The Hedge Fund of the Last Resort

"She thought that maybe - just maybe - Western Civilization was in a decline because people did not take time to take tea at four o'clock."

E.L. Konigsburg 1996, "The View from Saturday"

December 25, 2008 and the Bank of Japan reportedly decided to take (even more) drastic measures to revive the ailing patient, the Japanese economy. With no monetary policy bullets left in terms of interest rates (with the lending rate at 0.1%), the BoJ has moved from buying JGBs and CP to taking on corporate debt. The backstop has moved from the banking sector, then indirectly to the broader economy in the credit markets to directly boosting the industrial base.

The BoJ is signalling in no uncertain terms that its economy is flatlining, and barring flying over Tokyo Bay and dropping yen on the country there is nothing to stop the inevitable hard landing. Stocks are poised for further downside pressure as expected earnings are revised down.

The BoJ must now be considered the biggest hedge fund in Asia playing across a number of diverse asset classes including currencies, stocks, interest rates and now corporate debt. The irony is that there are no other "natural buyers" other than other Sovereign Hedge Funds (central banks) with an appetite to invest in such close to distressed opportunities. This begs the question that Asian political leaders need to sit down the collective risks and opportunities together- or else- expect a growing threat of social and politicial unrest in the region; and not just from a few displaced farmers, but from unemployed white collar workers!

While central banks have correctly tackled the economic levers individually it is becoming very clear that a more co-ordinated political strategy is now the best option to avoid what looks like a growing risk of cascading national economic disasters leading to global depression. It is noones interest to see this happen.

Other Sovereign Hedge Funds (central banks) in the U.S., U.K., Europe and elsewhere (China) are likely working the phones in the next few weeks. The biggest Sovereign Hedge Funds need to sit down very soon. Mahalo.

Asia Big Primes Prep for Deep Freeze

"One can survive everything, nowadays, except death, and live down everything except a good reputation."

Oscar Wilde, writer & poet

(1854 - 1900)

As overall trading flow from the US$1.5 trillion hedge fund industry asset goes, so goes associated service provider industries, including prime brokers.

Not too long ago (circa 2006) Asia hedge fund industry assets were an estimated US$150-200 billion or roughly 8-12% of total industry assets. Around a half of these assets came from Asia dedicated strategies which themselves comprised approx. 65-75% long short equity. The remainder came from so-called global managers (multi-strategy or global long/short equity) who, in the good old days, allocated anywhere from 10-40% of their global portfolios to Asia.

This latter group were (and still are) the real movers and shakers in the hedge fund business. They had the most capital to deploy, they were users of multi-currency and multi-market execution platforms (which favored the Big Primes) and they were largest users of stock lending, off balance sheet products, etc.

Pre Sub-Prime Era, global managers expanded their on-the-ground research and trading capabilities in Hong Kong, Singapore, Tokyo and to a lesser extent, Sydney. There were approximately 60 of these Big Funds. Today, many have scaled back laying off staff, allocating little to no money into Asian markets preferring to run night desk activity only, and shuttering any presence in Japan which has felt the biggest contraction on business.

Trading volumes have collapsed. Investors globally have withdrawn from Asia as they have from emerging markets. Not surprisingly, the unexpected drop in transactional activity, IPOs, in addition to the downward trend has changed the near term outlook for Big Primes as well as their competitors.

The pain has impacted all of the players including GS, MS and UBS. They are either laying off staff to skeleton shifts or they are quietly withdrawing altogether placing coverage to other time zones or regions. The next stage will hit Citi, ML, DB and then the other players in the so-called synthetic prime brokerage area including Nomura, Daiwa, Nikko et al.

This is not a short term change of course and talk of a rebound in the regions equity markets may be very premature. As even so called experts like Buffet have come to learn during the last few months, rather than merely another cyclical downturn (lasting 1-2 years) the Big Primes may in fact understand that this is a cyclical change (lasting 3+ years), and with the U.S. dollar falling there is less and less of an appetite to fund an increasingly expensive overseas operation in a stagnant trading environment.

The news will inevitable get a lot worse with many banks getting out of the prime brokerage business altogether in coming months and years. Depressing indeed. Mahalo.

Japanese Caught Up in Madoff Madness

"There must be more to life than having everthing!"

Maurice Sendak, 1967 from Higglety, Pigglety Pop!

Japanese institutional investors are believed to have suffered badly in one or more of the Madoff products that were marketed to them in recent years. Their exposure is likely to have been US$3-4 billion or maybe even as much as US$7-8 billion if trust banks or consultants had had enough time to direct the hoards of yield hungry Japanese pension funds.

