Put Into Perspective: Optimal Size For Hedge Funds – Big Is Not Better, Skenderbeg Alternative Investments

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Financial markets are one of the last bastions of socialism left on earth.” –+ Larry Elliott, Guardian economics editor

Optimal size for hedge funds – Big is not better

[drizzle]Investors like big hedge funds. They offer better infrastructure and usually are able to better meet operational due diligence standards. Big funds will have better client service. But bigger funds will miss on the essence for their exist-ence – performance. Hedge funds show diseconomies of scale and investors chase winners.

Hedge Funds

This has been well-documented with mutual funds, but with incentive fees the expectation is that diseconomies of scale would not be an issue. In fact, size does matter and not for the better.

A recent paper that explores the optimal size issue was published in the Jour-nal of Finance, “The Optimal Size of Hedge Funds: Conflict between Investors and Fund Managers”, by Chengdong Yin. The simple fact is that there are in-centives for managers to size their funds based on their fee arrangements. High management fees relative to incentive fees will have managers push for growth even if it negatively affects performance. The current combination of management fees and incentive fees for hedge funds does not solve this problem.

Yin’s research shows that the diseconomies of scale vary by investment style. Some styles have more diseconomies than others. For example, emerging markets, global macro, managed futures, and long/short equites all show diseconomies. Managers will continue to grow until that push their returns down to the style averages. Be with the crowd and then just collect your fees. The diversification of the manager is no help. This provides an incentive to grow one fund until you get the diseconomies and then start another to repeat the process.

The message is the same as with mutual funds. If you want to find the exceptional managers, go small and when the manager grows to a certain size, sell, and repeat the process.

AMPHI Research and Trading

Absent proper disclosure, allocation of manager expenses to funds may bring significant SEC penalties

The SEC recently settled an enforcement action against a private equity manager, serving as the latest reminder to investment advisers that they must scrupulously adhere to the terms of their disclosures when it comes to allocating fees and expenses to funds, particularly expenses incurred (or discounts obtained) by the adviser itself. In the action, the SEC claimed that the private equity manager, without providing ade-quate disclosure to fund investors, inappropriately allocated overhead expenses of manager affiliates to two private funds, charged certain funds liability insurance premiums in contravention of the funds’ governing documents and negotiated a legal fee discount for itself while its funds paid the same law firm full price for the same services.

Within the settlement order, the SEC also reiterated its view that conflicts of interest that have not been adequately disclosed to or approved by investors (or, where appropriate, their representatives) should be resolved in favor of the investors. See “SEC Enforcement Director High-lights Increased Focus on Undisclosed Private Equity Fees and Expenses” (May 19, 2016). This article summarizes the underlying facts, the SEC’s allegations, the remedial actions undertaken by the manager and the terms of the settlement.

Hedge Fund Law Report

Hedge funds have a place to deliver alpha pension funds need to meet expected returns

Nearly two years after its highly publicized withdrawal from the hedge fund asset class, the California Public Employees’ Retirement System reported a 0.61% net return on investments for its fiscal year ended June 30. While the giant pension fund’s decision may have had only a small effect on its performance, what we know is that it did not help the fund. CalPERS had $463 million in its hedge fund program at the end of last year. With bond yields at historic lows and stocks reaching bubble territory by many measures, the only way pensions funds like CalPERS are going to come close to meeting their funding goals is by investing in strategies that produce alpha. There’s no way around it.

CalPERS’ decision has had ramifications throughout the investment management sector, spurring other pension funds to rethink their own hedge fund strategies. Recently, the New Jersey State Investment Council decided to cut the New Jersey Pension Fund’s hedge fund target allocation in half, to 6% of assets, and the New York City Employees’ Retirement System voted to get out of hedge funds entirely. This ten-dency toward a wholesale pullback from hedge funds ignores a major challenge faced by almost every pension fund today. Given the under-funded status of many funds, it will be nearly impossible for them to generate sufficient return to meet their long-term return assumption — generally about 7.5% — using a conventional portfolio mix.

To underscore this point, Callan Associates estimated that a long-only investor seeking a 7.5% total return must take three times the risk today compared with 1995. In 1995, that investor could construct a 7.5% total return portfolio entirely from bonds. Today, that same return might require a mix of debt, large-cap equity, small-cap equity, real estate and private equity, according to a 2016 Global Hedge Fund Report, released by Preqin in July. This data suggests that rather than shun the entire hedge fund class, pension funds need to consider selected hedge fund strategies in their allocations if they are to have any hope of achieving their benchmarks and meeting long-term obligations.

Some challenges will need to be overcome in this process. Most large pension funds have rules that prevent them from owning more than a set percentage, perhaps 10%, of any hedge fund’s total assets. Given their vast size, they can only invest in the largest asset-gathering hedge funds. However, smaller and midsized hedge funds often successfully pursue alpha-driven strategies. Another advantage of these hedge funds is that they may not have the traditional “2 and 20” fee structure that has increasingly been called into question by asset owners.

Pension funds would be well advised to remember that the performance of their hedge fund holdings since the bull market started in 2009 should be uncorrelated to the broader markets. To reach their investment goals and satisfy their future obligations, these investors should assess the differentiating factors among hedge funds and consider incorporating a more diverse range of hedge fund strategies as part of a pension fund’s overall portfolio.

Pensions & Investments

Man v machine: “Gut feelings” key to financial trading success

Sensitivity to “gut feelings” is a strong predictor of success in financial trading, according to research led by Cambridge university. The study of 18 hedge fund traders found those with greater “interoception”, which is the ability to sense the state of their body, made more money and survived for longer in hectic financial markets. Results are published in the journal Scientific Reports. “Our results suggest that signals from the body, the gut feelings of financial lore, contribute to success in the markets,” the authors concluded. By combining body and brain, the best human traders can outperform computer algorithms, they said.

To assess interoception, the researchers measured the subjects’

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