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Hedge Funds in Asia

Wednesday, September 28, 2011

Performance Depression Is New Normal For Institutional Investors

"A race horse that can run a mile a few seconds faster is worth twice as much. That little extra proves to be the greatest value."

John D. Hess

The hedge fund industry originally stood for "credible" investment strategies that offered superior absolute performance. They were non-correlated to stocks and bonds; invested in liquid, listed instruments; hedged; and, charged a performance fee and no management fee. These tenets plus early performance returns made them attractive to institutional investors who were eager to escape the sharp swings in volatility and poor performance from long-only investments.

Time change, and the industry boomed. New managers and complex strategies sprung up. Moreover, as stocks and bonds underperformed, the hedge fund industry attracted more assets so they charged higher fees and this attracted even more managers who fled the long-only stock picking world.

But the investment climate changed too. Stocks became more volatile. Bond yields started to sink to multi-decade lows and even the concept of a risk-free asset has been pretty much thrown out of the window in light of banking crises including liquidity and solvency issues.

Which brings us the current predicament facing many institutional investors. Many have moved out of stocks and bonds and have been loading up on hedge funds particularly over the last 10 years. This jives with the anecdotal reports in the media about various public and private pension plans increasing allocations to hedge fund strategies.

According to Infovest21 survey data some US pension plans who used to allocate about 30% of assets to fixed income in 2000, in 2010 now allocate around 18%. This is a staggering decline. It is ironic too as a diverse exposure to long-only fixed income (e.e. Barclays Agg) would have produced a decent return while the bulk of traditional stock benchmarks would have not. Surveyed pension plans also invested 62% of assets in equities in 2000 only to sink to 46% in 2010.

The concept of cash as an asset class has also changed. For many this morphed into a game of chasing yield including products like the PIMCO Total Return Fund. This strategy worked - until it didn't. In fact it produced negative returns as the fund invested in "riskier" assets including foreign currency bonds and high yield paper.

All is not so bad as long as the hedge fund industry can still produce superior absolute returns. That "story" now has started to corrode. According to virtually any hedge fund data source including the Dow Jones Credit Suisse Core Hedge Fund Index, YTD numbers show returns of -6.62% for 2011. For a large institutional investors who typically are targeting around 6-8% in their performance returns this is a stunning fail. And boardrooms are in a panic over the short term as well as the medium term.

The worrying thing is that in the good old days hedge fund underperformance was reserved for small, emerging managers or medium sized shops that sis not have the lower cost of capital or brokerage relationships as the closed big boys. These days being big has become a liability. Virtually all of them have suffered staggering losses that will inevitably trigger a fresh round of investor redemptions heading into 1Q2012. Notice letters will be posted and many will flee to cash. Not even so-called managed accounts will avert redemption frustration at the coming negative numbers.

Which brings us the the real medium term dilemma. Where are all the funds that are non-correlated, charge only a performance fee, are hedged and that invest only in liquid, listed instruments and that focus on positive absolute returns?

It seems to me that there these are few and far between and that the real issue for institutional investors is in creating supply of managers to satisfy their demand. This may mean investing in emerging managers and not with the behemoths that are now too correlated to avoid stepping into drowning market situations such as the recent commodity blow-off. Sometimes the concept of diversification can get you in trouble, especially when the concept of risk can change so dramatically from one time period to the next and from one QE policy thrust to the next. Mahalo.