The End of Leverage Beta (Hedge Fund) Managers. What Next?

"He who has no taste for order, will be often wrong in his judgement and seldom considerate or conscientious in his actions".

Lavater, (1741-1801) Swiss Theologian and Mystic

2011 is rapidly turning into an annus horribilis for the hedge fund industry. Performance on an absolute and relative basis has been dreadful. Depending on the public database one looks at, roughly 75% of single managers are likely to post negative returns over the calendar year. Those general numbers applied generally can be applied across a number of long-only Asia-focused hedge funds which are likely to post -2% to -10% for the year.

According to Hedge Weekly #43 hedge fund data, by category and on an equal weighted basis, Multi-Strategy Asia was -2.29%; Equity Diversified Asia was -6.50%; Equity Diversified Japan was -6.53%; Market Neutral Discretionary Asia was +9.72%; and, Multi-Strategy Diversified Asia was -15.82% all through the first 3 weeks of October 2011.

Question: What can investors do in light of this? Answer: They need to go back to hedge fund basics.

1. Look for the correlation truth. The fact is that many analysts have spent so much time looking at manager specific risk factors that they have kind of forgotten to consider the strategy or portfolio level risk that has changed since 2008. The heart of this issue is the fact that hedge fund correlation has been changing. The fact is that there are very few single managers whose funds still can claim to exhibit non-correlation to stocks, bonds or even other hedge fund peers.

This is an inconvenient truth, and by implications it means that investors are not in fact investing in "alternatives". Sceptics charge that the vast majority of long-short equity hedge fund managers are simply high-fee, leveraged beta vehicles.

It is incumbent upon prospective hedge fund investors to identify how correlated their prospective hedge fund manager's performance is versus an equity and bond index as well as to examine that correlation over 6-month, 12-month and 36-month time periods. Clearly, the higher the number to 1 the clearer that what they will be looking at is not a hedge fund.

2. Define the hedge. The bulk of long-short equity managers use broad market ETFs to hedge against single stock exposure in their portfolios. This is inadequate. Moreover, the value-growth or large cap-small cap hedge which has often been deployed in Japan simply has not worked. If the hedge cannot be defined then the case for investing in the hedge fund does not exist anymore.

3. Are manager-investor incentives aligned? A.W. Jones offered one of the first hedge fund vehicles in 1949 with a 0% management fee and 20% performance fee. In a climate of awful performance is a sub-par hedge fund still deserved of any management fee? It is easy to see where this question leads...

4. Managed accounts are no guarantee of hedge fund performance. Managers do not like them as they are often lower margin versions of existing fund structures. For investors, having more frequent snap-shots of performance and transparency are no panacea for fraud or incompetence. If the manager cannot or will not provide a comfortable level of information on asking at the fund level then why bother? Forget the middle-man platform provider and simply ask for daily or weekly GAV numbers. The majority of hedge funds do and can provide this information.

The hedge fund industry shake-out which began in 2008 continues and the field is expect to whittle down in coming years. Those who survive will offer products that are closer to the original hedge funds that offered: liquidity, transparency, limited counter-party risk, investment in listed instruments, and, non-correlated absolute returns i.e. genuine alpha managers will get paid, and, the pretenders will not.

With increasing numbers of institutional investors searching for alpha, expect the shortage of good alpha producers to remain one of the most enduring problems facing investors. The end is nigh for leveraged beta managers offering alternative investments. Mahalo.