Obituary: Hedge Fund of Funds Model

"I am not afraid of death; I just don't want to be there when it happens!"

Woody Allen b. 1935
Actor, Playwright, Comedian and Musician

Fast forward to 2016. Didn't we see this coming? Didn't we warn ourselves of the coming commoditization of the the hedge fund industry? Didn't the naysaysers warn that simply repacking a group of underlying managers added so apparent value if performance sagged, correlations shot up across strategies and so-called superior due diligence did not prevent a continued stream of blow-ups? We all knew that these risks existed. Why did we still support to the Hedge Fund of Fund industry? Why did we all run into the light, along a busy road?

Times have changed and the industry with it. Smaller, niche oriented operations may survive. Scale is now no guarantee of success. Operators who are seeders may also find a time and a place. The cruz will be in actions of institutional investors. Lets hope they get it right this time around. Aurora Management RIP.

Asia Fights Back: Hedge Funds Stagnate

"Nearly all men can stand adversity, but if you want to test a man's character, give him power."

Abraham Lincoln (1809 - 1865)

Amid a backdrop of volatile global equity markets, weak U.S. employment data, a resurgence of Euro Sovereign debt risk and trading losses at JPM, the hedge fund industry as measured by the HFRX Global Hedge Fund Index posted a meagre +2.01% YTD return (through mid-May).

In comparison Asia-focused hedge fund managers appear to be fighting back. According to HSBC HedgeWeekly edition #19, the Equity-Diversified category posted a +3.93% YTD return (through May 11) led by WF Asia Fund run by Scobie Ward with +12.63%, while the biggest loser has been Nezu Cyclicals Fund Ltd with -1.01%. Those focused on Japan have produced an average of +3.51% led by SR Global Fund H - Japan with +12.86% (albeit with only $15 million in AUM) and the the worst performer being Martin Currie ARF - Japan Fund with -1.80%. Compared to terrible 2011 numbers, it appears that there has been somewhat of a rebound in 2012 although the number of managers and their respective AUM have all undergone significant shrinkage. The leading funds in terms of size in Asia continue to be Ellerton and Joho although both produced fairly lackluster 2011 returns. Living on past performance? Who knows.

What is clear is that there has been no decoupling in terms of hedge fund manager performance for those situated in Asia. On the contrary, there is a lock-step performance with their western brethren as they all suffer the wild and manic directional swings brought on by risk-on and risk-off in the current trading environment. Mahalo.

2011 Asia's Hedge Fund Annus Horribilis

"A man's respect for law and order exists in precise relationship to the size of his paycheck"

Adam Clayton Powell Jr. (1908 - 1972), "Keep the Faith, Baby!", 1967

The debris caused by the risk-on, risk off storm of 2011 uncovered an ugly end to the net of fee performance of many hedge funds, including those specializing in Asia. The HFR hedge fund index came in at -5.25% over 2011 while Asia-focused strategies tracked by HSBC Private Bank were as follows: Asia Multi-Strategy, -3.91%; Equity Diversified Asia -9.06%; Equity Diversified Japan -7.69%; Macro Diversified Asia +6.10%; Market Neutral Discretionary Asia +10.13%; Multi-Strategy Asia -0.15%; and, Multi-Strategy Diversified Asia -15.99%.

Overall, not an impressive performance put up by the industry. That plus rising operational costs and an absence of early western investors suggests that the near term performance landscape will remain bleak with an outflow of AUM and quiet firm closings.

The reasons are numerous for the generally poor showing among the majority of funds. Aside from negative macro money policy actions from a number of the regions cbs, the vast bulk of investors were swept away with the same risk-on and risk-off bipolar like volatility that afflicted developed western markets. In such an environment, much foreign liquidity simply raced back home or sought safety in gold (at least initially) then U.S. Treasuries. More traditional bottom up, stock picking or liquidity driven momentum investing was thrown aside as retail fled for cash or cash equivalents.

Until risk-on returns the picture will remain difficult for long-biased equity hedge fund managers trawling Asian financial public markets. Mahalo.

