Pedigree Be Damned; Give Me Performance
"A casual stroll through the lunatic asylum shows that faith does not prove anything."
Friedrich Nietzsche
'Tis the season to make forecasts. Frankly speaking, I or anyone else for that matter, has no idea what shape the hedge industry will take in coming months let alone years. There have been so many surprises over the last 3 months.
But here goes:
1. Deleveraging. Many equity long short funds had already cut back in 4Q07 through 1Q08 from an average of 3:1 to 5:1 only to ramp up again during the summer as the whole world (and virtually all strategies) chased the same Long Commodities-Short Financials "bubble".
Of course many so-called quant-driven funds employed double that amount in leverage terms and had already taken various hits (see Goldman's Global Alpha, RIEF and various AQR funds).
In the months and years ahead, "primes" will not be actively bidding against each other to throw free money to the big hedge funds in order to capture their flow. In this new environment, the 250-300 bps execution cost advantage that Big Funds ( AUM over US$6 billion) had will vanish! This will hit the performance of many famous names such as Citadel.
On the single manager level much of the deleraging is likely to be over by Jan/Feb 2009 as the situation with regards to investor redemptions should look clearer. Look for single managers to start to employ more capital very soon into the new year.
Another often missed point when it comes to deleveraging is the fact that maybe up to 20-25% of HFoF total assets were in products that were effectively levered at the portfolio level. The underlying assets were typically relative value strategies and "low vol" in normal trading conditions.
Bye-bye normal trading conditions. These funds which were aggressively marketed through Swiss private banks and many European FoHFs have cratered. Simply put, a minus 25% return in the unlevered fund now turned into a minus 50-75% loss (depending if the fund was levered 2X or 3X). Naturally, these investors have run for cover and the brand damage to the remaining FoHF firms has been crippling. Many HFoFs may go under as a result. I expect as many as 75% might disappear/merge in 2009.
The reality is that other non-hedge fund players have employed significantly more leverage including investment banks (30-50X) as well as some of the prop trading operations of the SWFs.
2. Redemptions. The media guessing-game as to how much the industry is going to lose has been greatly exaggerated. Listening to so-called talking heads making guesstimates is about as analytical as a monkey throwing darts at a board!
The reality is that October and November saw 2 of the biggest monthly redemptions by investors from mutual funds not hedge funds. The sums amounted to close to US$1 trillion and US$800 billion respectively on a global basis. That compares with the hedge fund industry total assets of just under US$2 trillion. You tell me which players have experienced the more shocking outflows? Look at the press today and the Fidelities of the world are in retrenchment mode due to the investor outflows. This is the real issue. Retirees have been voting with their wallets out of these vehicles, heading into short term Treasuries and CDs. Why have significant exposure in equities and bonds if you cannot hedge?
Among single hedge fund managers I have looked at, not all managers have 3 month redemptions or 90 day notice periods, so that there could never be a situation where a tsunami of redemptions would be unleashed on the financial and commodity markets. And yet the press keeps on harping on it as if it were a fact. Strange. Strange too, is the fact that many institutional investors like pension plans and endowments actually have long-term investment horizons and this means that they too will tend to flip unprofitable with profitable strategies and managers in their portfolio mix.
It is more likely to be the panic sellers who need cash here and now who have sold and will continue to do so (often hiding in short term U.S. Treasuries). I estimate that US$250-US$300 billion in AUM will redeem from hedge fund strategies especially from long/short equity, event driven, convertible arbtirage and fixed income arbitrage.
In the new hedge fund world, if you as a manager cannot prove that you are not in crowded trades and do not have a hedge then it will be hard to raise capital. The days of relying on pedigree alone will be over. Investors want performance pure and simple. We will enter into a "Show Me The Money" world of investor expectations.
On a not unrelated note, expect redemptions from HFoF to really take off. This is where I think the real potential issues will lie with investors. Now that the bulk of these bastions have not offered diversification or poor performance institutional investors may take a very large bite out of those firms that have really bombed out in 2008.
HFoFs may endure fee reduction in return for short-term investor loyalty. This is really here the shocking impact of redemption flight that is taking place right now. Big established FoHFs will go under or be forced to merge. They will look to cut costs and so outsource increasing portions of the business model in order to specialize on the portfolio construction aspect of the operations.
One way that FoHFs are fighting back is by setting up the same model operated through SMAs. Time will tell whether this model will be flexible enough to encompass a broad enough range of hedge fund strategies to be considered a truley scalable business model (i.e. taking in several billion dollars).
