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The End of Hedge Funds? |
rffrydr
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 Posted: Sun Mar 23, 2008 4:30 am Post subject: The End of Hedge Funds? |
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Martin Wolf runs some numbers looking for what's real. --Maybe better not to look too deeply into the well....
| Quote: | Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap.
Getting away with producing adulterated milk is hard; getting away with an investment strategy that adds no value is not. That was the point made by John Kay, in a superb column last week (this page, March 11). With the “right” fee structure mediocre investment managers may become rich as they ensure that their investors cease to remain so.
Two distinguished academics, Dean Foster at the Wharton School of the University of Pennsylvania and Peyton Young of Oxford university and the Brookings Institution, explain the point beautifully*. They start by asking us to consider a rare event – that the stock market will fall by 20 per cent over the next 12 months, for example. They assume, too, that the options market prices this risk correctly, say at one in 10. An option costs $0.1 and pays out $1.
Now imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.
There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.
The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money.
The immediate response may be that so naked a scam is inconceivable. Well, imagine a fund that leverages investors’ money by borrowing massively in short-term money markets in order to purchase higher-yielding paper. Assume, again, that the premium gives a correct estimate of the risk. With sufficient leverage, this fund, too, is likely to make profits for years. But it is also very likely to be wiped out, at some point. Does this strategy sound familiar? It certainly should by now.
We can identify two huge problems to be solved. First, many investment strategies have the characteristics of a “Taleb distribution”, after Nicholas Taleb, author of Fooled by Randomness. At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.
Second, the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit.
Professors Foster and Young argue that it is extremely hard to resolve these difficulties. It is particularly difficult to know whether a manager is skilful rather than lucky. In their telling example, the chances are more than 10 per cent that the fund will run for 20 years without being exposed. In other words, even after 20 years the outside investor cannot be confident that the results were not being generated by luck or a scam.
It is also tricky to align the interests of managers with those of investors. Obvious possibilities include rewarding managers on the basis of final returns, forcing them to hold a sizeable equity stake or levying penalties for underperformance.
None of these solutions solves the problem of distinguishing luck from skill. The first also encourages managers to take sizeable risks when they are close to the return at which payouts begin. Managers can evade the effects of the second alternative by taking positions in derivatives, which may be hard to police. Finally, even under the apparently attractive final alternative it appears that any clawback contract harsh enough to keep unskilled managers away will also discourage skilled ones.
It is obviously best not to pay the manager, as a manager, at all, but rather to invest alongside him, as at Berkshire Hathaway, Warren Buffett’s investment company. But we still have the challenge of knowing whether the manager is any good. We know this today of Mr Buffett. Fifty years ago, that would have been very hard to know.
What we have then is a huge “lemons” problem: in this business it is really hard to distinguish talented managers from untalented ones. For this reason, the business is bound to attract the unscrupulous and unskilled, just as such people are attracted to dealing in used cars (which was the original example of a market in lemons). The lemons theorem states that such markets are likely to disappear. The same may happen to today’s hedge-fund industry.
Now consider the financial sector as a whole: it is, again, hard either to distinguish skill from luck or to align the interests of management, staff, shareholders and the public. It is in the interests of insiders to game the system by exploiting the returns from higher probability events. This means that businesses will suddenly blow up when the low probability disaster occurs, as happened spectacularly at Northern Rock and Bear Stearns.
Moreover, if these unfavourable events – stock market crashes, mortgage failures, liquidity freezes – come in stampeding herds (because so many managers copy one another), they will say: “Nobody could have expected this, but, now that it has happened to all of us the government must come to the rescue.”
The more one believes this is how an unregulated financial system operates, the more worried one has to become. Rescue from this crisis may be on the way, but what about next time and the time after next?
*Hedge Fund Wizards, and The Hedge Fund Game, January 2008 |
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The End of Hedge Funds? Replies |
HenryTo
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| Posted: Tue Jan 12, 2010 5:05 pm Post subject: |
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Note that there are also going to be start-up funds that did well and whose names haven't made it to the databases just yet. In the meantime, inflows look rather healthy:
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Investors add billions to hedge funds in late 2009
BOSTON, Jan 12 (Reuters) - Investors around the world, encouraged by strong returns, poured billions of dollars into hedge funds late last year even though they pulled some money out in December, new data released on Tuesday show.
Pension funds, endowments and wealthy individuals invested $18.7 trillion with hedge funds in November, more than twice the $8.2 billion they added in October, TrimTabs Investment Research and BarclayHedge said.
Hedge funds took in $54 billion in August, September, October and November, TrimTabs and BarclayHedge said.
"Flows into hedge funds are back to pre-crisis levels," said Sol Waksman, founder of BarclayHedge.
Hedge funds now invest $2.034 trillion, industry research firm HedgeFund.net reported.
Investors have yet to put back the record $402 billion they removed from hedge funds between September 2008 and July 2009. On average, hedge funds gained 20 percent last year.
Since hedge funds are not required to report their asset flows or performance numbers, all reports from research companies like BarclayHedge and HedgeFund.net are closely watched for possible trends in the industry.