Hedge Fund Alpha Gets More Elusive

"The secret of success is sincerity. Once you fake that, you've have got it made."

Jean Giraudoux (1882-1944)

Whatever happened to hedge funds posting 8-12% average returns? Whatever happened to the so called Super Funds producing +200 basis points over their peers and the top quartile of the same Super Funds producing +600 basis points over their peer average? Why all now?

As 2011 comes to a close the average global hedge fund will post anywhere between -5% to -10% (depending upon which database you subscribe too). That is dreadful for a number of reasons.

First, lower performance fees means that GPs, analysts and traders will have less income heading into 2012.

Second, on a broader scale the lower performance means lower commission volumes for service providers such as prime brokers, administrators, auditors and attorneys.

Third, it hurts the returns of the many institutional investors (such as private and public pension plans in the US) that piled into these strategies in the aftermath of 2008.

Forth, the losses undermine the (academic) moral high ground that states that unconstrained, active management out performs relatively and absolutely. This last point is potentially the most damning as it questions many conventional wisdoms about hedge funds, the so-called talent pool that it has attracted, and, the very way that institutional investors approach portfolio allocation today and into next year.

In my opinion, this not a cyclical phenomena but a secular one. The growth of the industry from the late 1990s to today has undergone a number of important shifts. Looking at the distribution of high performing managers and their underlying strategies one can see how the drivers of returns are not static. In fact, they have changed.

In the early days, hedge funds simply made money in equity market neutral trades principally in stocks. They bought cheap stocks and sold baskets of expensive ones. They also rode up the technology-led bubble. This worked for a few short years until everyone fell into the same crowded trades.

Then came the era of "inside information" and access to deal-flow was one of the best features of the return profile of the so-called macro strategies. a number of managers heard about macro changes (interest rates, devaluation policy, forex etc.) before the crowd. They took advantage of these moves and made fortunes.

This coincided with the growth, popularity and outperformance of the so called Super Funds. They also enjoyed a significant cost of capital advantage and access to stock loan, for shorting and event driven purposes.

Then the rules were changed with Sarbanes-Oxley. Instead, the best performers rode the ear of low interest rates and the bull run in bonds in the 2000s in addition to the emergence of emerging markets. It was the time of event driven managers, mega M&A deals and the start of the quant managers and commodities.

The subtle strategy shifts clearly favored the larger hedge funds (Super Funds) that were geographically dispersed and that enjoyed lower cost of capital. They diversified their portfolios and as other did so too they moved into the PE space taking up more illiquid investments to boost returns, as many liquid strategies started to become crowded.

In 2006/07 correlations between managers and strategies started to really move violently. Both short and long horizons reflected a growing correlation between asset classes, and even managers. Now, commodity bets became very aligned with the NASDAQ and equities in general for example. The tipping point became the 2008 Credit & Liquidity Crises. This critical period once and for all eroded the reign of the Super Fund.

The irony is that many of them still managed to survive by shifting their investor base out of HNWI and hedge fund of funds into more institutional "sticky" money such as pension plans. The amounts were larger. The inflows represented investments on previous year's performance numbers -sadly, under different correlation and liquidity regimes. Fast forward to today. Almost all Super Funds are underwater or near to being underwater in 2011.

The onset of Risk-On and Risk-Off crushed previously established correlation patterns. Suddenly, correlations became very high across virtually all asset classes. Moreover, investors were unwilling to take on the illiquid investments that they were in the past. This is the new performance reality. Simply saying that one runs a hedge fund is no longer a recipe to collect high management fees based upon historical returns, certain "career pedigree" or strategy (stock-picking) bucket.

Dreadful average hedge fund returns, and the emergence of high volatility is going to make life considerably harder for alpha producers to fake. The stick is now firmly in the hands of the investors to demand lower fees, or else. Now more than ever, the old DDQ qualifications of a Wharton or Harvard MBA, a stint at GS and "failure" at a Super Fund will not be reason enough for an entrepreneurial manager to hang his shingle as a bone fide hedge fund producing alpha. Ironically, these may be qualifications for eventual failure in the industry.

