The Hedge Fund Scam?

Emily Jane Fox of Vanity Fair reports, Another Hedge Funder Admits That Hedge Funds Are a Scam:

Wall Streeters, as a group, are not known for their humility. They are a collection of chest-thumping, ego-raging (mostly) men who think highly enough of their own intelligence that they brazenly take risks with other people’s money and think it will all turn out O.K.

That has been a hard conclusion for even the most deluded hedge funder to draw this year. Returns have tanked, some firms have closed shop entirely, and a number of prominent investors have swallowed their pride and flat out admitted their own failures.

It seems like the safest bet, then, in this “hedge fund killing field,” as Dan Loeb called it, would be for hedge funders to distance themselves from themselves. Perhaps that is why Steve Cohen said he was “blown away by the lack of talent” in the industry earlier month at a conference in Beverly Hills. “It’s not easy to find great people. . . . Talent is really thin.” Cohen came to great prominence within the industry as head of SAC Capital, which enjoyed 30 percent annual returns before it pled guilty to securities-fraud charges three years ago and paid a record $1.8 billion fine. Cohen, the luckiest man on Wall Street, is currently banned from directly managing other people’s money until 2018, but he is running Point72 Asset Management, a family office with $11 billion in assets.

On Monday, Kynikos Associates’Jim Chanos became the latest hedge funder engaged in some strategic self-loathing, telling Business Insider that hedge funds are charging fees that outweigh what they’re worth. “Really, it’s befuddled me, and I’m in the industry . . . how the industry’s gotten away with the high fees for so long for what in effect is beta, market exposure,” he said.

Now, it’s not as though Cohen and Chanos are not participating in the same game. They’re playing in the same market, collecting the same fees, courting the same investors. But what they are doing is carefully distancing themselves from the P.R. nightmare hedge funds are currently enduring. If they critique what is going on, they will not be seen as part of it. Jamie Dimon did something similar as his rival banks collapsed around him during the financial crisis nearly a decade ago: he positioned JPMorgan—and himself—as the white knight close enough to the wreckage to see the full picture, but removed enough that he could play the sagacious critic. It worked for Dimon; he is still atop his perch atop the bank. In fact, last year, he was the highest-paid bank C.E.O. on Wall Street. As far as strategies go, they could choose a worse one to mimic.

Jamie Dimon and Jim Chanos are two of the most successful Greek Americans I know and I have tremendous respect for both of them even if I don't agree with the former's call on the bond market.

I haven't always agreed with Chanos either, especially on his bearish macro calls on China, but lately I've been warming up to his ideas as well as those of Soros on China. China is experiencing one huge bubble after another and when I see their state pensions gambling on stocks, I get a bad feeling that this isn't going to end well for them and the rest of us.

These are all desperate attempts to save the titanic from sinking but make no mistake, it's sinking and along with it the whole oil and commodity complex will be toast for many more years, especially if we don't get some major infrastructure spending in the developed world. If things get really bad, China will be exporting deflation to the rest of the world for decades. That's the deflation tsunami that keeps me up at night even if some silly economists dismiss it as the dog which has not barked.

Anyways, back to hedge funds. They have come under attack from within the industry and from outside the industry. Chanos follows Cohen in questioning what hedge funds truly offer is nothing more than snake oil, and being an expert on scams (the man is a legendary short seller who exposed Enron's scam), he takes it a step further to state the industry's dirty little secret, namely, too many hedge fund charlatans have become big fat asset gatherers charging alpha fees for leveraged beta!

If you think I'm way off, go talk to Ron Mock, Ontario Teachers' CEO. The first time I met him back in 2002 when he was running Teacher's fund of hedge funds, he laid it all out to me: "Beta is cheap, you can swap into any bond or stock index for a few basis points. Real alpha is worth paying for."

Unfortunately, nowadays there's not much real alpha worth paying for in hedge funds or private equity funds, which is why Canada's large pensions are increasingly looking to invest huge sums directly in foreign and domestic infrastructure.