After months of positive flows, investors' enthusiasm ebbed late in 2009, according to HedgeFund.net, which reported that $4.07 billion was removed from hedge funds during the month.
"Hedge fund assets rose slightly in December supported by performance; investor flows were slightly negative," the group reported. |
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rffrydr
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| Posted: Mon Jan 11, 2010 10:33 pm Post subject: |
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Looks like the Serengeti is where it's at.
The real question is results adjusted for closures....reopened closures--after liquidation.
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HenryTo
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| Posted: Mon Jan 11, 2010 7:31 pm Post subject: |
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Best year for hedge funds since 1999 - returning over 20%:
http://dealbook.blogs.nytimes.com/2010/01/11/hedge-funds-had-banner-year-in-2009/
| Quote: | | “2009 was pivotal year for hedge funds to see if they could recover from their worst year in history,” said Bradley H. Alford, a money manager who runs Alpha Capital Management in Atlanta. “We were pleased they did so well in 2009, but we are still cautiously optimistic about the asset class.” |
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nodoodahs
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| Posted: Tue Jan 05, 2010 6:48 pm Post subject: |
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I was browsing through some institutional products and found this interesting.
A particular vendor/asset manager has multiple "absolute return" products at multiple fee levels. Benchmark is 3-month money and performance fees are highwatered and hurdled at RF+fixed fees.
The AR funds I checked all were aimed at producing a target of 6% above RF "after fees" with standard deviations ranging from 6% to 10%. Note the targets weren't all 6%, but when you accounted for fee structure, the after-fee performance delivery target became 6%.
What I found most curious was that the fees didn't seem to have jack to do with the volatility! Both the lowest and highest standard deviation programs had a performance fee of 20%, and the fund aimed at 6% with 8% stdev had NO performance fee.
Also, none of the management fees ran over 120 bps max.
Considering that a naïve G10 3/3 carry trade delivered about 7% above RF with 13% standard deviation from 1993 through YE 2009 (including the crash of 2008), I don't really find these products that impressive or difficult-to-beat. Yet, two/thirds of them get X + 20 fees?
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HenryTo
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rffrydr
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| Posted: Fri Dec 11, 2009 9:43 am Post subject: |
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No doubt Hedge Funds were the villain we all wanted to hate...and blame. As it turned out the devil lay within. The magnitude of the disaster and the necessity of Madoff also ended up masking many of their shenanigans. And, in the end, institutions will always be willing to pay a price for somebody else to blame. In that way a Hedge Fund is like an ad agency.
That said however it's almost a matter of mathematics that a 2-20 structure must be closed down in this bear....and reopened. VIX here we come. 
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nodoodahs
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| Posted: Fri Dec 11, 2009 6:14 am Post subject: |
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In the eyes of the institutions, the better relative performance of HF during the crash more than makes up for the lack of absolute performance from most HF investment styles during the period.
If only they knew how easy it was to capture that HF performance with alternative beta! Even that wouldn't "kill" HFs, but it would compete for funds if it were more widely known,
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HenryTo
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| Posted: Fri Dec 11, 2009 1:27 am Post subject: |
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I still maintain it's "greatly exaggerated." 
http://dealbook.blogs.nytimes.com/2009/12/09/more-signs-of-revival-in-hedge-fund-industry/
| Quote: | | A total of 224 new hedge funds were started in the third quarter, compared with 190 funds that liquidated or closed shop, bringing the total number of hedge funds to 6,775, Hedge Fund Research said. That is the highest number of funds since the end of 2008, when there were 6,845 funds. |
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rffrydr
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| Posted: Wed Dec 09, 2009 10:47 am Post subject: |
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Well...maybe just exaggerated:
| Quote: | | .....More than 1,000 participants attended the group's annual Collateralized Debt Obligation conference before the credit crisis hit two years ago. The group has since canceled its annual CDO and CLO conference and focused on alternative investments. |
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HenryTo
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| Posted: Wed Dec 09, 2009 12:19 am Post subject: |
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Again, the death of hedge funds has been greatly exaggerated:
| Quote: | Pension funds seek alternatives in hunt for yield
* Allocations to hedge funds, PE, emerging mkts growing
* Calpers spearheaded move into alternative investments
* Numbers down at Alternative Investment conference (Adds details on fund assumptions in fifth graph)
By Walden Siew
DANA POINT, Calif., Dec 7 (Reuters) - Large public pension funds in New York, California and Ohio are looking increasingly to alternative investments in hedge funds, private equity and emerging markets in a global hunt for yield, senior managers and trustees said.
The global credit crisis has put a squeeze on money managers who must try to boost returns by looking at nontraditional investments that are a growing allocation in some portfolios, in some cases making up more than a quarter or more of fund holdings.
"We're going to act prudently and be hesitant to rapidly increase our assets to alternatives, but we're pretty much of the opinion that that's where you have to be," said Joe Alejandro, treasurer of the New York City Patrolmen Benevolent Association, during an Alternative Investment conference on Sunday.
