Hedge Funds: Put Into Perspective – Ahead Of The Mainstream by Bruno J. Schneller, CAIA & Miranda Ademaj, Skenderbeg Alternative Investments
“The world’s most influential economic mentor is neither Keynes nor Hayek, but Charles Ponzi.” — Tim Morgan
Smaller reigns supreme in hedge funds
When it comes to hedge funds, the little guy has the upper hand.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
Smaller hedge funds — those with less than $100 million in assets under management — have notched the greatest year-to-date gains, standing at 4.1 percent, according to data re-leased by Preqin. By comparison, funds whose assets exceed $1 billion averaged year-to-date gains of just 0.54 percent, the worst class of performers in terms of size.
"After a difficult start at the beginning of the year, 2016 has now proved to be a positive year for hedge fund performance, with July marking the fifth straight month of industry gains," Preqin said in its report. As for the recent success of smaller funds, their size is proving to be an advantage in a challenging environment.
Recently, Barclays released a study of the hedge fund industry and concluded that the hedge fund industry has become too big for the opportunities in it. "As hedge funds become larger, their investable universe can often be diminished (e.g., due to position limits) as it is often not "worth it" to invest in smaller situations that can hardly move the profit and loss needle," Barclays wrote.
The ten excuses for bad performance
At two recent Morgan Stanley investor conferences, the question of poor hedge fund performance surfaced repeatedly. We surveyed a group of long/short fundamental equity hedge fund managers at one of the conferences, asking them for the primary reason for poor performance of their industry.
The answers were: 54% said "crowding", 23% said "factor exposures", 8% blamed "macro headwinds" and 8% said "poor liquidity". The remaining group (also 8%) said "poor stock selection".
In other words, when performance is bad, it is beta, when performance is good, it is alpha. The truth is that 100%, at some level, should have said "poor stock selection", and what these data reveal is that 92% of respondents are blaming something other than their stock selection methodology for the current underperformance. Our portfolio has outperformed for five straight years, and is lagging this year. It is 100% stock selection.
The alpha from the HFRI long-short index was close to 14% per annum in the early 1990s, and has been slightly below zero for the past few years.
Why is this? We don't claim to have some systematic rank ordering of reasons for the decay in performance, but here are ten thoughts.
- First, there has been massive growth in the total number of hedge funds, with HFR estimating that there are 3,400 equity-focused hedge funds today (about as many as stocks under global coverage by the Morgan Stanley research department).
- Second, low interest rates have removed the rebate that hedge funds received, a non-trivial driver of historical returns when rates were materially higher.
- Third, hedge fund CIOs are increasingly cautious. Since 2003, FAS123R has made it illegal for hedge funds (and everyone) to know any-thing material and non-public in the US, at least, and the high-profile and frequent investigations of hedge funds have curtailed information-seeking at some level.
- Fourth, the more rapid availability of information has materially shortened the time arbitrage that existed previously. The days when you ran to a pay phone to call a large portfolio manager in Boston when you learned something you thought mattered have been over for years. You have to publish something first that passes the smell test from nine different editors, compliance officers, control groups and stock selection committees.
- Fifth, there increasingly appears to be a "group think", as going to Omaha to hear what Warren Buffett says has transitioned to systematically tracking billionaire holdings and riding out the last bit of momentum from their ideas. Everyone attends or hears about the pitches made by successful hedge fund owners at industry conferences, dinners, charity events and presentations, making questions about "crowding", well, crowded, to quote a friend.
- Sixth, the quants have stolen some of the alpha. Everyone knows the quants are onto something, so they are hiring junior quants to analyze their "factor exposures", even though they don't know what to do with the information once they get it. The HFRI equity market neutral index has beaten the HFRI long-short by about 3% per year for the last ten years, so the "quant thing" isn't new. In addition, liquidity quant trading, baskets and ETFs have potentially been "sucking" alpha out of the traditional long-short industry.
- Seventh, the LPs don't invest in hedge funds for as long as they used to, as their manager selection gets analyzed and evaluated, creating more fear of redemption today vs. yesteryear, and exacerbating short-termism among the hedge funds. We don't remember anyone saying in 1995 that they were bullish on the market because hedge fund performance has been so bad that there may be redemptions and a 'you might as well go for it' melt-up. We hear that regularly now.
- Eighth, macro explains a higher percentage of total returns today than in the past, and most hedge funds are set up for bottom-up security selection. This may have been prudent in a 1995 world where 80% of the average stock's performance was idiosyncratic, but with macro now explaining well over half of the average stock's returns, many classic hedge funds may be sub-optimally staffed for the current opportunity set. Macro explaining a higher percentage of returns has, in turn, impacted dispersion (which became low) and correlation (which became high), and the dollar, rates and oil exposures, among others, are material on many books.
- Ninth, while all active management has suffered, long-only firms began to realize they could replicate some of the more successful hedge fund approaches, shifting some of the alpha away from the hedge fund industry over time.
- Tenth, the capital markets have been less supportive, meaning, the 'free money' associated with IPOs in the 1990s has clearly slowed. Very few high-profile deals have been monster stocks this cycle.
While this surely isn't a comprehensive or rank-ordered list of reasons for weak alpha generation, it hopefully touches on some of the issues. When will excess performance be likely again? Our suspicion is that much wider dispersion is required, and this isn't likely until long-dated rates back up meaningfully or economic volatility grows materially. That said, dispersion is clearly wider than it was a year ago, and active management has yet to enjoy an improvement in performance. Here's hoping that later this year we won't need any excuses, due to good stock selection.