In effect, Canada's powerful pension funds are telling the world, not only is the 2 & 20 model dead, the gig is up for all these multi-billionaire hedge fund and private equity titans. They are not willing to pay these guys (and they're mostly men) excessive fees for what is essentially leveraged beta and since many of them are underperforming and not delivering, they prefer investing in infrastructure or real estate to gain stable, predictable returns over a long investment horizon.

And unlike their US counterparts, Canada's large pension funds have the right governance to attract and retain qualified pension fund managers that can invest directly across public and private markets. Some of them, like HOOPP, are investing like a large multi-strategy hedge fund and delivering better long-term returns than top multi-strategy shops.

In fact, if you look at the performance of all of Canada's Top Ten pensions, they have been able to deliver better long-term risk-adjusted returns than many top hedge funds.

So why invest in hedge funds? Seriously why? Both bonds and stocks have outperformed them in the last few years and increasingly institutional investors are giving up and walking away from hedge funds altogether and even demanding that their fees be repaid back.

Well, it's not that simple. On one level, hedge funds and private equity funds know that delusional US public pensions need to make their 7% or 8% bogey to meet their actuarial liabilities and they know that they lack the expertise of Canada's large public pensions to replicate strategies in-house. They also get a lot of help from useless investment consultants that have hijacked the entire investment process and keep shoving their clients in the same brand-name hot hedge funds they should be avoiding.

So, there are structural issues which keep feeding the hedge fund and private equity fund beasts. That is the main reason why hedge funds and private equity funds aren't going to die even if a lot of them are scamming their clients silly, charging outrageous fees for leveraged beta.

But there's another reason why hedge funds aren't going to die. Remember what Ron Mock said: "Real alpha is worth paying for." Just like HOOPP, Ontario Teachers engages in a lot of absolute return strategies internally, but it's way bigger so when their managers can't allocate risk internally, they will seek to allocate it externally and pay for an alpha strategy they can't replicate internally.

Also, Ontario Teachers' and other large Canadian pensions take a total portfolio approach to all their investments. As Ron Mock told me when I went over their 2015 results: "last year privates kicked in, three years ago bonds kicked in" and another year hedge funds will kick in.

But most hedge funds stink and even the top ones know their glory days are ending. Institutional investors are increasingly putting more pressure on them to cut the fees and deliver real alpha.

Amazingly, the message from hedge funds is one of defiance, telling their investors to stop being so skittish and give them more permanent capital:

Beware the Ides of May. And February, August and October. The latest mid-quarter deadline for investors to submit redemption requests to many hedge funds has just passed, so we will find out soon enough if investors have followed through on their grumbling about performance by pulling money out en masse. If so, there could be downward pressure on popular hedge fund stocks and perhaps even on the market generally over the next six weeks, as funds liquidate positions ahead of returning cash at the end of the quarter.

Regardless of whether redemptions jump further from the first quarter of the year — which, at $15.1bn, was the worst total since 2009 — the market swings and industry underperformance of the past few months are forcing hedge fund managers to spend more time talking to their investors. That surely explains the yearning for permanent capital that was on display at the SALT conference for the industry last week.

Several participants bemoaned institutional investors’ skittishness and tendency to pull money after short bursts of underperformance, and there were warnings that investors may be giving up on hedge funds just at the time they are about to prove their worth as a portfolio diversification tool in a down market.

Some famed managers are raising capital for new funds that will lock in investors for much longer periods, so they can make private equity-style investments or more complex trades in illiquid markets, according to private comments.

And Lee Cooperman, the industry veteran who runs Omega Advisors, mused publicly about whether funds would not be better to convert into family offices, giving back external money entirely and just managing the fortunes of founders and staff. He and his partners accounted for about 40 per cent of Omega’s capital, said Mr Cooperman.

It is not just the hedge fund managers who have an interest in making sure they have a lot of locked-up or partner capital. Investors do, too.

All else equal, investors ought to allocate to funds whose managers own the larger chunk of the assets, not just because one wants managers to have “skin in the game” but because dealing with skittish investors is a distraction that can hurt performance, and redemptions pose real risks. If money is draining away, managers can be forced to sell their best or most liquid positions, reducing the quality of the remaining portfolio.

