The Elusive Search For Alpha?

Svea Herbst-Bayliss and Lawrence Delevingne of Reuters report, Some hedge funds post mega-gains, brighten industry gloom:
Hedge funds have suffered a steady drumbeat of bad news this year: poor performance, withdrawals, prominent closures, bribery and insider trading charges, and accusations from a state regulator that the whole sector is a "rip-off."

Yet amid the gloom there are still a few managers posting the double-digit percentage gains that turned hedge funds into an elite asset class more than a decade ago, according to performance data provided by fund investors.

For instance, Eric Knight's activist-oriented Knight Vinke Institutional Partners is up nearly 50 percent before fees this year, while the Russian Prosperity Fund, which picks stocks in the former Soviet Union and is led by Alexander Branis, has climbed 43 percent (click on image below).

Then there are Jason Mudrick's Mudrick Distressed Opportunity Fund and Phoenix Investment Adviser's JLP Credit Opportunity Fund, which are both up 38 percent. Energy-oriented Zimmer Partners' ZP Energy Fund is up 27 percent, while Gates Capital Management's ECF Value Fund has risen 26 percent and Michael Hintze's CQS Directional Opportunities Fund has climbed 20 percent.

By contrast, the average hedge fund returned a little more than 4 percent over the first nine months of the year, according to data from Hedge Fund Research. That is about half of what the S&P 500 Index has returned over the same period, including dividends, and compares to a 7 percent increase for the Barclays Capital U.S. Government/Credit Bond Index, a common measure of the credit markets.

"In general there is no doubt this has been a tough year in terms of performance, but there are still winners out there," said Mark Doherty, a managing principal at PivotalPath, an investment consultant.


The winners are harder to find. They tend not to be multi-billion-dollar household names whose managers appear on television and at industry conferences, attracting money to invest from the largest pension funds.

Although they pursue a variety of strategies, they are united in their relatively small size, investors said.

Gates Capital manages $1.8 billion, while Mudrick Capital oversees $1.5 billion and Phoenix's JLP Credit Opportunity and Zimmer Partner's ZP Energy Fund are smaller, with about $1 billion in assets, investors in the funds said. Representatives for the firms declined to comment.

There are a number of even smaller firms delivering blockbuster returns. Former Paulson & Co partner Dan Kamensky's $125 million Marble Ridge, which started trading in January, is up 23 percent. Svetlana Lee's Varna Capital, which invests less than $100 million, is up 20 percent. Halcyon Capital's $200 million Halcyon Solutions Fund, managed by Jason Dillow, is up 22 percent.

"These funds may be able to capitalize on smaller and more inefficient securities that are too small for the larger funds," said Michael Weinberg, chief investment strategist at New York-based Protégé Partners, which invests in smaller funds.


Knight Vinke's gains were largely driven by the merger of French electronics company Fnac with electrical retailer Darty, which the hedge fund pushed for, its most recent letter said.

Bets on steelmaker Evraz, Russian airline Aeroflot and Federal Grid Company, which manages Russia's unified electricity transmission grid system, helped the Russian Prosperity fund, its investment chief Branis said.

Some of the winners, including Dallas-based Brenham Capital, which manages $1.3 billion and is up 19 percent this year, also scored big by betting on the beaten-down energy sector as it recovers. Mudrick Capital won with bets on Alpha Natural Resources as the coal miner exits bankruptcy and closely held driller Fieldwood Energy, a fund investor said.

To be sure, this year's strong returns were preceded by big losses in 2015 and early in 2016 at some firms. Mudrick Capital, which made early bets on distressed energy and commodity companies, lost 26 percent last year, and Gates' ECF Value Fund lost 19 percent.

Some clients have not had the patience to stick around. Last month Rhode Island's pension fund voted to cut its hedge fund allocation in half following in the footsteps of New Jersey, which voted for a similar reduction in August. This week New York's financial regulator called hedge funds a "rip-off" in a report that said the state pension fund lost $3.8 billion on them in the last eight years.

Investors pulled an estimated $23.3 billion from hedge funds over the first half of the year, according to Hedge Fund Research, less than 1 percent of the industry's $2.9 trillion overall assets.
While a handful of less well-known hedge funds are delivering great returns, the majority are struggling to master their miserable new world where their compensation is getting sliced as big investors pull out, fed up of paying hefty fees for mediocre returns.

A couple of weeks ago, I discussed why Rhode Island met Warren Buffett, stating that while I don't buy Buffett and Munger's biased views on hedge funds, I agree with them that most US public pensions have no business whatsoever investing in hedge funds or even private equity funds which are raking them on fees and delivering paltry returns.