Trump once sued the hedge fund managed by his campaign finance chair because of course he did
We've been borderline obsessed with Donald Trump's Goldman alum, recovering hedge funder, bailout profiteering campaign finance chair for a while now, but never did we think we'd be treated to an embarrassment of riches such as this!
In an infinitely readable profile of Steven Mnuchin, Bloomberg writers Max Abelson and Zachary Mider paint a pretty indelible image of the man who is shocking seemingly everyone he knows by getting Trump all that cheddar.
We've introduced Mnuchin to you guys a few times now, so let's just get to the wondrous highlights of this awesome profile. Like his indelibly post-modern introduction to the Trump campaign…
He was supposed to be at a dinner downtown, but after receiving a last-minute invitation to Donald Trump's victory speech, he stopped by Trump Tower. Mnuchin—53, stiff bearing, stylish black glasses—was milling around, swallowing some Trump-brand wine, when the candidate swanned into view. The two had worked together on building deals years earlier. The billionaire beckoned his friend to follow him onto an escalator, and suddenly they were both onstage, Trump jabbing at the roaring crowd and bragging that the group assembled behind him included some of the world's great businessmen. Mnuchin beamed. From where he stood, Trump's iridescent hairdo was almost close enough to pat. He spotted a monitor, glimpsed his own face, and realized he was on TV.
How exciting! That must have been a total rush for such a backwater rube like Stevie…
Mnuchin was born into a level of privilege that makes Trump's deluxe childhood look ordinary. His grandfather, an attorney, co-founded a yacht club in the Hamptons, and his father, Robert, was a top Goldman Sachs trader who later became an art dealer. Mnuchin followed his father to Yale, where he lived in the old Taft Hotel with Eddie Lampert, now a billionaire investor, and Sam Chalabi, whose uncle, Ahmad, later ran the Iraqi National Congress.
Mnuchin drove a Porsche in college, two friends say. His classmate Michael Danziger, an heir to a pharmaceutical fortune, says he was also tapped to join Skull and Bones but turned down the secret society. "You're going to live to regret this," he recalls Mnuchin saying. Danziger, who knew his classmate was headed into finance, says he answered: "You put the 'douche' in fiduciary." Mnuchin says the exchange never happened.
And there was no need for name-calling. Mnuchin was clearly just a child of privilege on a search for himself. That journey led him to very interesting places, like the time he experimented with Salomon Brothers…
He got summer jobs at Salomon Brothers before graduating from Yale in 1985. His bosses at the bank asked why they should bring him on. "You're just going to end up going to Goldman Sachs," Mnuchin remembers one telling him. "I said, 'No, I really don't want to go to Goldman Sachs. I'm going to go do something different.'" He went to Goldman Sachs.
And from there he went into the hedge fund game, apprenticing with George Soros before going out on his own… sorta…
In 2004, Mnuchin founded his own hedge fund, Dune Capital Management, named for a spot near his house in the Hamptons, and got hundreds of millions of dollars from Soros.
Running a hedge fund brought him into his first contact with Trump, which ended predictably…
The firm invested in at least two Trump projects, a branded condo in Waikiki and a Chicago skyscraper. Trump sued Dune and other lenders over the Chicago deal before settling.
Abelson and Mider go on in the piece to postulate that Mnuchin's interest in the Trump campaign is cagily self-serving, offering him an opportunity to become Treasury Secretary. That job would not come his way under literally any other administration. And he clearly puts up with a lot for the mere whiff of possibly seeing his name on money one day.
Here's Trump giving a speech in Scotland…
"You know, I sit with 20 people, and we talk, and they all hand you checks. Bing! Bing! Bing! Bing!" Trump said. "In fact, Steve Mnuchin is here someplace. Steve? Are we doing well, Steve, huh?" Mnuchin prefers to be called Steven.
But the coup de grace of Abelson and Mider's little masterpiece comes right at the end, when Mnuchin runs into another New York hedge funder with a fondness for The Donald and an inability to engage in social niceties…
At an August Trump fundraiser in the Hamptons, he encountered Carl Icahn, the billionaire investor whom Trump floated as a Treasury pick last year. "I hear the rumor is you will be secretary of the Treasury," Icahn told Mnuchin. "And I will support you 100 percent on that! Because there's no f--ing way I would ever do that."
This is a must-must-read, you guys.
Law of averages
Star funds rarely outperform for long
When Citadel, a Chicago-based hedge fund, was bleeding money during the global financial crisis, its boss, Ken Griffin, says CNBC, a broadcaster, parked a van outside its doors to chronicle its demise. Last year CNBC crowned Mr. Griffin "King Ken"; in recent years he has done spectacularly well.
Such abrupt twists of fortune appear dramatic. In fact, they are predictable. Novus, an analytics firm, has crunched numbers from Hedge Fund Research, a data provider, to suggest that hedge-fund performance shares a trait boringly familiar from other forms of investment: funds that do poorly then do better, and outperformers then underperform. In other words, past performance is not a guide to future returns (see chart).
The study filters data for two periods: from June 1st 2008 to February 28th 2009, when equity and credit markets were crashing, and from March 1st 2009 until the end of 2015. The funds are anonymized but show plenty of Citadel-like cases. One fund that lost 91% during the crash returned an annualized 42% afterwards. Conversely, among the 93 funds that finished in the top decile during the crash, only three remained star performers. Perhaps they were dazzlingly smart back then. Perhaps they were just lucky.
The study is not perfect. The database includes 928 firms that are still around; others may have closed their doors. But the dots also re-veal that quite a few funds performed poorly during both periods, belying the claim that hedge funds optimize returns during good times and minimize damage when things turn nasty. That may explain why this year is expected to be the first since the crisis when investors pull more money out of hedge funds than they put into them.
See the full PDF below.