While the trend has been to offer more liquidity to investors — many funds offer monthly redemptions — funds that stagger the amounts of money that can be pulled at once have an advantage.

There is a reason that Bill Ackman has been emphasising just how much of his fund’s capital is not subject to redemption requests — almost half, in fact, at the end of March. He and his partners accounted for only 4 per cent of Pershing Square’s assets at the end of last year, but 33 per cent came from a permanent vehicle listed on the stock market in Amsterdam, with another 8 per cent from a bond issue. With losses of 19 per cent this year thanks to the disastrous Valeant Pharmaceuticals investment, Mr Ackman has been selling down his winners, including Mondelez and Zoetis, but the permanent capital has at least given him more flexibility to respond to the Valeant debacle.

Paying attention to how much capital is permanent or manager-owned is not enough. A hedge fund may be relatively less at risk from redemptions by its own investors, but is it exposed to redemptions from investors in other hedge funds? If the industry moves into a period of capital outflows, the most popular hedge fund trades will have a headwind against them. Checking the correlations between a hedge fund’s portfolio and the industry as a whole is, rightly, moving up investors’ agenda.

As an aside, there may be ways for retail investors to exploit any period of outflows from the hedge fund industry: Goldman Sachs’ planned exchange traded fund tracking the 50 most popular hedge fund stocks might be better shorted than purchased.

There was no denying the downshift of mood at SALT this year. Underperformance makes hedge fund managers shy, so there were noticeably fewer big-name managers in attendance. Meanwhile, investors such as Roslyn Zhang of China Investment Corp were outspoken in their criticisms of the industry’s shallow research efforts, herd-like behavior and weak results.

If this all translates into higher redemptions, it will be even more urgent for investors to seek out funds that have a larger proportion of locked-up or permanent capital. The irony is that investors are in no mood at all to grant managers those advantages.

There is some truth to this article. In world of historic low or negative interest rates, it's in the best interest of all parties to invest with hedge funds and be a lot more patient given how volatile markets are. But the flip side to that argument is just how patient can investors be when managers are losing huge sums year in, year out?

And if another financial crisis occurs, the last thing a client wants to hear is "be patient, it will all work itself out" (lots of investors never forgot what happened when top hedge funds closed the gates of hedge hell back in 2008, they got nuked!!!).

At the SALT conference, Cooperman stated “The hedge fund model is under challenge" and maybe the hedge fund structure is the wrong structure. On this last point, Cliff Asness wrote a great comment on Hedging on the Case Against Hedge Funds and followed that up with another comment which you can read here. 

I will let you read both comments but I like the way he ended the first one:

To be sure, there are things to worry about in hedge-fund land. First, my long-standing critiques -- that hedge funds need to hedge more and charge less -- still apply. Second, this problem has grown as hedge funds have become more correlated with traditional markets, which is of great concern today given the likelihood that traditional asset classes now offer a lower long-term expected return than usual. Third, hedge-fund performance, even when compared to the right amount of stock-market exposure, has retreated in the past few years. Fourth, although managers can’t fully control their returns, they have more control over how much risk they take. There is evidence that hedge funds as an industry are less aggressive than they used to be. This could be a sign that the value proposition is weakening as hedge funds simply do less (the equivalent of closet indexing in a long-only world). Perhaps this means that they manage too much money.

Then again, one of the truisms of markets seems to be that investors and pundits overreact. Only time will tell if the hostility to hedge funds is an accurate harbinger of tougher times to come or the typical knee-jerk reaction that comes with any period of below-norm performance.

By charging so much, sometimes for fairly simple and known strategies, hedge-fund managers set expectations too high and gain no slack for the inevitable tough times all investments face. They are learning that now. I hope that investors will sift through the overblown case against hedge funds and use this moment to exhort the industry to become better by charging less, hedging more and providing real diversification.

