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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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rffrydr
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| Posted: Fri Oct 03, 2008 11:19 pm Post subject: |
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Contemplate the buying in grandfathered short positions on Financials. Novastar anyone?
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Rubedo
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| Posted: Fri Oct 03, 2008 9:38 pm Post subject: |
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http://seekingalpha.com/article/98458-what-the-hedge-funds-bad-september-could-mean-for-markets
Here is the scary stat (well, the whole story is scary)
* Funds of hedge funds probably put in more than $100 billion in year-end redemption notices by this week's Sept. 30 redemption deadline, according to London-based advisory firm Clontarf Capital.
So depending on the leverage in the hedge fund system, multiple $100 Billion x (amount of leverage in those hedge funds) and that's how much selling could potentially go on in the 4th quarter to meet redemption requests. This is why I don't expect much sustained success to the upside in markets in the fourth quarter, although I'd be happy to be wrong.
Hopefully by Dec. 31 a lot of smaller to medium funds have closed up shop, exited positions, and we can carry some semblance of normalcy beginning Jan. 1. But I'd love to be a fly on the wall at some of these offices as the "brightest and best" explain to their investors how a "hedge(d)" fund could perform quite so poorly. |
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rffrydr
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| Posted: Mon Sep 29, 2008 10:14 pm Post subject: |
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End-of-quarter and lotta money locked up LEH.PK The big pinch.
I might have to buy Cramer's copper stock in a few days.
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HenryTo
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HenryTo
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| Posted: Fri Sep 26, 2008 6:49 am Post subject: |
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According to Hedge Fund Research, about 350 funds have closed this year YTD. They also believe that this number will double by the end of this year. In addition, the industry is now sitting on around $600 billion in cash, or one out of every three dollars in assets under management:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aYMbQvrlfUe4 |
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HenryTo
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| Posted: Sat Sep 06, 2008 9:43 am Post subject: |
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No doubt the continued redemptions/deleveraging by the hedge fund industry was one of the reasons why the Treasury decided to act sooner rather than later in bailing out the GSEs:
http://online.wsj.com/article/SB122064949992405069.html?mod=loomia&loomia_si=t0:a16:g2:r2:c0.133015
| Quote: | Some investors, particularly what are known as "funds of funds," are demanding their money back and may ramp up requests in the weeks ahead. That has prompted hedge-fund managers to sell securities to raise cash.
"As the hedge fund investor base broadens, hedge fund portfolio management...slips out of the hands of the portfolio managers and into the hands of the investors," wrote Andrew Redleaf, who runs Whitebox Advisors, a Minneapolis hedge fund with about $5 billion under management, in an August client letter. "It is no insult to the investors to say that this worsens performance."
Funds-of-funds select hedge funds on behalf of pension funds, wealthy individuals or other investors, and charge a layer of fees on top of the hefty fees levied by hedge funds themselves. They often ask hedge funds for the option to redeem money as often as monthly and get good terms because they can bring in big chunks of cash at once.
Some put in withdrawal notices to keep their options open, though they may ultimately decide to leave the money.
Investors know that it can pay to be the first out the door of an underperforming hedge fund because as other investors cash out, the fund sells its holdings, pushing down prices. Many investors themselves have borrowed funds to juice their returns and when leverage amplifies their losses they can end up more eager to pull out.
In some cases, funds-of-funds withdraw money at their investors' behest, despite solid performance from hedge funds. For 2008, a fund-of-funds run by RCG Capital Advisors in Boulder, Colo., was up about 1% through the end of August, compared with a 13% decline in the S&P 500.
But the fund's manager, Ken Phillips, says he is redeeming $100 million from 36 hedge funds because one of his key investors, a financial company, had a setback and needs its money now. |
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HenryTo
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| Posted: Sat Jul 26, 2008 3:27 pm Post subject: |
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Hedge funds set for their worst month since April 2000, assuming the various markets close at current levels at the end of the month.
http://www.ft.com/cms/s/0/c47cdfa8-5aac-11dd-bf96-000077b07658.html
| Quote: | Hedge funds are having their worst month in eight years after popular bets against banks and in favour of rising commodity prices went badly wrong.
Among those hit by the unwinding of the bank/energy trade, according to letters to investors, are two of the best-performing hedge funds of the past 18 months - Harbinger Capital and Clarium Capital.