While the proponents will point to the likes of Lyxor as having a sustainable business model, many single managers do not like to have these large behemoths moving large % of assets in and then out of their coffers. Size and reliance on size can kill!
In short I expect about 50% of the HFoFs to "die". The lone growth area will be seeding and incubation where the capital provider typically takes some of the economics if not the equity of the General Partnership. Remember too that it will take capacity in the future to feed the impending supply-demand imbalance in the industry.
3. Attrition. In normal times, Tremont had calculated average attrition rates since 1994 at 8% for single managers and 12% for FoHFs. Depending on which region you are talking about (Asia will almost certainly be higher) look for 25% for single managers and 40% for HFoFs. there will be many zombie hedge funds in coming months and years as management fails to execute the changes necessary to turn their businesses around to attract assets.
In any case, it might simply be easier to shut the firm down and start again minus the legacy of losses and the weight of being way under the high water-mark. Unlike previous times, I am not too sure that institutional investors will be as forgiving the next time around to these managers.
4. Performance. Why is so little debate raging about performance? In my estimation barring the blip up in 2007 performance compression is a fact of life for the industry moving forward. I believe that equity markets will rally within a range in the next 12-24 months and some of the upticks will be rapid and sharp in percentage terms. But let us to confuse beta with alpha.
Overall performance will probably be subdued. Rememebr that the risk free rate is falling again and especially with significantly lower leverage this mean that average FoHF returns will fall back to 4-7% annually and not the 8-12% that was marketed by many a few years ago.
Of note too, the days when the top quartile Big Funds enjoyed a 660 bps performance advantage over average hedge funds from 2002-2007 may be over too due to almost inevitable restrictions that might be placed on them by global financial authorities, such as in the case of shorting stocks, or in cases of activism.
Performance is the most important issus facing managers in the months and years ahead. For those boutique firms that produce alpha and that can hedge, I predict that they will command higher fees. The fee gaps between these managers and those that offer low performance, non-correlated returns will widen. They are starting to anyway. I do not think that the 2-20% model is dead. In fact, I think it will should thrive and investors would be unwise to give the wrong signals to the those managers that in this environment have produced alpha.
Shouldn't these managers with proven skill be rewarded if they can produce outsided alpha? It might be worth thinking about, if we all want to enjoy any pensions in the coming years. Now is not the time to kill the goose that lays the golden egg. Mahalo.
"A casual stroll through the lunatic asylum shows that faith does not prove anything."
Friedrich Nietzsche
'Tis the season to make forecasts. Frankly speaking, I or anyone else for that matter, has no idea what shape the hedge industry will take in coming months let alone years. There have been so many surprises over the last 3 months.
But here goes:
1. Deleveraging. Many equity long short funds had already cut back in 4Q07 through 1Q08 from an average of 3:1 to 5:1 only to ramp up again during the summer as the whole world (and virtually all strategies) chased the same Long Commodities-Short Financials "bubble".
Of course many so-called quant-driven funds employed double that amount in leverage terms and had already taken various hits (see Goldman's Global Alpha, RIEF and various AQR funds).
In the months and years ahead, "primes" will not be actively bidding against each other to throw free money to the big hedge funds in order to capture their flow. In this new environment, the 250-300 bps execution cost advantage that Big Funds ( AUM over US$6 billion) had will vanish! This will hit the performance of many famous names such as Citadel.
On the single manager level much of the deleraging is likely to be over by Jan/Feb 2009 as the situation with regards to investor redemptions should look clearer. Look for single managers to start to employ more capital very soon into the new year.
Another often missed point when it comes to deleveraging is the fact that maybe up to 20-25% of HFoF total assets were in products that were effectively levered at the portfolio level. The underlying assets were typically relative value strategies and "low vol" in normal trading conditions.
Bye-bye normal trading conditions. These funds which were aggressively marketed through Swiss private banks and many European FoHFs have cratered. Simply put, a minus 25% return in the unlevered fund now turned into a minus 50-75% loss (depending if the fund was levered 2X or 3X). Naturally, these investors have run for cover and the brand damage to the remaining FoHF firms has been crippling. Many HFoFs may go under as a result. I expect as many as 75% might disappear/merge in 2009.
The reality is that other non-hedge fund players have employed significantly more leverage including investment banks (30-50X) as well as some of the prop trading operations of the SWFs.
2. Redemptions. The media guessing-game as to how much the industry is going to lose has been greatly exaggerated. Listening to so-called talking heads making guesstimates is about as analytical as a monkey throwing darts at a board!