The reality is, most losers are likely to have been investors of firms like Nomura investing proprietary monies, or worse still levering up investments of their HNWIs. In this case the revenue model would have been an up-front load (maybe 2-3% of assets) then a charge for the borrowed funds used to buy into the investment. It is also conceivable that the investor also paid a performance fee too, to Nomura! Clearly, with fees from selling Madoff's "investment" likely to have been as high as 6-7% of assets this was a lucrative "pump and dump" type of scheme.

It is a shame that Japanese individual investors will have to endure a lot of shame in this. Nomura and firms like it should be the ones covered in shame. Ideally, some brave soul should step forward with a Nomura prospectus that shows clearly just how much money Nomura was compensated in the marketing process. All products should have their fees clearly delineated on in investor-friendly adn accessible website. Let there be greater transparency on fees paid!

You can bet that the phone lines from Tokyo to New York and Connecticut were jammed when news hit the wires of the fraud on December 11th!

From an estimated peak of about US$65-70 billion of invested assets in single managers and fund of hedge funds a few years ago Japanese institutional investors have been pulling back from hedge fund products to under a third of that today. After Madoff the contraction is likely speed up.

The reasons were numerous. First, there was the issue of performance. A lot of Asia-regional products had effectively imploded starting with the Japanese focused ones from 2006 onward. The broader Asia-madate managers started to really tank in 2007.

Second, there had been a regulatory consideration (Basel II) that cut sharply the appetite for hedge funds by most financial institutions.

Third, the impact of Subprime Syndrome convinced many investment committees that the marketing pitch of diversification was not reliable or realistic in times of market stress. Aside from hitting hard fixed income arbitrage managers and those that with credit market exposure it also cut demand for many multi-strategy hedge fund of funds that had sold well in the good times on the basis of "name" and "brand". Once performance dipped on these products to below 5% the benefit to Japanese end-investors became questionable, especially in a falling foreign currency denominated product!

Fourth, many Japanese also pulled back investments in toxic structured products when these also fell sharply in value beginnning in the summer of 2007.

The Madoff product was a natural "winner" among weary Japanese investors. It fulfilled many superficial bureaucratic checks that a lot of institutional investor blindly followed: it had a long track record (10+ years); it had the "backing" of established companies who surely had done their own on the ground due diligence (at least visiting the premises once per year); it had an apparently appealing investment story which needs to be really ease to understand or really complex (in this case, complex; it was too big to fail (somehow size always is considered a positive and never a negative); and then, there were those impressive, non-correlated returns that offered an apparent yield of 700-900 bps over LIBOR - attractive to fixed income investors. Some Florida retirees referred to this as their "Madoff bond"!

The Madoff Madness that has erupted should teach Japanese institutional investors a number of lessons. First, hedge fund of fund firms (regardless of name, reputation or size) are no panacea for averting fraud in the industry. In fact, it could be argued that the bigger tyhe firm the more likely the process problems sith catching "problem managers". Second, if performance numbers look good to be true, they often are. Third, if the strategy takes longer than 2 minutes to understand chances are it is riskier than you think!

Fourth, every entity along the hedge fund distribution value chain should be incentivized to take responsbility for short term due diligence as well as longer term performance. Maybe a fixed fee should be imposed with a clawback dependent on various time/performance markers.

Why should a marketer care about the origins of those returns, and how is it that only the end investor loses out in the final analysis? Intermedaries collected their fees and paid their sales teams!

More risk (financial and legal) needs to fall on intermediaries and sales in order to unclog these conflicts of interest and impose responsibility where it belongs. Perhaps, investors should demand that the intermediaries also invest in the same products (and share classes) that they are peddling?

Now, Japanese investors should use the recent Madoff Madness as an opportunity, not to shy from all hedge fund strategies. That does not make sense. Instead, they should stand tall and negotiate responsibility from marketers of these products including deciding not so much how much fees are paid but rather when those fees are paid out. There should be benchmarks and deferred fee agendas to ensure that the interests of the marketers are more closely matched with those of the investors.

Finally, the Japanese investors themselves need to be more professional; they need to hire, retain and pay specialists (real market rates) to ultimately invest directly into hedge fund managers in much the same way that the US endowments and other global allocators are doing. The days of running their financial/investment arms from the HR or General Affairs departments are over. I am sure that this argument has been raised many times in the past. Mahalo.

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.

The Golden Age of Hedge Funds in Asia is Officially Over

"Sometimes it is harder to deprive oneself of a pain than a pleasure."

F. Scott Fitgerald
Novelist, from Tender is the Night (1896-1940)

As 2008 draws to a close the case for investing in Asia dedicated hedge funds appears to be falling like the collective performance of the industry.

It seems like a million years ago when all of the fundamental arguments in favor of Asia were trumpted by the media, academics and managers-alike. Asia was the place of fast growth companies; a growing, middle class consumer; a place where savings still outstripped personal consumption; and, where hedge fund managers could trawl for more abundant alpha.