New York-based Harbinger, which manages $26bn, lost 12 per cent in the first two and a half weeks of July, while San Francisco's Clarium plunged 10 per cent in a week to leave it down 4.3 per cent for the month to the 18th. Both remain strongly up for the year.
"There has been a ferocious bear squeeze in banks and it is becoming apparent that financials/energy position was much more widely held than had been understood," one investor said.
The Chicago-based Hedge Fund Research's daily index said hedge funds were down 2.77 per cent for the month to Wednesday. If that is sustained to the end of the month, it will make July the worst since the dotcom bubble burst in April 2000.
Many hedge funds have been betting that bank stocks would fall further as the credit crunch continued to bite, and that oil and other commodity prices would keep rising - a trade which generated big profits this year, helping offset losses in other areas.
But over the past fortnight the trade has been hit by one of the most vicious falls in commodity prices on record and a leap in financial stocks.
"One of the things that's obvious with the financials/resources trade is that everybody had it on," Paul Meader, director of Guernsey-based hedge fund investor Corazon Capital said. "There are quite a few people who are hurting this month." Several investors said many hedge funds were still betting on a rebound in commodities and more trouble for the banks. |
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HenryTo
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| Posted: Thu May 29, 2008 5:01 am Post subject: |
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We're still seeing increasing interest in hedge funds from institutional investors - but as the article asserts, the hedge fund industry has now become very "institutionalized":
http://www.iht.com/articles/2008/05/28/business/rtrinvest29.php
| Quote: | Cautious investors are no longer content with prestigious academic credentials and the names Goldman Sachs or Morgan Stanley stamped on a résumé.
"The No. 1, No. 2 and No. 3 things that anyone who wants to start a fund has to have had is direct responsibility for a profit and loss statement," said Bailin, the Bank of America executive.
A legal department, a compliance officer, a tested risk management program and a few portfolio managers are must-haves for start-up funds these days, according to managers and investors.
They say that all these requirements make it more costly to start a fund and that this is why they now calculate that a new fund has to have $250 million to $500 million in starting capital to have a reasonable chance at success.
"The guys with $10 million, $20 million or $30 million are dying a slow death," said Brad Alford, founder of Alpha Capital Management, an advisory firm that invests in hedge funds. |
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rffrydr
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HenryTo
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| Posted: Sun Apr 13, 2008 10:26 am Post subject: |
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More on the current and the continuing shakeout in the hedge fund industry:
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More hedge funds likely to collapse: BofA exec
Wed Apr 9, 2008 6:37pm EDT
By Svea Herbst-Bayliss
NEW YORK (Reuters) - There will be more hedge fund collapses this year as many managers struggle to borrow the new money they need to trade with and face investors disappointed by recent losses, a top industry executive said on Wednesday.
"The level of blowups will continue," said David Bailin, who heads Bank of America's (BAC.N: Quote, Profile, Research) alternative investment group, which invests in roughly 100 hedge funds.
"Some funds simply will not do well, particularly those specializing in fixed income markets," he said at the Reuters Hedge Fund and Private Equity Fund Summit in New York. "It will be rough trading for the rest of the year."
As a group, hedge funds recorded their worst-ever quarter in the first three months of 2008, and managers overseeing some $3.9 billion in assets have already shut down their businesses, according to data from trade magazine Absolute Return. Peloton Partners and the Sailfish Multistrategy Fixed Income Fund rank among the year's biggest casualties so far.
The industry has roughly 10,000 funds.
The pressure for hedge fund managers is two-pronged, Bailin said. Investors are hastily handing in redemption notices to get their money out. Meanwhile, bankers are getting stingier with loans after having written down billions of bad debt recently.
"If this condition (of stingy lending) lasts for a long time, then it can dampen returns," Bailin said, adding that the industry "does need leverage (or borrowed money from banks) for returns."
Bank of America, for example, last year fired roughly 15 percent of the hedge fund managers it uses. Bailin suspects other large investors are also scrutinizing their managers more closely than ever before, ready to act fast in case a manager stops performing the way he promised he would. This can hasten the pace of potential collapses.
"We are not big fans of quant funds," Bailin said, speaking about a group of once-popular and top-performing hedge funds that rely on computer models to make trades. These types of funds, including, for example AQR Capital Management, hit rough times last year and might find it tough to convince investors to stay on, Bailin and other guests at the summit have said.
