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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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rffrydr
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HenryTo
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HenryTo
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HenryTo
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| Posted: Wed Feb 24, 2010 12:46 pm Post subject: |
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| Agreed completely. There is some (perhaps just a little) value-added in terms of fund-of-fund research but these guys don't deserve "1 and 10," IMHO. The market will figure this out in time. |
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nodoodahs
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| Posted: Wed Feb 24, 2010 10:58 am Post subject: |
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| HenryTo wrote: | Hedge funds' assets expected to climb another 14% this year - with many investors now moving away from funds of funds:
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IMHO that's good, FoF = multistrat HF with double fees ....
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HenryTo
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HenryTo
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HenryTo
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HenryTo
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| Posted: Mon Jan 25, 2010 6:40 pm Post subject: |
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This is a significant piece of news for non-bank-sponsored hedge funds. Note that the biggest hedge funds, fund of funds, and private equity funds are typically sponsored by banks (although you don't often hear about them because they are boring as heck):
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Hedge funds could gain from Obama plan
Mon Jan 25, 2010 6:41am EST
LONDON (Reuters) - Hedge funds and private equity could be surprise winners from U.S. President Obama's clampdown on risk-taking by banks, as competition in trading is cut and star managers take their skills elsewhere.
The proposals would stop banks owning or sponsoring a hedge fund or private equity fund, as well as so-called "prop trading", where banks trade on their own account, forcing them to spin-off such operations into stand-alone boutiques.
"For some strategies, particularly many arbitrage-related and quantitative strategies, fewer parties chasing the same trades will improve margins and hence profits," said Odi Lahav, vice president at Moody's alternative investment group.
An exodus of talent from banks, and cut-backs in proprietary trading have boosted the hedge fund industry in recent years, and the trend is likely to accelerate if Obama's plans are implemented in the United States and Europe, commentators say.
Equally, many leading private equity firms were born in banks and then spun out -- such as CVC out of Citi -- and industry insiders expect the same could happen to remaining bank-controlled firms, such as Barclays Private Equity and Lloyds Development Capital.
"For those players that are captives and still part of banking groups, the writing appears to be on the wall," said Paul Cooper, a partner at accountants Grant Thornton.
According to consultancy firm Preqin, all of the 19 funds-of-hedge-funds units of major U.S. banks that it monitors, which have more than $180 billion in assets and which back hundreds of hedge funds, could be affected.
Banks account for about 9 percent of capital invested in private equity -- $85 billion to $100 billion (53 billion to 62 billion pounds) worldwide.
LACK OF CAPITAL
Whilst the full details of the plans remain hazy, talented traders in banks are likely to be already looking at starting up on their own, Andrew Clare, chair in asset management at Cass Business School, said.
Not everyone will find it easy, however.
Start-ups have already been struggling as investors favour the big funds they perceive as safer, and less capital at banks could further hurt smaller players.
"Some people will just disappear from the field if banks don't give them capital to run. A lot of hedge funds relied on banks seeding when they left prop desks and it may not be so easy for some people," said David Stewart, chief executive of Odey Asset Management.
In the short term, the exit of banks would remove some of the capital available in the buy-out pool, and there could be unintended -- negative -- consequences.
"Does it mean recovery teams can't do a debt-for-equity swap on loans because they would suddenly own equity in a private company?" said a private equity partner who declined to be named.
But there could also be positive effects. Any conflict of interest that would exist if a bank was both a financier of a deal, and an investor in a buy-out fund, would be removed, HarbourVest managing director Peter Wilson said. |
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HenryTo
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| Posted: Thu Jan 14, 2010 1:28 pm Post subject: |
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Looking for strong inflows into hedge funds in 2010:
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Hedge funds set for bumper 2010 inflows: Gottex
ZURICH (Reuters) - Hedge funds are set to see solid inflows in 2010 after a strong performance last year virtually wiped out the heavy losses seen in 2008, Gottex (GFMN.S) head of European business Max Gottschalk said on Wednesday.
Deals
Investors who remained invested in hedge funds through the financial crisis are by and large very pleased with how they have performed, and many who pulled their money out are now returning said Gottschalk, whose Swiss-based company manages almost $9 billion in funds of hedge funds.
"There has been a clear change of attitude toward hedge funds between 2009 and now. Many institutions say they will up allocations, and private investors who stayed on the sidelines for much of 2009 are now coming back," Gottschalk told Reuters.
By October 2009, hedge fund assets had slumped 38 percent from their $2.7 trillion peak reached in the first half of 2008, but some analysts say inflows are now picking up, and assets could soon be back close to their peak.
Hedge funds lost an average 20 percent in 2008 as markets slumped. Many funds were forced to liquidate positions at unfavorable prices when investors asked to pull their money out, and in 2009 many of those investors remained in cash.
However, many funds have now recouped those losses, whereas equities are still well below their market peak in spite of the strong run up last year, Gottschalk said.
He said funds of hedge funds were among the first investors to start reinvesting their cash in hedge funds.
"Early last year many funds of funds were holding a large proportion of their portfolio in cash in order to deal with client redemption requests from the end of 2008," he said.
"In the second half of the year they redeployed the cash that was left, which accounted for a large component of the inflows to hedge funds in that period."
2010 NOT AS GOOD AS 2009
Going into 2010 there has been an uptick in institutional research into hedge funds, expected to translate into a healthy growth in demand, with many institutional investors looking to invest, mainly via fund of funds, for the first time. Even so, Gottschalk said, funds which did not perform well in 2009 will find it hard to attract assets, and many have already closed. But that has left the industry leaner, and means inflows are allocated among fewer funds, leaving more for each of them.
This year Gottschalk said individual investors and private banks were likely to focus on the more liquid hedge fund strategies while institutions were likely to diversify across all strategies.
"Some of the less liquid strategies like relative value and convertible arbitrage did extremely well in 2009 and the environment seems good for 2010. These strategies will likely attract institutional investors," Gottschalk said.
"Overall, I don't believe hedge fund performance will be as good as 2009, an exceptional year, but prospects are still above average in terms of performance expectations," he said. |
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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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