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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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HenryTo
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nodoodahs
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| Posted: Fri Sep 30, 2011 2:11 pm Post subject: |
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Rumors (or rumours, depending) on JAT Capital.
Forgot about Paulson's gold fund for a few days there, that makes sense.
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rffrydr
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| Posted: Wed Sep 28, 2011 3:30 pm Post subject: |
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Out for the summer....out for the year:
http://ftalphaville.ft.com/blog/2011/09/28/687576/man-alive-3/
| Quote: | | Put in that light, perhaps the GLG redemptions are part of a wider industry trend – a massive dash for cash and safety in volatile markets — and investors should not worry unduly about the division’s performance or Man’s strategy in buying it. That said, the $1.6bn acquisition was supposed to diversify Man’s business away from the computer driven AHL fund something it manifestly has failed to do. |
This in accord with my sense of the early August dump.
...and in fine vulture fashion:
| Quote: |
John Paulson already has lots to worry about: turbulence in the stock market, a rocky economy and volatile gold prices.
As the hedge-fund manager suffers through the worst losses of his career, Mr. Paulson now is facing a flock of vulture investors who hope he will be forced to conduct a fire sale of stock and debt holdings.
Rival hedge funds, brokers and other firms are combing through Paulson & Co.’s investments, trying to anticipate what Mr. Paulson might sell if he needs to return cash to investors. |
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rffrydr
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rffrydr
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| Posted: Mon Aug 29, 2011 11:35 pm Post subject: |
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Hadn't realized how much money is coming out of Hedge Funds this year on account of Dodd-Frank. Indeed, cited as primary reason Soros is closing up. Ichan, right on down, going private in face of 80pg questionnaires--all no doubt part of our vindictive self-loathing of a sell out we've been putting in lately.
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HenryTo
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rffrydr
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| Posted: Wed Mar 09, 2011 9:01 am Post subject: |
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Self-limiting?
Hedge funds: Carl Icahn, but won’t
Published: March 8 2011 19:12 | Last updated: March 8 2011 19:12
| Quote: | The cliché hedge fund manager is an introverted numbers-geek staring at multiple screens, with just one book, Ayn Rand’s Atlas Shrugged, perched on the shelves. Now it seems as if the industry’s obsession with the 1957 novel extends beyond nomenclature (Anaconda Capital, Rearden Capital, etc). Mirroring the plot, hedge fund bosses are disappearing off the map.
The latest is Carl Icahn, who on Tuesday released a letter to outside investors saying he has decided to give them their money back by the end of June. Although stopping short of predicting another “dislocation”, he said that he did not want the responsibility of losing other people’s money if another crisis occurred. With gross returns in 2009 and last year of 33 per cent and 15 per cent respectively, Mr Icahn feels he is closing shop on a “high note”.
Mr Icahn is not the first. Last summer Stanley Druckenmiller of Duquesne Capital chucked it all in and Paolo Pellegrini returned outside money at PSQR Capital. Cynics say that hedge funds are simply being found out at last. Weak markets, rising correlations between asset classes and an increasingly crowded industry are making excess returns scarce. Sympathisers can counter with Mr Icahn’s 107 per cent gross return since 2004. At 75 years old, he deserves a rest.
But the decisions to quit raise a bigger concern: that the industry remains a fragile one based on superstars. Where is the succession planning? The teamwork? Hedge funds spend half their days explaining their investment process to investors; the idea being that processes are repeatable. It seems, though, that the superstars think only they can do the repetition. Worse, outside investors don’t even get to find out if any underlings can keep up the record. With one letter, one person can decide when it’s all over for everyone. |
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rffrydr
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| Posted: Mon Dec 20, 2010 5:12 am Post subject: |
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Hedge funds
Published: December 19 2010 19:43 | Last updated: December 20 2010 09:46
| Quote: | In June 2006 thousands of hedge fund managers, investors and assorted hangers-on gathered in a field in Hertfordshire, just north of London, for “a festival of networking” that was headlined by rock group The Who. The two-day event – they called it “Hedgestock” – proved the high water mark for hubris. Four years on, a humbler generation is emerging.
This year’s fast, skittish markets provided good fodder for skilled long/short managers but buying and holding would have done just as well: by the end of November, hedge funds had in aggregate marginally underperformed the FTSE World index, according to Hedge Fund Research. The benefits accruing to managers are shrinking, now that funds are smaller, liquidity terms are looser and fees are falling. Three-fifths of funds today manage less than $50m, up from under half in October 2007. The old default “two and 20” fee structures, allowing managers to keep 20 per cent of profits, are now more likely to be 1.6 and 17. Compliance costs are rising, under the pincer movement of the Dodd-Frank Act in the US and the European Union’s Alternative Investment Fund Managers Directive. |
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rffrydr
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HenryTo
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rffrydr
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| Posted: Wed Oct 27, 2010 5:41 am Post subject: |
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Brazil has hedge-funds too. And now so does JPM:
http://www.ft.com/cms/s/0/502508e2-e114-11df-90b7-00144feabdc0.html
| Quote: | | The acquisition comes in spite of US regulations to limit banks’ direct investments in hedge funds and private equity groups. But its structure will enable JPMorgan to comply with the new legislation. |
Of course it comes from the former Central Bank head.
| Quote: | | “There are many fund managers that can be successful for a given strategy and at a given moment in the business cycle. There are very few that can build themselves into institutions and repeat that success on a consistent basis. Gavea is one of them”. |
That's an interesting measure.
Long suffering Morgan now has foreign presence. Too bad. We're running out of "pure plays."
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