"People are willing to trust black boxes only when they work," Bailin said.
Across the board, large investors like Bank of America are demanding more and better risk management at funds in which they invest. They also want to see track records of roughly five years and often as much as $1 billion in assets from other investors.
This makes is more difficult for bankers and traders at Wall Street firms or mutual funds to quit and launch their own hedge funds, guests at the summit agreed. |
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HenryTo
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| Posted: Fri Apr 11, 2008 9:44 am Post subject: |
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Looking for a giant shake-out over the next 12 months but it looks like the industry will continue to grow as a whole for the foreseeable future:
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Hedge funds losing money but keeping clients
Thu Apr 10, 2008 2:59pm EDT
By Svea Herbst-Bayliss - Analysis
NEW YORK (Reuters) - Hedge funds are losing money but that doesn't mean the $1.8 trillion industry is losing clients -- yet.
Pension funds and endowments, whose big bets on hedge funds helped double industry assets in the last five years, are sticking with loosely regulated hedge funds for now, even as returns sag.
But they are also paying extra close attention to who is up and who is down, moving faster than ever in rotating among the industry's estimated 10,000 individual funds and firing losers before they can do real damage to a portfolio.
"Yes, big investors are getting nervous about losses but they are not reducing exposure to the bucket we call alternatives as a whole," said Stephen Moseley, president of private equity firm StepStone Group LLC, at the Reuters Hedge Fund and Private Equity Fund Summit in New York this week. StepStone works with large pension funds.
Jane Buchan, who runs Pacific Alternative Asset Management (PAAMCO), a $10 billion fund of funds that selects hedge funds for pension funds and endowments, agreed. "People may be pulling out of managers but they are not shutting down programs."
The shock of losing big when hedge funds Amaranth Advisors and Sowood Capital collapsed in 2006 and 2007, respectively, raised red flags for fund trustees to more closely monitor hedge funds.
This year their worries are bigger still.
In the first quarter the average hedge fund lost 4.4 percent, according to BarclayHedge, marking the industry's worst first quarter ever.
DEEPER LOSSES
But losses in the stock market are even deeper, and trustees are hoping hedge funds can make up the declines that mounting job losses, a deepening housing crisis and fears the U.S. economy is already in recession are dealing their portfolios.
So industry experts say money is still flowing into hedge funds but with more restrictions attached.
"The standard of due diligence they are applying is greater and people are generally more cautious and deliberate in their decision making," StepStone's Moseley said.
The $52 billion Massachusetts state pension fund, whose assets are off from $53.7 billion earlier this year, decided to stick with funds of funds like Buchan's PAAMCO instead of trying to make hedge fund manager selections alone.
Michael Travaglini, the fund's executive director, told the Reuters Summit he is happy to pay a middleman's extra fees for the peace of mind that hedge fund experts will be policing his portfolio of 140 hedge fund managers better than his staff of 23 ever could.
At Bank of America, which puts certain clients' money with roughly 100 individual managers, David Bailin, who oversees the alternative investment unit, said he removed 15 percent of them from his roster last year. "That level was up in 2007 from 2006," he said at the summit.
Bailin's team got out of so-called quant funds which rely on computer models to pick investments and have delivered uneven returns recently.
LOSING
"Losing money is not good. But losing more money than you are supposed to is very bad," Bailin said, adding his team might fire someone for drifting from their style in the way Amaranth Advisors did before it collapsed. Personnel shifts and a major loss of capital are also potential red flags for his team.
Indeed, investors are so aggressive in monitoring their funds now that many get out at the first rumors of potential trouble. "There is an attitude of shoot first and ask questions later," PAAMCO's Buchan said as redemption notices piled up.
Hedge fund manager D.B. Zwirn & Co, for example, was flooded with redemption notices this year, forcing it to close down one of its portfolios.
But that money usually then goes to another hedge fund manager or even moves into real estate, for example, within the alternative investment sector, people said.
Still as money is being rotated around, many investors expect hundreds of hedge funds to go out of business this year, falling victim both to banks' stingier lending practices and investors' demands for their money back.
Already the pace of hedge funds closing is higher this year than in previous years, industry experts said, with managers who oversaw some $3.9 billion out of business in the first quarter.
Overall though, winnowing the number of fund managers might not be a bad thing, industry experts agreed. "I am not worried about the health of this industry," Bailin said. |
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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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