2012 Through the Looking Glass

"Strategic leadership requires one other skill. It requires a readiness to look personally foolish; a readiness to discuss half-baked ideas, since most fully baked ideas start out in that form; a total honesty, a readiness to admit you got it wrong."

Sir John Hoskyns, b. 1927, CEO, The Burton Group

Here is a brief overview of some of the broader themes that are likely to impact the hedge fund industry heading into 2012:

• Performance Expectations. Investors need to have clear expectations about what an investment in a hedge fund should produce. It seems that many do not. In fact, they may have unrealistic expectations based upon the fictitious belief that what happened in the past will continue into the future. The truth (in 2011) is that getting +10% may be unrealistic, even for 2012, especially in a zero interest rate environment. 2012 is likely to be punctuated by a continuation of choppy markets and RISK-OFF...much more suitable for trading strategies. In this author's opinion, the investor should be gunning for high absolute returns as well high relative returns i.e. non-correlation to stocks, bonds and hedge fund peers. For many institutional investors this might mean actually reducing their hedge fund allocations in favor of making a greater allocation to a 60-40 portfolio keeping a portion in cash (short term U.S. Treasury Securities) in times of high market volatility. Returns from Asia-based investments are likely to be worse that those derived in a number of developed markets in light of liquidity pressures in 2012.

• Macro Themes will Dominate - Macro Funds Not. 2011 has already shown many investors that just because one has a view across a number of different geographies and asset classes it does not mean you will make money. Ironically, it might be more difficult given the heightened cross-market correlations. In fact, this year has probably taught many investors that diversification on a portfolio level might actually increase overall risk rather than the conventional view that it does the opposite. For example, the slow moving train wreck that is European debt, and bank sector difficulties has not as yet made a billion $ for any hedge fund managers (sometimes the goal posts keep on moving). Investors might do best in 2012 by focusing on niche strategies that are not so diversified but rather have quantifiable risks with little counter-party risk factors.

• Current Hedge Fund Fee Model is Broken. This authors believes that close to two thirds of managers in 2011 will post negative returns of somewhere between -3% to -10%. Investors cannot and should not pay ANY management fee if there is no performance. In fact, if they do then then there is no real alignment of interests between managers and investors. I expect that a new set of managers will come about that will focus on added-value and the performance fee component. Expect more spin-offs from larger managers and a flurry of commodity related managers to raise assets as investors flock to non-correlated assets and strategies.

• Hedge Fund of Funds: A Dying Breed. They are already becoming out-sourced due diligence factories rather than purveyors of an exclusive stable of hard to find managers. They cannot guarantee that they might not provide "stinkers" in their portfolio offerings (Paulson anyone?), plus, they really need to produce at least 8-10% in returns in order to cover their own costs (fees on fees...). One way to survive might be to offer up a real life Darwinian model that on a monthly basis cuts managers who underperform, starting the year with 12 managers and ending it with 4-5 always culling the poorest performers. This seems radical and might only be feasible within a managed account platform but then components of such a platform will have issues in themselves. Overall AUM in the HFoF space are likely to start to decline from 30% in the mid 2000s to around 10% in 2012 as institutional investors realize that performance and fees are not attractive anymore.

• Small is Beautiful. Expect hedge fund firms with assets under $2 billion to now represent the sweet performance spot for many investors, as the so called $10 billion+ shops take a bath in 2011. This is a radical change in the investment regime previously undertaken by institutional investors since the 2000s in which the data showed that not only did the larger managers perform better but that diversification of strategies was the sure way to go. Today, that ideology has been thrown out of the window...big managers have not performed well at all since 2008, and moreso in 2010 and now in 2011. Expect an increasing number of larger funds that lose assets and to turn back from being hedge funds to being family offices in order to escape the long arm of regulation and costly transparency and reporting requirements. This is a major change in the way investors view the industry. I do not think that it will necessarily help Asia-focused managers though as many of their strategies are typically not scalable beyond $500 million before diseconomies of returns set in. If they are scalable, they tend to involve diversification (increased risk) and (il)liquidity issues. I believe that a number of larger Asia-focused funds will close if they focus on Asia alone.

• Asia Hedge Fund Industry Assets to Shrink 25%. While there are approximately $130 billion in combined AUM today (Eurekahedge), the combination of poor equity markets plus underlying issues related the Asia-region banks is likely to hinder markets. China is likely to be down and India certainly has a lot to do including dealing with high inflation before stocks will take off. As the bulk of Asia hedge funds still focus on long-short equity is is reasonable to estimate that poor performance plus a lack of fund raising will hurt many of these funds. Many will be forced to close like Boyer Allan or RSR capital due to underperformance, while other larger multi-strategy shops will probably cut costs and reduce their exposure to the region especially if global P&Ls remain pressured as they have been. Why retain an expensive office in HK or Singapore with staff when a night desk is relatively cheap Chicago or San Francisco might suffice for now?

Overall, there is likely to be a more focused industry, with many asset gatherers being driven out. A number may simply transform into long-only investment shops too while others might simply split up allowing those PMs with experience with illiquid PE-type investments continuing on their own. Those managers that are able to survive this rough patch will benefit from a whole host of opportunities once the global markets are back on a positive growth course. Mahalo!