[Note: Interestingly, Business Insider ran an article on how private equity giants are emulating Warren Buffett, trying to lock up more assets for a longer period, which is something I discussed last year. The problem is that these are treacherous times for private equity and many experts are openly questioning the industry's alignment of interests.]

This week I went over why CalSTRS cut $20 billion from external managers and why New York's Department of Financial Services (DFS) issued a report finding that the New York State Common Retirement Fund (CRF) for years has invested pension system funds in high-cost underperforming hedge funds, costing the system $3.8 billion over the last eight years.

I ended that comment by stating the following:
Is this the beginning of something far more widespread, a mass exodus out of external managers? I don't know but clearly there are some big pensions and sovereign wealth funds that are tired of paying hefty fees to external managers for lousy absolute and risk-adjusted returns.

The diversification argument can only take them so far, at one point funds need to deliver the goods or they will face the wrath of angry investors who will move assets internally and never look back.
This week we find out that hedge fund investors withdrew $28.2 billion in third quarter but I take these figures with a grain of salt. Matthias Knab of Opalesque sent this out in an email this morning (click on image):

Clearly there is no mass exodus out of hedge funds (or private equity funds) and the reason is simple, many US public pensions cannot manage assets internally because they lack the size or don't have the governance and compensation system to attract talented investment officers to manage assets across public and private markets internally.

Instead, they hire useless investment consultants which shove them in large brand name hedge funds they typically should be avoiding (because many have become large asset gatherers who focus more on the 2% management fee and less on delivering stellar performance).

If you don't believe me, ask Mark Rzepczynski, Founding Partner, Chief Investment Officer AMPHI Research and Trading, who wrote this on Harvest Exchange:
Investment consultants are a force to the reckoned with in the pension world. They advise and drive many pension decisions around the globe. Consultants literally control trillions of dollars of allocations to managers through their recommendations, yet there have been no studies on the effectiveness of their choices. There may be limited argument that they provide useful information and education for pension managers, but they also give specific advice on managers, so an analysis of their picks is extremely valuable. The result may surprise you. Their investment manager picks do not outperform some simple benchmarks.

The recently published study in the Journal of Finance, "Picking Winners? Investment Consultants’ Recommendations of Fund Managers", makes a carefully researched assertion that consultant recommendations have little value. Worthless may be too strong, but that is close to what most would conclude when they read the paper. Given all of the work on trader skill and market efficiency, this should not be surprising. But, given that consultants supply their work to leading pensions, it is should be surprising that no one has called them on their recommendations.

The authors do a very careful job of researching this topic through analyzing what drives recommendations. Recommendations are driven by more than past performance but by soft factors such as philosophy, service, fees, and size. Consultants are not return chasers but are slaves to size which is a key driver for this results. The soft factors also seem to be key drivers for recommendations. The due diligence process identifies managers that have a well-defined process and can explain well. Given their client base and job, consultants have to be size sensitive. Perhaps in an imperfect world, the best they can do is conduct due diligence and make the best recommendations given size constraints.

Nevertheless, it may be too easy to let them off the hook based on the size argument. First, there is no evidence of outperformance and equal weighted portfolios of recommendations underperform. Second, these performance results hold for a number of different factor models. Third, the size or scale effect can explain the underperformance, but it cannot explain why the recommendations do not outperform alternatives.

Use your consultants carefully. If you want them to sift through managers and find those that meet size criteria and have well-defined processes, you are in safe ground. If you are asking them to pick future winners, beware.
You can read the full article with all charts and tables on Harvest Exchange here.

I agree with Mark Rzepczynski, use your consultants carefully and you should spend a lot more time understanding and vetting your consultants, their business model and any potential conflicts of interest.

In my experience, most consultant are backward looking and they definitely have a size bias. It's not their fault, of course, as their clients are big pension or sovereign wealth funds that are looking to write huge cheques to a few brand name funds but in many cases, there are gross conflicts of interest where consultants recommend funds they themselves invest in or trade with.

I discussed some of this when I went over the Montreal emerging managers conference a few weeks ago and was perplexed as to why some LPs think there are conflicts of interest in bfinance's approach where they put out the RFP, the LPs choose the managers that best suits their needs, and then the GPs have to pay a one time fee to bfinance based on the assets they receive if they are selected by the LP for the mandate.

[Note: I am not just plugging bfinance, on my blog you will find links to a list of advisors and consultants on the right-hand side, many of which are well known but others that are less well-known, small, excellent, independent and conflict-free, like my buddies over at Phocion Investment Services (and I have no monetary arrangement with them).]

Anyways, I am rambling on a bit too much and want to get to the article above. Be very careful when you read articles like this, extremely careful not too get overly excited about any hedge fund manager shooting the lights out on any given year.

