Put Into Perspective: Optimal Size For Hedge Funds – Big Is Not Better, Skenderbeg Alternative Investments
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- Q3 2016 hedge fund letters
- Q2 2016 hedge fund letters
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
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.
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.
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 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.
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’ ability to count their own heartbeats over varying periods, while at rest and without touching their pulse or any other part of their body. The 18 volunteers, all male, were engaged in high-frequency trading, buying and selling futures contracts at an unnamed London fund during a particularly volatile time towards the end of the Eurozone crisis. They held their trading positions for short periods, from seconds up to a few hours — an activity that requires decision-making with split-second timing, based on the assimilation of large amounts of information flowing from news feeds and rapid recognition of price patterns.
“This niche of the financial markets is particularly unforgiving and selection acts quickly,” said John Coates, senior author, who used to run a Wall Street trading desk and then became a neuroscientist. “While successful traders may earn in excess of £10m a year, unprofitable ones do not survive for long.” The traders as a whole were better at the heart beat detection tasks than a control group of Sussex University stu-dents, scoring an average of 78.2 per cent compared with 66.9 per cent for the controls. Within the study group, interoceptive ability pre-dicted both profits generated and years of experience as a financial trader. “Traders in the financial world often speak of the importance of gut feelings for choosing profitable trades. They select from a range of possible trades the one that just ‘feels right’,” said Mr Coates. “Our findings suggest [that] they manage to read real and valuable physiological trading signals, even if they are unaware they are doing so.”
The researchers say the findings have implications for economic theory, undermining the “efficient markets” view that human participants cannot outperform the market consistently through superior skill or other traits. “A large part of a trader’s success and survival seems to be linked to their physiology,” said Mark Gurnell of Cambridge, another member of the study team. “Such a finding has profound implications for how we understand financial markets.” Earlier research by the same team showed how varying levels of stress hormones affected the performance of financial traders. The work should also inform the debate over whether computer algorithms can outperform human traders, Mr Coates added. “If we focus on conscious mind and model it as a piece of software we will conclude that humans are doomed,” he said. “But if we recognise that body and brain act as a single functioning unit, that they form a parabolic reflector collecting signals inaccessible to the conscious mind, then we will also recognise how exquisitely we are constructed for rapid pattern recognition. Humans can indeed com-pete against the machines.”
Surge in passive strategies will be boon – Hedge fund executive Okada
Money moving from hedge funds and other active investment managers to low-cost passive strategies will ultimately be a boon for professional money managers, according to Mark Okada, co-founder of Highland Capital Management. “All of this chasing of beta and passive management, et cetera, is just setting up for the next opportunity for alpha for active management,” Okada, also Highland’s chief investment officer, said on Thursday at the Alpha Hedge West conference in San Francisco. Beta refers to overall market gains, whereas alpha refers to the extra returns from a manager’s investment skill.
Okada was optimistic in the face of mounting gloom in the industry after several years of returns near or below low-cost index funds. “Regardless of what rates do, we’ll mean-revert around active management,” he said, referring to how prices and returns ultimately move back to their historical average. “I think that 2017 and 2018 will be great times to be in the hedge fund and the alternative credit space.”
Five fallacies of international investing
Investors should always be careful about basing decisions solely on well-worn market proverbs such as “Sell in May and go away.” Lately, I’ve heard many false claims related to international investing that are blithely passed off as truisms.
To correct some of these misconceptions and mistaken beliefs, I put together this list of five classic fallacies of international investing:
- You need “boots on the ground”: There is this myth about globetrotting investment managers – that they supposedly travel to exotic locales to inspect factories wearing a hard hat to find undiscovered companies. Yes, for private equity deals, infrastructure projects and private real estate investments, it makes sense to have focused local knowledge. But, with over 70 liquid equity markets in the world, you would need a lot of boots on the ground to actually realize this vision. If you’re investing in a publicly traded stock, you don’t need boots on the ground.
- Avoid low-quality companies: Unfortunately, there is not a strong link between “good companies” and excess returns on stocks. In fact, usually it is the cheap stocks of unattractive-looking companies that have better return prospects. But, even this “truism” is not always true, as the recent performance of the value indexes will attest.
- Maintain a high “active share”: A common refrain is that managers should have high active share, meaning their port-folios shouldn’t have a lot of overlap with the benchmark. In
fact, there is no proven relationship between active share and excess return over the market index. Similarly, there is a view that active managers should concentrate their portfolios in a small number of high-conviction stocks. But, just being concentrated does not increase your chances of outperforming.
- It’s all about the macro: It does sound comforting to be in-vested in stocks that are domiciled in countries with a growing GDP and other favorable macroeconomic trends. Unfortunately, there are no strong links between economic growth and stock market returns. Macroeconomic forecasts, like other types of forecasting, have a very poor track record at timing markets and producing consistent excess returns.
- Pay attention to politics and the media: Political issues definitely have an impact on stock prices, but the relationships are not obvious. Attempting to time markets based on political analysis or by reading newspapers (or by scrutinizing billions of tweets) is a fruitless endeavor.
See the full PDF below.