The U.S. recession has hit states including Ohio hard but alternative investments in areas such as real estate and casinos may present opportunities, added J.P. Allen, investment committee chairman of the Ohio State Highway Patrol retirement system.
Allen said many funds have assumptions of 7 percent to 8 percent return and his fund is expected to beat those assumptions this year.
"When things are bleak, now is the time to buy, when there's blood on the street," said Allen, who said his fund benefited from real estate and timber investments in 2008. It has since pared back on some of those investments, he said.
The California Public Employees' Retirement System, or Calpers, the world's biggest public pension fund with over $200 billion in assets, spearheaded the move by public pensions into alternative investments.
Calpers invested in private equity, high-end vineyards and hedge funds in the late 1990s and early 2000s. But not all of those investments fared well. A $500 million equity investment in Manhattan's Peter Cooper Village and Stuyvesant Town, a sprawling apartment complex, has drawn criticism.
The venture's partners are now close to defaulting on $3 billion of debt and the equity has been wiped out. For more see [ID:nN2250368].
New York's Alejandro said his current allocation is about 70 percent equity and about 25 percent in bonds and alternative investments, which he would like to increase to between 30 and 35 percent. He said he has made a push for greater investments in hedge funds of funds, private equity and real estate to the new comptroller, who starts in January.
About 350 hedge fund managers, trustees and treasurers attended an Alternative Investment conference that began on Sunday held at the Ritz-Carlton in Dana Point, California, sponsored by the Opal Financial Group.
That's down from about 400 participants last year, organizers said, and a sign of how the market for complex investments has shrunk.
More than 1,000 participants attended the group's annual Collateralized Debt Obligation conference before the credit crisis hit two years ago. The group has since canceled its annual CDO and CLO conference and focused on alternative investments.
Keith Rodenhuis, trustee of the $7 billion Orange County Retirement System, said he holds about a 10 percent allocation in real estate, 7 percent in "absolute return," which includes hedge fund positions, and 5 percent in private equity.
Rodenhuis said his fund boosted "real return assets" to 13 percent from 10 percent, involving investments in commodities and timber. The fund cut back investments in international fixed income to boost those real return assets, he said.
The fund is looking to allocate from zero to 5 percent in opportunistic investments such as distressed mortgage funds.
"We're hoping that slowly climbs back," said Rodenhuis, who also sees opportunities in energy, green technology and local medical technology, as "Orange County is a hotbed for medical technology," he said.
Ohio's Allen said many retirees took hits in the wake of the global credit crisis, but alternative investments in timber and real estate in 2008 helped offset losses, although he has since sold some of those assets to book profits. |
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nodoodahs
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| Posted: Sun Nov 22, 2009 3:08 pm Post subject: |
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| rffrydr wrote: |
| Quote: | | ....Politicians’ remarkable investment acumen is equally bothersome. Members of Congress outperformed the market by an astounding 12 per cent a year from 1994 to 1998, according to a study by economist Alan Ziobrowski. |
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Well, if I had a hand in writing legislation that influenced the profits of major corporations, or in earmarking pork for different projects in different sectors, I could probably make better "investment" decisions than I might make otherwise ...
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rffrydr
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| Posted: Sun Nov 22, 2009 12:59 pm Post subject: |
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Seeking Alpha? I'm from the government. I here to help you:
| Quote: | | ....Politicians’ remarkable investment acumen is equally bothersome. Members of Congress outperformed the market by an astounding 12 per cent a year from 1994 to 1998, according to a study by economist Alan Ziobrowski. |
http://www.ft.com/cms/s/0/221cb406-d605-11de-b80f-00144feabdc0.html
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nodoodahs
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nodoodahs
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| Posted: Tue Nov 17, 2009 9:44 am Post subject: |
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I agree with you 100% on it not being worth what used to be paid for it.
The more I research, the more that I don’t think ANY managed investment is worth more than a percent or two off the AUM. In the way that the terms are used today (vernacular), I don’t think that “alpha” exists – only “strategy beta” along with other sources of “beta” (liquidity beta, kurtosis beta, etc.). Note that the vernacular is divorced from the statistical meaning of the terms.
However, what it’s worth depends on who’s paying. It’s not worth it to me (or you), but it reminds me about an old joke concerning expensive services in an old profession; somebody is probably willing to pay somebody 2 and 20 for a product they could get in a fund or ETF today for 1.5 and 0.
I also agree that there’s a time in the market for anything, and that the relative value strategy is probably “safe” for a few years, having blown up recently.
That said, personally I don’t like the higher-order moments and would avoid these things like the plague, especially in the hands of a manager whose incentives aren’t the same as mine (running a fund is owning an option).
Frankly, there’s enough high kurtosis and negative skewness in equity investing. I don’t need more!!!!
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HenryTo
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| Posted: Mon Nov 16, 2009 9:35 pm Post subject: |
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| There is a time for everything - and I would not mind putting funds into a relative value fund in this environment once I've evaluated the management team, track record, risk management systems, etc. That said, these kind of strategies are not worth paying close to 2 and 20 anymore. If it's a black box in a relative value world, I would pay 1.5% of assets at the most with no incentive fees. |
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