Four years ago, I wrote a very popular comment on the rise and fall of hedge fund titans. Investors get so enamored when some hedge fund "superstar" (or no-name) hits a home run in any given year but I'm speaking from experience, one or even two years of stellar results guarantees nothing in terms of future performance and if you chase hot hedge funds, no matter how big or small they are, you will more than likely get your head handed to you.

Does anyone remember Vega Asset Management which was based in Madrid, Spain? I visited them with Mario Therrien of the Caisse back in 2003. Vega was a global macro fund run by Ravi and Jesus, two very experienced traders formerly of Santander. Great macro fund, tight risk management, a marketing machine, assets mushroomed from $2 billion to well over $12 billion in a few short years and after doing well, it sustained heavy losses in 2005-2006 and eventually closed.

In 2003, before all this happened, I recommended an allocation to this fund but also recommended to cut the initial allocation in half. My biggest concern was that I totally disagreed with their main thesis, which was to short US bonds, but I also had issues with how the fund was aggressively marketing to prospective clients.

Still, they had a great operational setup, knew their stuff, were seasoned traders and who was I to question their thesis? And to be fair, they were making excellent risk-adjusted returns even after I left the Caisse later that year (2003) to join PSP.

Sometimes you pick managers who have it all, experience, skills, a great team, great operational setup, tight and first rate risk management, and they still can run into big problems.

Can this even happen to Citadel or Bridgewater? Absolutely, it can happen to any fund and that's why I agree with Jacques Lussier, President and CEO of Ipsol Capital, Return = Alpha + Beta + Luck!!!!!!

[Note: Jacques's second book which he co-authored with Hugues Langlois, Rational Investing: The Subtleties of Asset Management, will be out in March 2017 and you can pre-order and read about it here.]

A lot of novice hedge fund investors need to read When Genius Failed just to get a reality check. I've said this before and I will repeat it, stop pandering to glorified hedge fund gurus and treat everyone the same and start grilling them hard no matter how poorly or well their fund is performing.

"But Leo, I'm very intimidated when sitting in front of a Ray Dalio, his top lieutenants or any other hedge fund guru. I just can't grill them like you used to do." Then investing in hedge funds is not for you, it's that simple.

When you sit in front of a Dalio, a Tepper, or anyone else and start asking them tough questions, you need to be very well prepared and be ready to get jabbed a couple of times (comes with the territory, you're dealing with egos the size of Trump's or worse in some cases).

[Note: Nowadays, even if you're a big investor, you have a better chance of winning the lottery than getting to sit in front of any hedge fund guru to ask them tough questions. Instead, you will deal with some investor relations person which is far from optimal.]

And that brings me to the point I want to make about why you need to be careful reading too much into the performance of any hedge fund manager. Do you understand the process? The sources of returns? The risks of the strategy? Are they benchmarking their performance properly or trying to pull wool over your eyes? Are their operations solid? Is their risk management rigorous or all smoke and mirrors? Are the managers simply lucky, riding a big beta wave up?

That last question might seem easy to answer, after all, if you get the beta benchmark right, it should be easy to determine whether there is any real alpha there, but there is an element of luck that is very underappreciated in all investment strategies.

I mention this because while there is a crisis in active management, we are living in extraordinary times where the alpha bubble has shifted to a giant beta bubble spurred by record low rates, a buyback bubble which is reaching its limits, robo-advisors shoving billions into "low volatility" and other ETFs, etc.

All this to say while it's tough finding elusive alpha, especially for the big giant funds, everyone needs to take a step back and really understand the market environment and what is driving returns in various long-only, hedge fund and private equity strategies.

And yes, on any given year, you will find exceptional outperforming hedge funds and long-only mutual funds, but try to understand their process and source of returns before chasing them (actually, you should never chase after any fund, period).

Hope you enjoyed this comment, if you have anything to add, feel free to email me at As always, please remember to subscribe or donate to the blog via PayPal on the top right-hand side under my picture (need to view web version on your cell phone).

Below, hedge fund billionaire David Tepper is pretty cautious on the market. Remember what I keep telling you, "beware of gurus with dire warnings!", and read my comment on bracing for a violent shift in markets.

More interestingly, Barry Rosenstein, JANA Partners founder, shares his take on why stock picking isn't dead (once the ETF bubble bursts). Richard Pzena, Pzena Investment Management, also weighed in on active vs. passive fund management, as well as market volatility.

Lastly, I embedded the full Al Smith dinner from Thursday night where Donald Trump and Hillary Clinton were supposed to be relaxed and look at the lighter side of things, all in the name of charity.

Trump started off well but then he really "trumped up" and you could feel the tension in the room (thought the good cardinal was going to fall off his chair but apparently they played nice behind the scenes). Have a great weekend and enjoy watching the elusive search for political humor.