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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 |
rffrydr
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| Posted: Mon Mar 24, 2008 10:49 pm Post subject: |
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Yes, they come in all shapes and sizes...and performance levels over dramatically volitile markets this last year. Some are outright crooked, some more political than performance oriented and some downright ideological. Renaissance was based on mass spectrophy if not critical mass. But Wolfe's just playing it by the numbers--the leverage necessary to make a 2/20 payout justifiable. The advantage of a recession is that can now be done sans leverage. Enter the new "hedge" fund investing in distress. Ironic 
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HenryTo
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| Posted: Mon Mar 24, 2008 9:20 pm Post subject: |
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A reader's response to Martin Wolf's original article:
http://www.ft.com/cms/s/0/0aed8d4e-fa0d-11dc-9b7c-000077b07658.html
| Quote: | Sir, If the hedge fund "industry" were comprised entirely of dedicated mortgage securities managers using 30 times leverage, there might be some validity to Martin Wolf's article (March 19). As I would imagine he is aware, however, that is not the case. Many of the 10,000 or so private investment partnerships that are referred to as "hedge funds" are equity focused, utilising very modest levels of leverage or none at all. Many of these types of partnership are doing just fine.
Additionally, his comment that "the systems of reward fail to align the interests of managers with those of investors" could not be more wrong. Anyone who knows the first thing about private investment partnerships knows that the alignment of interest is what separates hedge fund managers from traditional investment managers. In fact, a recent article in the Financial Times, "Hedge funds demonstrate resilience in thorny times" (January 29), speaks to this very point. As the article points out, the fact that many hedge fund managers have most of their own money invested in their funds is a huge controller of risk.
I do enjoy reading such articles, though, and faithfully clip them and keep them in what is now becoming a sizeable collection. Interestingly enough, the first one that I have is written by Fortune magazine's Carol Loomis. The article, "Hard times come to the hedge funds", also predicted the demise of the hedge fund industry. It was written in January 1970. |
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nodoodahs
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| Posted: Mon Mar 24, 2008 8:05 am Post subject: |
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Sure, if I quit the day job!
This cloning of discrete hedge fund strategies is pure marketing gimmickry. Of course, because the idea is to accumulate the most funds under management, and not necessarily to make the best risk-adjusted return, it makes perfect sense.
I believe the best use of the technique used, multivariate regression on liquid futures asset classes to match a known return distribution, is actually trying to match a steady, non-volatile stream of returns at an above-market rate (15% annual or thereabouts). Then the strategy is really a total investment strategy, rather than a substitute for an asset allocator's "hedge fund" allocation. That's a project I'd like to take on, if I had the time ...
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rffrydr
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| Posted: Sun Mar 23, 2008 10:37 pm Post subject: |
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They continue to exist....in image only:
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Credit Suisse to set up hedge fund clones
By Steve Johnson in London
Published: March 9 2008 17:33 | Last updated: March 9 2008 17:33
Credit Suisse will today unveil a plan to muscle in on the nascent, but potentially highly lucrative, hedge fund replication industry.
The Swiss bank has teamed up with three of the leading academics in the field, Professors William Fung and Narayan Naik of the London Business School and David Hsieh of Duke University, to create a suite of products designed to replicate mechanically the returns of the major hedge fund strategies.
Investment banks have scrambled to launch hedge fund clones in the past 18 months, with Merrill Lynch, Goldman Sachs and Deutsche Bank among those seeking to provide cheap, generic hedge fund returns.
Credit Suisse said its experience running the CS/Tremont family of hedge fund indices, allied to the link with messrs Fung, Naik and Hsieh, would give it an advantage over its rivals.
“They have been among the leading academics in the field going back to the 1990s. We felt it would be a strategic advantage to align ourselves with individuals of such knowledge and stature,” said Oliver Schupp, head of beta strategies at Credit Suisse.
Replication, or cloning, is based on the view that the performance of hedge funds is largely driven by movements in underlying assets, such as the S&P 500 or the dollar, rather than the intrinsic skill of managers.
If so, it should be possible to replicate hedge fund returns by mechanically recreating the industry’s exposure to these underlying assets.
This would yield many benefits; investing in real hedge funds is expensive with managers levying a 2 per cent annual charge and a 20 per cent performance fee, if not more.
It is also opaque and illiquid, with lengthy lock-up periods the norm. The risk of an Amaranth-style blow-up is ever present, while diversification via a fund of hedge funds adds a second layer of fees.
Replication strategies have yet to attract large sums of money, with some $500m-$600m estimated to be held by Merrill, Goldman, Deutsche and Société Générale, as well as $700m managed by Partners Group, a Swiss alternative assets specialist, and perhaps a similar sum in over-the-counter derivatives. But proponents believe replication has the power to revolutionise hedge fund investing in the way that index tracking shook up the traditional fund management world a generation ago.
Credit Suisse is to launch three clones mimicking directional equity strategies, relative value arbitrage and tactical trading strategies. Fees will be in line with the industry, typically 100 to 120 basis points a year. |
Bill, can you set us up with one of these?
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HenryTo
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| Posted: Sun Mar 23, 2008 10:31 am Post subject: |
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Yes, the "great deleveraging" has now begun and the first casualties are the "dumb" carry traders like Carlyle Capital and those hedge funds that are short the Yen, the Swiss Franc, and/or long the Rand, NZD, the Iceland Krona, etc.
No one knows the true magnitude of the carry trade over the last few years but the fact that 1) money has been cheap in parts of the world (Yen, Swiss Franc), while 2) credit/EM spreads touched historical lows during 2006 is indicative of a truly historical event.
The unwinding has already been swift. With the Fed's "lifeline" to the primary dealers and the demise of Bear Stearns, however, this first phase of the "great deleveraging" is already over. Just like the popping of the technology bubble during 2000 to 2002, the next phases of the unwind would be slow, but steady. At this point, I am not looking for any spectacular hedge fund blow ups - but I expect many more hedge funds to fail as hedge fund investors bail out of this "asset class" as money gets tight and as the carry trade goes out of fashion. I also expect some private equity funds to under perform dramatically going forward.
Many former hedge fund investors will learn that "true alpha" is really elusive in the first place, and thus will move back into the traditional "beta strategies" - such as buying - for the most part - the unlevered and the well-managed companies in the Russell 3000 or EM equities. The UK and Eastern Europe will also dramatically go out of style. |
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