Unlike most hedge fund managers, Asness gets it which is why even though CalPERS nuked its hedge fund program, it still invests with AQR who I consider more to be a great alpha asset manager than a traditional hedge fund charging huge fees for leveraged beta.

But Asness raises points which make me think the real problem is the hedge fund industry has gotten way too big for its own good and more importantly, for that of its clients, and maybe there are serious structural reasons behind why they're not delivering the goods (not their lame excuses blaming central banks run amok!).

Then again, billionaire robots and algorithms are redefining the entire hedge fund landscape:

The guys who are still making money hand over fist are doing so using not their own brains, but computer models. To be specific, they are “quants”, or quantitative hedge fund managers: eight of the ten top earners on Alpha’s list fall into that category, and half of the 25 richest of the year are quants. Either they rely exclusively on computer models to tell them when and what to buy and sell, as Jim Simons at Renaissance Technologies – who holds the distinction of being the only person to appear on the list 15 years running – does, or they use them extensively to guide their decision-making, as does Ray Dalio of Bridgewater Associates.

What this data shows is the beginning of a schism in the hedge fund universe between the traditional active hedge fund managers – traders or investors who scour the markets in search of a clever idea and then bet on it, sometimes using derivatives or other kinds of leverage to magnify the impact of their position – and the quant world. The latter group is tied to computer models and their screens, and couldn’t care less about a company’s business model or “story”, as long as all those numbers they are screening for show up clearly.

Last year, David Siegel, cofounder of Two Sigma Investments, one of those quants, announced that one day “no human investment manager will be able to beat the computer”. Siegel, himself a computer scientist, now manages more than $35bn, and qualified for Alpha’s “rich list” for the first time this year. He debuted at No 7 with estimated 2015 earnings of $500m.

Clearly, even if some pension funds, including the California Public Employees’ Retirement System (CalPers), have decided that the hefty fees simply don’t make sense for most hedge funds, they remain willing to pay big money to these “quants”. They don’t mind making the managers rich if those managers deliver blockbuster returns to investors, as well. And while CalPers was earning only 7.1% from its portfolio of hedge fund investments in the year before it pulled the plug on them in 2014, the big quant funds have posted significantly better results. Two Sigma’s two benchmark funds both returned 15% (after fees) last year, when many actively managed hedge funds posted losses or only meager returns.

If the trend continues, brace yourself for a shakeup in the hedge fund universe.

Below, Doug Dachille, AIG chief investment officer talks about the hedge fund market and the reallocation of his company's portfolio. Listen carefully to his comments, in my opinion, he nails it and a lot of what he states is of interest to large pensions too. This is a great discussion, one of the best I've heard on hedge funds (and one of the most devastating too).

Also, let me end this comment by plugging a small consulting firm based here in Montreal, Phocion Investments run by Ioannis and Kosta Segounis and David Rowen. Unlike other due diligence shops, they aren't delivering "cut and paste" bogus reports (I call it the cookie cutter approach to build volume business) and go in-depth covering operational risk, compliance, performance and investment due diligence on hedge funds and long-only managers.

They have a few clients but are looking to ramp up their business here in Canada, the United States and elsewhere. If you are a large pension fund, sovereign wealth fund, insurance or endowment fund, I highly recommend you contact them here and try their services. They also work with hedge funds and long-only funds who want to beef up their operational, compliance and performance standards.

I like them because they're extremely nice, smart, entrepreneurial and hard working and they add real value to their clients. Unlike most useless consultants looking to drum up volume business by offering their clients the same generic "one size fits all" recommendations, they will dig deep to understand your needs and concerns and offer meaningful tailor made solutions to address them.

By the way, Ioannis will be presenting at the CFA Toronto on Thursday May 19^th regarding CRM2. You can read more of their articles here including one on enterprise risk management culture at pension plans (they have all worked at large pensions and know what they're talking about).

On that note, I remind all of you that I too work very hard to offer you great insights on pensions, hedge funds, private equity funds, and a lot more. I loathe begging people for money but I'm not shy to remind you to please contribute to my blog by either donating or subscribing on the top right hand side under my picture. I thank all of you who support my efforts and value my work.