Wednesday, October 3, 2012

'Enormous Unraveling' of Hedge Funds Near?

Jeff Cox of CNBC reports, Hedge Fund Returns Worsen: Is 'Enormous Unraveling' Near?:
The more stocks rise, the further behind hedge funds fall—with the industry now lagging market returns by double-digit percentage points.

Though hedges actually have attracted more investor cash this year, the bulk has gone to bond funds and away from equities, even though the Standard & Poor's 500 is up a robust 14 percent so far in 2012.

As a result, hedge funds have returned just 3 percent year to date, though assets under management have swelled to $2.56 trillion, according to eVestment, a data firm that tracks the industry.

The change in fortune for hedge funds, which had trounced stock performance over the past two decades, has market insiders searching for answers.

"Could the underperformance be cyclical or is there a structural change that has changed the return structure of returns for the hedge fund industry?" Mary Ann Bartels, technical analyst at Bank of America Merrill Lynch, wondered in a report Monday. "We continue to conclude as in prior research, there (are) likely too many hedge funds chasing (too) few returns."

There are about 8,300 active hedge funds, and while the financial crisis wiped took a large toll new funds continue to crop up.

BofA research shows that convertible arbitrage (simultaneously buying convertible shares and shorting common stock) and event-driven (headline-following) strategies fared best in September, with respective returns of 5.6 and 5 percent. Market neutral lagged, losing 5.31 percent.

For the year, this is the third-worst performance to date since BofA began tracking hedges in 1994.

Nevertheless, fixed income-based hedge funds have seen inflows of $38.8 billion this year, while equity funds have watched $7.4 billion come out.

That risk aversion during an aggressive stock market run-up may be what is holding back fund performance more than anything else.

Hedge fund manager and author James Altucher predicts more trouble ahead, in which there will be "an enormous unraveling of hedge fund assets at end of year when hedge funds open their doors and this will lead to a bad Q1 in 2013."

From the end of 1994 until August, globally diversified hedge funds have outperformed the S&P 500 by 130 percent, though the returns have waned as the American economy has sought to shake off the financial crisis.

"Generally speaking, hedge funds have delivered better risk-adjusted returns during this period," Bartels said. "Although long/short strategies were unscathed by the 2000-2003 downturn, they did not fare as well during the financial crisis and have underperformed the market since the end of 2010."

Moreover, industry insiders say managers have struggled to meet benchmark returns as the market has become far less fundamentally driven and more influenced by headline events such as the European debt crisis and fiscal peril in the U.S.

Aggressive monetary easing from global central banks also has made it more difficult for fund managers to anticipate market movements, with active fund managers overall suffering what could turn into their worst year ever against benchmark returns.

"I worry that crowded trades will become more crowded. We may see hedge fund hotels become more overbooked and that will make them roach motels. You can check in but you can't check out," said Michael Block at Phoenix Partners. "That will make markets more vulnerable to exogenous shocks."
These are tough times for all active managers. Some well known hedge funds are closing shop. FINalternatives reports that Sweden's Wiborg Kapitalförvaltning is closing its 10-year-old Consepio hedge fund:
Wiborg becomes the latest hedge fund to throw in the towel in the face of tough markets. The fund has returned an average of 6.14% annually since its debut in February 2002 and has "recently disappointed investors and portfolio managers alike."

"In the current environment, where markets are influenced more by money flows driven by government and central bankers' actions rather than by underlying fundamentals of economic conditions or company performance, it has become difficult to realize profits on ‘value' and ‘hyped' investments within a time frame acceptable to our unit holders and ourselves as portfolio managers," Wiborg wrote to investors.
"We do not see this environment changing in the near future. In light of this, we have arrived at the painful decision to wind down Consepio and return the money to our investors."

In an interview with Norway's E24, Wiborg founder Ragnhild Wiborg denied that the decision to close was the result of pressure from investors.

Consepio manages about 332 million Swedish krona (US$50.5 million).
Wiborg isn't the only big fund closing shop. In Texas, Will Deener of the Dallas Morning News asks, Have hedge funds lost their mojo?:
I knew it wasn’t all wine and roses in the hedge fund industry these days, but geez things seem to have really taken a turn for the worse.

One of Dallas’ largest and most respected hedge fund firms, WS Capital Management, announced a few weeks ago that it would turn out the lights because the party was over. The fund, operated by Reid Walker and G. Stacy Smith, managed $550 million in assets, which will be returned to investors.

Dallas is home to more than 100 hedge funds, and there are always new ones starting and old ones closing, but WS Capital was one of the heavyweights. In a letter to investors, the firm cited “increased macroeconomic risks” for stock pickers and “liquidity” demands as reasons for the closure.

No one at WS Capital was available to comment, so allow me to translate: The fund’s performance has been lackluster, so investors have been withdrawing their money like there is no tomorrow. At its height, WS Capital had about $1 billion in assets.