Let the winners of 2012 be a reversion to an older investment philosophy based on non-correlated returns emerge. Lets also hope that investors come to realize that like the golden goose, finding genuine and consistent alpha in a hedge fund is really hard to come by and that out of the 9,000 or so firms that exist probably less than 100 can actually fit the bill rather than the same 450 Super Funds that have been benefiting from inflows since the mid-2000s. That group sill be culled in 2012. It appears that small may again be beautiful in terms of elusive alpha generation. Mahalo.

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!

Understanding the Asia Fund Performance De-Coupling Myth

"There are three kinds of lies: lies, damned lies, and statistics".

Benjamin Disraeli (1804-1888), British Prime minister

Asia is not the U.S.

It is not an island with mineral resources, a developed financial market infrastructure, and a powerful domestic consumption motor to keep it going. Never has been and still a long, long way from being in such a situation. But that has not made it attractive with followers highlighting cheap labor, a growing middle class, an entrepreneurial spirit of many of its peoples and the absence of a costly western-style social net for the sick and aged.

Ever since the early 2000's when the world witnessed a rebound in a moribund Japanese economy, and the BOJ effectively offered up a backstop to the domestic banking sector, western investors have been fascinated by the "growth story" of Asia - its products, its export orientation and its ability to offer up global corporations and billionaires. They are in the same situation as the U.S. in the 1920s...private equity will boom and public market gains will soon follow. This was the consensus.

For western investors deep in capital, they sought +20% returns to go afar and in some instances there were many markets and hedge funds that were able to deliver. Buy into Asia after a deep decline and ride it up, or buy "cheap" (levered) beta.

However, since the Great Market Depression since 2008 and rapid whiplash rebound in 2009 Asian markets have failed to pull away from the same impulses that have infected other developed markets.

In fact, many of their equity markets have fallen far further than their developed market partners. Global liquidity has pulled back as "risk-off" has taken hold. Export driven industries have witnessed sales and revenues collapse especially with self-imposed austerity taking grip all over Europe. The outlook is ugly too. Traditional market indices have fallen and Asia-specialist hedge funds have fallen too.

Asian hedge funds have produced ugly returns, often in the -10% performance range through calendar year 2011. Manager belts have tightened, employees laid off and the bulk of strategies have suffered from greater volatility as bank prop desks and capital has been pulled in. This author has said many times that 2011 would be a year of retrenchment in the industry and this will likely continue in 2012 as tough times continue and big money sits on the sidelines of capital markets including hedge funds. Hedge funds have to lived up to all the Asia hype!

The reality is that many Asian large caps generate a greta deal of revenues from export markets that are now in effective "recession". With domestic markets also subject to high interest rates in an effort to dampen inflation, now more than ever Asia is exposed with its growth intertwined with the fate of Europe, the U.S., Latin America and the Middle East. There has been NO decoupling through this cycle, nor should we have expected there to have been given how inter-related industrial product and market cycles have become.

Hedge fund performance of Asia specialists versus global specialists are equally dreadful. There has been no decoupling of performance. None. This year, overall hedge funds have been down around -7% while in Asia the numbers are -7% to -10%. Perhaps part of the problem is that the ability of capital to move more quickly from market to market has effectively arbitraged a lot of opportunities that might have appeared ten years ago, but are simply not liquid enough today. Plus there have been few IPOs to goose returns.

This author believes that in times of stress it is often in the private markets where well-capitalized hedge funds will be able to make a performance difference. Asset market downs are taking place over a number of industries and shrewd hedge funds that understand these pricing dislocations will be able to weather the short-term storm and come out of 2012/2013 cycle with pricing power and valuable assets, especially if they are food, water, energy or raw materials - all necessary for vibrant, growing populations in the region. Asia is not decoupling from the rest of the world. Performance problems are likely to persist. Mahalo!

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.