Jean Giraudoux (1882-1944)
Whatever happened to hedge funds posting 8-12% average returns? Whatever happened to the so called Super Funds producing +200 basis points over their peers and the top quartile of the same Super Funds producing +600 basis points over their peer average? Why all now?
As 2011 comes to a close the average global hedge fund will post anywhere between -5% to -10% (depending upon which database you subscribe too). That is dreadful for a number of reasons.
First, lower performance fees means that GPs, analysts and traders will have less income heading into 2012.
Second, on a broader scale the lower performance means lower commission volumes for service providers such as prime brokers, administrators, auditors and attorneys.
Third, it hurts the returns of the many institutional investors (such as private and public pension plans in the US) that piled into these strategies in the aftermath of 2008.
Forth, the losses undermine the (academic) moral high ground that states that unconstrained, active management out performs relatively and absolutely. This last point is potentially the most damning as it questions many conventional wisdoms about hedge funds, the so-called talent pool that it has attracted, and, the very way that institutional investors approach portfolio allocation today and into next year.
In my opinion, this not a cyclical phenomena but a secular one. The growth of the industry from the late 1990s to today has undergone a number of important shifts. Looking at the distribution of high performing managers and their underlying strategies one can see how the drivers of returns are not static. In fact, they have changed.
In the early days, hedge funds simply made money in equity market neutral trades principally in stocks. They bought cheap stocks and sold baskets of expensive ones. They also rode up the technology-led bubble. This worked for a few short years until everyone fell into the same crowded trades.
Then came the era of "inside information" and access to deal-flow was one of the best features of the return profile of the so-called macro strategies. a number of managers heard about macro changes (interest rates, devaluation policy, forex etc.) before the crowd. They took advantage of these moves and made fortunes.
This coincided with the growth, popularity and outperformance of the so called Super Funds. They also enjoyed a significant cost of capital advantage and access to stock loan, for shorting and event driven purposes.
Then the rules were changed with Sarbanes-Oxley. Instead, the best performers rode the ear of low interest rates and the bull run in bonds in the 2000s in addition to the emergence of emerging markets. It was the time of event driven managers, mega M&A deals and the start of the quant managers and commodities.
The subtle strategy shifts clearly favored the larger hedge funds (Super Funds) that were geographically dispersed and that enjoyed lower cost of capital. They diversified their portfolios and as other did so too they moved into the PE space taking up more illiquid investments to boost returns, as many liquid strategies started to become crowded.
In 2006/07 correlations between managers and strategies started to really move violently. Both short and long horizons reflected a growing correlation between asset classes, and even managers. Now, commodity bets became very aligned with the NASDAQ and equities in general for example. The tipping point became the 2008 Credit & Liquidity Crises. This critical period once and for all eroded the reign of the Super Fund.
The irony is that many of them still managed to survive by shifting their investor base out of HNWI and hedge fund of funds into more institutional "sticky" money such as pension plans. The amounts were larger. The inflows represented investments on previous year's performance numbers -sadly, under different correlation and liquidity regimes. Fast forward to today. Almost all Super Funds are underwater or near to being underwater in 2011.
The onset of Risk-On and Risk-Off crushed previously established correlation patterns. Suddenly, correlations became very high across virtually all asset classes. Moreover, investors were unwilling to take on the illiquid investments that they were in the past. This is the new performance reality. Simply saying that one runs a hedge fund is no longer a recipe to collect high management fees based upon historical returns, certain "career pedigree" or strategy (stock-picking) bucket.
Dreadful average hedge fund returns, and the emergence of high volatility is going to make life considerably harder for alpha producers to fake. The stick is now firmly in the hands of the investors to demand lower fees, or else. Now more than ever, the old DDQ qualifications of a Wharton or Harvard MBA, a stint at GS and "failure" at a Super Fund will not be reason enough for an entrepreneurial manager to hang his shingle as a bone fide hedge fund producing alpha. Ironically, these may be qualifications for eventual failure in the industry.
Let the winners of 2012 be a reversion to an older investment philosophy based on non-correlated returns emerge. Lets also hope that investors come to realize that like the golden goose, finding genuine and consistent alpha in a hedge fund is really hard to come by and that out of the 9,000 or so firms that exist probably less than 100 can actually fit the bill rather than the same 450 Super Funds that have been benefiting from inflows since the mid-2000s. That group sill be culled in 2012. It appears that small may again be beautiful in terms of elusive alpha generation. Mahalo.