual meeting on Saturday, Warren Buffett unloaded what he called a “sermon” about hedge funds and investment consultants, arguing that they are usually a “huge minus” for anyone who follows their advice.I couldn't agree more with Buffett and Munger on that last point and I too have railed against useless investment consultants that have hijacked the entire investment process at U.S. public pensions, typically recommending hot hedge funds their clients should be avoiding.
The Berkshire chairman has long argued that most investors are better off sticking their money in a low-fee S&P 500 index fund instead of trying to beat the market by employing professional stockpickers. He used the annual meeting to update the tens of thousands in attendance—and others watching via a webcast–about his multi-year bet with hedge fund Protege Partners. The bet, initiated by the New York fund back in 2006, was that over a decade, the cumulative returns of five fund-of-funds picked by Protege would outperform a Vanguard S&P 500 index fund, even when including fees.
Mr. Buffett showed a chart comparing the cumulative returns of the two sides of the bet since 2008. As of the end of 2015, the S&P 500 index fund had a cumulative return of 65.7%, outdoing the hedge fund teams’s 21.9% return. The S&P has outperformed in six of the eight individual years of the bet too.
The chart was preamble to the real point Mr. Buffett wanted to make: that passive investors can do better than “hyperactive” investments handled by consultants and managers who charge high fees.
“It seems so elementary, but I will guarantee you that no endowment fund, no public pension fund, no extremely rich person” wants to believe it, he said. “They just can’t believe that because they have billions of dollars to invest that they can’t go out and hire somebody who will do better than average. I hear from them all the time.”
But he was just getting started.
“Supposedly sophisticated people, generally richer people, hire consultants, and no consultant in the world is going to tell you ‘just buy an S&P index fund and sit for the next 50 years.’ You don’t get to be a consultant that way. And you certainly don’t get an annual fee that way. So the consultant has every motivation in the world to tell you, ‘this year I think we should concentrate more on international stocks,’ or ‘this manager is particularly good on the short side,’ and so they come in and they talk for hours, and you pay them a large fee, and they always suggest something other than just sitting on your rear end and participating in the American business without cost. And then those consultants, after they get their fees, they in turn recommend to you other people who charge fees, which… cumulatively eat up capital like crazy.”Mr. Buffett said he’s had a hard time convincing people of this case.
“I’ve talked to huge pension funds, and I’ve taken them through the math, and when I leave, they go out and hire a bunch of consultants and pay them a lot of money,” he said, earning a laugh from the crowd. “It’s just unbelievable.”
“And the consultants always change their recommendations a little bit from year to year. They can’t change them 100% because then it would look like they didn’t know what they were doing the year before. So they tweak them from year to year and they come in and they have lots of charts and PowerPoint presentations and they recommend people who are in turn going to charge a lot of money and they say, ‘well you can only get the best talent by paying 2-and-20,’ or something of the sort, and the flow of money from the ‘hyperactive’ to what I call the ‘helpers’ is dramatic.”A passive investor whose money is in an S&P 500 index fund “absolutely gets the record of American industry,” he said. “For the population as a whole, American business has done wonderfully. And the net result of hiring professional management is a huge minus.”
Mr. Buffett has long had a testy relationship with Wall Street, and he’s positioned himself for decades as an outsider to the world of New York finance. In addition to repeatedly attacking the fees charged by hedge funds and investment professionals, he’s criticized the tactics of activist shareholders, the danger of derivatives and the heavy use of debt by private-equity firms.
The antipathy can run in the opposite direction as well. As our Anupreeta Das noted in an article last year, many on Wall Street believe the Berkshire chairman to be a hypocrite. They accuse him of hiding behind the image of a folksy, benevolent investor while pursuing some of the tactics and investing in some of the companies that are the targets of his attacks.
On Saturday, Mr. Buffett worked in a fresh plug for a book he’s been recommending for decades, “Where Are the Customers’ Yachts?,” by Fred Schwed. The title comes from the story of a visitor to New York who was admiring all the nice boats in the harbor, and was told that they belonged to Wall Street bankers. He naively asked where the bankers’ clients kept their boats. The answer: They couldn’t afford them.
“All the commercial push is behind telling you that you ought to think about doing something today that’s different than you did yesterday,” Mr. Buffett told his shareholders. “You don’t have to do that. You just have to sit back and let American industry do its job for you.”
Berkshire Vice Chairman Charlie Munger jumped in to offer a counterpoint, of a sort:
“You’re talking to a bunch of people who have solved their problem by buying Berkshire Hathaway,” he said. “That worked even better.”
From 1965 through the end of last year, Berkshire shares have risen 1,598,284%, compared to the 11,355% return on the S&P 500.
“There have been a few of these managers who have actually succeeded,” Mr. Munger said. “But it’s a tiny group of people. It’s like looking for a needle in a haystack.”
Mr. Buffett conceded that point, but concluded the first half of the day’s proceedings by saying that Wall Street was better at salesmanship than investing.
“There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities,” he said. “There are a few people out there that are going to have an outstanding investment record. But very few of them. And the people you pay to help identify them don’t know how to identify them. They do know how to sell you.”
But while I don't pity hedge fund managers, I think Buffett's epic rant was somewhat harsh for a few reasons:
- That famous bet he made and is winning big on is part luck too. He made it back in 2006 before the financial crisis and profited from a huge beta thrust in the years following that crisis as central banks pumped extraordinary liquidity into the financial system.
- More importantly, this is a dumb bet to begin with. Why? By definition, hedge funds hedge or are suppose to hedge, which means they're not always long the market even if most of them are net long and have way too much beta in their strategies. So it's hard to conceive how a portfolio of hedge funds are going to beat the S&P after fees when rates dropped to record lows as central banks fight deflation. If we get a prolonged period of deflation, maybe then a portfolio of top hedge funds will outperform the S&P over a long period (maybe but I doubt it).
- Also, big pensions and insurance companies don't invest in hedge funds as an alternative to the S&P 500, they do so as an alternative to bonds. They typically swap into some bond index and use the money to invest (overlay) in market neutral, L/S, global macro, CTA or multi-strategy hedge funds (but even bonds are beating them hands down this year!).
For another view, AQR Capital Founder Cliff Asness talks about the state of the hedge fund industry. He speaks to Erik Schatzker from the Milken Institute Global Conference on "Bloomberg Markets."
Also, hedge funds have come under fire from the top names in finance over fees, performance, and talent as the industry suffers through its worst start to any year. Bloomberg's Simone Foxman reports on "Bloomberg ‹GO›."
Lastly, Steve Schwarzman, Blackstone's chairman and chief executive officer, discusses hedge funds with Bloomberg's Erik Schatzker at the Milken Institute Global Conference. He also discusses why Blackstone's in-house multi-strategy hedge fund Senfina is down big so far this year, stating it too was a victim of crowded trades.
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