According to data as of late November 2008, a sample of diversified equity hedge funds specializing in Asia followed by HSBC Private Bank, produced an average year-to-date return of minus 24.04%. The worst performer at minus 94.47% was 788 China Fund Ltd run by Jacques Mechelany and Michel Artaud. The best performer was Arnott opportunities Fund at 4.14% run by Kenneth Arnott. Aside from the stunningly poor performance one cannot help but notice the fact that assets have declined substantially across this and other single managers.

Looking at diversified equity hedge funds specializing in Japan, HSBC produced an average year-to-date return of minus 13.16%. This is one of the few times when having exposure to Japan rather than the rest of the world might actually have been "good". The worst performer was GAM Japan Equity Hedge Fund run by Lesley Kaye at minus 46.00%. The best performer was Gary Rosenfeld's Rosehill Japan Fund A at 3.36% through the end of October 2008.

The problem with falling asset base is that it inevitably pressures managers into cutting overhead which means losing staff and rolling up strategies or even funds. It also leads to price pressure as managers do what he/she can to keep clients or find new ones (if they can!). This, in turn, means that there is less liquidity across Asian markets. So much for talk of decoupling, at least for now!

The hedge fund model in Asia (and elsewhere for that matter) is broken. It will take time, education and "proof in the pudding performance" to bring back investors into these strategies. This is not just an ailment afflicting simply hedge funds but long-only mutuals and more critically the hedge fund of fund model as well. If anything, this recent blight that has impacted global equity markets has highlighted the importance of the "hedge" in the term hedge fund and either your fund can do so or it can't.

In some ways we may see a return to the original hedge fund trading style initially launched way back in 1949 which was essentially an equity market neutral kind of strategy. The days of investors backing levered-beta factories may be over. I for one will not back someone who offered this model to me, cloaked it in a 2-and-20 fee schedule and still did not cushion my downside risk. It simply does not add up.

That said, for those looking for signs that a turnaround in the markets may be coming it might be wise to focus on the region's banking sector. When these "pop", the chances are that the markets will rebound sharply. The question for investors might be to get access to such beta through a cheap ETF rather than through an expensive hedge fund format. But even in a recessionary cycle there will likely be more than one bear market rally. Take care out there. Mahalo.

Trading Companies Retreat From Hedge Fund Business

"He who is not courageous enough to take risks will accomplish nothing in life."

Muhammed Ali, former boxing world champion (b. 1942)

To date, the 4-5 biggest of Japan's trading companies have been treating from the hedge fund business. In their hey day, Japanese trading companies managed either directly or indirectly approximately US$8-10 billion of hedge fund product and brought it over to Japanese investors. Many of the these companies also invested (and some still do) on a proprietary basis in hedge fund strategies.

But the short term performance losses and redemption pressures from Japan-bsed investors have forced senior management in many of these firms to make an about face - in many cases to dump the same business model that they had built up since 2003/04.

By some accounts, Japanese institutional investors have put in 30%-40% redemptions with FoHF and single managers in 2008. The sudden and shocking appearance of "gates" and the move by some firms to imposee additional lock-ups sent many of them out, and potentially for good. At the very least it kepy up European and U.S. based operations to handle the Tokyo requests for clarity of what is going on in hedge fund land!

The fact of the matter is that Japanese institutional investors and many of their disrtributors are rotational investors. That means that they follow the "hot hand" in terms of strategy and manager. As investors you do not get rewarded for making good investment decisions, but you od get punished (by being sent to some remote regional posting) for bad investment decisions which means that the incentive system is also screwed up.

One such "victim", a prominent Japanese trading company has effectively shut down its business seeding 6-8 managers out of New York. In the old days they would try to find and negotiate equity on a one-for-one basis in return for US$20 million investment in the fund and in the firm (for operational fixed costs). The Japanese partner also marketed the returns to Japanese investors through its brokerage network back in Japan.

A similar pressure to streamline and/or retreat is now going on with other larger trading companies. But not all are moving back at the same pace. Mitsubishi is an exception. It has recently bought a stake in a European based finxed income arbitrage manager utilizing a relative value strategy. At the same time it is believed to have pulled somewhere in the order to US$200 MM from an existing investment that it had made with the CT seeder called Weston Capital.

Sumitomo has been a seeding manager with US$25-30 Million stakes and is apparently now culling those that "are not working" while focusing on those that are working. This means they are focusing on the positive performers (if indeed they have any of them).

Marubeni has not been doing too much although they were late to the business initially and when they did get involved they were CDO distributors in Japan. Of course that model has gone up in smoke!

The critical issue remains: what will Japanese institutional investors like pensions and some financial institutions do in the months and years ahead with equity markets likely to remain range-bound, the currency remaining strong and bond yields remaining very low? Surely they will have to find "profitable" absolute return product somehow? And where will that supply come from? Mahalo.