The reality is that October and November saw 2 of the biggest monthly redemptions by investors from mutual funds not hedge funds. The sums amounted to close to US$1 trillion and US$800 billion respectively on a global basis. That compares with the hedge fund industry total assets of just under US$2 trillion. You tell me which players have experienced the more shocking outflows? Look at the press today and the Fidelities of the world are in retrenchment mode due to the investor outflows. This is the real issue. Retirees have been voting with their wallets out of these vehicles, heading into short term Treasuries and CDs. Why have significant exposure in equities and bonds if you cannot hedge?
Among single hedge fund managers I have looked at, not all managers have 3 month redemptions or 90 day notice periods, so that there could never be a situation where a tsunami of redemptions would be unleashed on the financial and commodity markets. And yet the press keeps on harping on it as if it were a fact. Strange. Strange too, is the fact that many institutional investors like pension plans and endowments actually have long-term investment horizons and this means that they too will tend to flip unprofitable with profitable strategies and managers in their portfolio mix.
It is more likely to be the panic sellers who need cash here and now who have sold and will continue to do so (often hiding in short term U.S. Treasuries). I estimate that US$250-US$300 billion in AUM will redeem from hedge fund strategies especially from long/short equity, event driven, convertible arbtirage and fixed income arbitrage.
In the new hedge fund world, if you as a manager cannot prove that you are not in crowded trades and do not have a hedge then it will be hard to raise capital. The days of relying on pedigree alone will be over. Investors want performance pure and simple. We will enter into a "Show Me The Money" world of investor expectations.
On a not unrelated note, expect redemptions from HFoF to really take off. This is where I think the real potential issues will lie with investors. Now that the bulk of these bastions have not offered diversification or poor performance institutional investors may take a very large bite out of those firms that have really bombed out in 2008.
HFoFs may endure fee reduction in return for short-term investor loyalty. This is really here the shocking impact of redemption flight that is taking place right now. Big established FoHFs will go under or be forced to merge. They will look to cut costs and so outsource increasing portions of the business model in order to specialize on the portfolio construction aspect of the operations.
One way that FoHFs are fighting back is by setting up the same model operated through SMAs. Time will tell whether this model will be flexible enough to encompass a broad enough range of hedge fund strategies to be considered a truley scalable business model (i.e. taking in several billion dollars).
While the proponents will point to the likes of Lyxor as having a sustainable business model, many single managers do not like to have these large behemoths moving large % of assets in and then out of their coffers. Size and reliance on size can kill!
In short I expect about 50% of the HFoFs to "die". The lone growth area will be seeding and incubation where the capital provider typically takes some of the economics if not the equity of the General Partnership. Remember too that it will take capacity in the future to feed the impending supply-demand imbalance in the industry.
3. Attrition. In normal times, Tremont had calculated average attrition rates since 1994 at 8% for single managers and 12% for FoHFs. Depending on which region you are talking about (Asia will almost certainly be higher) look for 25% for single managers and 40% for HFoFs. there will be many zombie hedge funds in coming months and years as management fails to execute the changes necessary to turn their businesses around to attract assets.
In any case, it might simply be easier to shut the firm down and start again minus the legacy of losses and the weight of being way under the high water-mark. Unlike previous times, I am not too sure that institutional investors will be as forgiving the next time around to these managers.
4. Performance. Why is so little debate raging about performance? In my estimation barring the blip up in 2007 performance compression is a fact of life for the industry moving forward. I believe that equity markets will rally within a range in the next 12-24 months and some of the upticks will be rapid and sharp in percentage terms. But let us to confuse beta with alpha.
Overall performance will probably be subdued. Rememebr that the risk free rate is falling again and especially with significantly lower leverage this mean that average FoHF returns will fall back to 4-7% annually and not the 8-12% that was marketed by many a few years ago.
Of note too, the days when the top quartile Big Funds enjoyed a 660 bps performance advantage over average hedge funds from 2002-2007 may be over too due to almost inevitable restrictions that might be placed on them by global financial authorities, such as in the case of shorting stocks, or in cases of activism.
Performance is the most important issus facing managers in the months and years ahead. For those boutique firms that produce alpha and that can hedge, I predict that they will command higher fees. The fee gaps between these managers and those that offer low performance, non-correlated returns will widen. They are starting to anyway. I do not think that the 2-20% model is dead. In fact, I think it will should thrive and investors would be unwise to give the wrong signals to the those managers that in this environment have produced alpha.
Shouldn't these managers with proven skill be rewarded if they can produce outsided alpha? It might be worth thinking about, if we all want to enjoy any pensions in the coming years. Now is not the time to kill the goose that lays the golden egg. Mahalo.
posted by Franklin Scruggins | 5:51 PM
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