When I heard about the closing, initially I just thought that Walker and Smith, both respected and savvy money managers, had simply lost their stock-picking mojo. But, alas, that is not the case.

The entire hedge fund industry has been in the doldrums for the better part of three years. And by doldrums I mean mediocre performance and significant asset outflows have disillusioned investors, and they are pulling out their money.

Nationwide, assets managed by 3,000 hedge funds have declined from $2.4 trillion in June 2008, before the financial crisis, to $1.7 trillion currently — a 30 percent drop, according to TrimTabs Investment Research.

The average return for those funds through August is a paltry 3.1 percent, while during that same period the overall stock market gained 13.5 percent.

Same in Dallas

Precise estimates on asset flows and performance for Dallas funds were not available, but hedge fund experts I contacted agreed that the situation in Dallas mirrors that of the rest of the country.

“I don’t think investors have given up on hedge funds, but something has changed for now,” said Ed Easterling, who is on the advisory board of SMU’s Alternative Asset Management Center. “I don’t think all of sudden hedge fund guys lost their minds but they are struggling with performance.”

Last year, when the Standard & Poor’s 500 index posted a 2.1 percent return (including dividends), hedge funds were down 5 percent. Hedge fund managers typically are more aggressive than mutual fund managers, and their goal is to post positive returns in both bull and bear markets.

They use options, futures, shorting and arbitrage to gain an advantage, but in recent years those strategies aren’t working too well. Especially in severe down years in the market, such as 2008, hedge funds are supposed to, well, hedge.

But the average hedge fund dropped 20 percent that year.

“Hedge funds have really been struggling with performance,” said Leon Mirochnik, vice president at TrimTabs. “They are failing to do what they were created to do, and that is provide absolute [positive] returns no matter what the market does.”

Dysfunctional market

No one knows precisely the reason for this, but Easterling’s explanation is as plausible as any I’ve heard. The marketplace has been dysfunctional ever since the financial crisis of 2008. By dysfunctional, he means the stock and bond markets are buffeted and influenced by outside forces that distort their behavior.

For example, the Federal Reserve is artificially holding interest rates down at record low levels by purchasing trillions of dollars of U.S. Treasury bonds. Bond yields would probably be much higher without this intrusion, but hedge fund managers who bet on higher rates were clobbered.

The European debt crisis has also unduly influenced our markets. Hedge fund managers typically prowl the investing landscape looking for mispricing in the markets. Then they buy or sell based on the mispricing and capitalize when the markets re-value the assets.

Many hedge fund managers believed the weak economic recovery would result in lower corporate profits. Actually, companies have been reporting record profits.

“It’s just hard for a hedge fund manager to rationally analyze and evaluate a company with so much dysfunction in the markets,” Easterling said.

Be that as it may, Easterling believes this long period of underperformance may be followed by a long period of outperformance. Ultimately, when assets are priced either too high or too low, the markets absorb that information and eventually return them to proper value.

At the moment, though, markets aren’t functioning normally, but eventually they will. When they do, expect hedge funds to get their mojo back.
So have hedge funds lost their mojo? Yes, most are struggling but keep in mind, this isn't something new. Three years ago, I commented on hedge funds losing their mojo. Nothing has changed, most are struggling but there are still top performers, especially in structured credit space which has seen massive outperformance as CLOs and CDOs make a comeback.

But the hedge fund industry is changing. The good old days where you can charge dumb money 2 & 20 for beta are over. Institutional investors are waking up, demanding more, focusing on alignment of interests. This is true of hedge funds and private equity.

As for the 'enormous unraveling' of hedge funds, take this with a grain of salt. I believe that top money managers will always gravitate toward the hedge fund model because it provides the best incentives to capitalize on their talent. Sure, lots of charlatans enter the industry but they don't survive long. The very best adapt and thrive in any market environment.

Also, notice one of the articles above states assets under management have swelled to $2.56 trillion, according to eVestment, while another cites a 30% drop according to TrimTabs Investment Research. No doubt in my mind, eVestment got it right and TrimTabs wrong; assets under management for the industry as a whole continue to swell despite overall weak performance. Underfunded US pensions have fueled this growth.

Finally, Bloomberg reports that a former SAC Capital Advisors LP portfolio manager told the FBI it was “understood” that those assigned to give their best trading ideas to founder Steven A. Cohen would provide him with insider information, according to an agent’s notes of the conversation.

I'm not here to defend Steve Cohen or SAC Capital but take all this media coverage with a shaker of salt. The truth is that during the 'Wild West' days of hedge funds, there were many funds engaged in dubious trading activity. And it still goes on except nowadays the war is being waged by multi-million dollar computers engaging in high frequency trading and naked short selling.

Below, Bloomberg's Erik Schatzker reports on allegations from SAC's former portfolio manager. Aslo embedded a CNBC interview with David Bailin, Citi Private Bank, discussing how hedge funds are seeing a rebound but are still lagging equity markets for the year overall.