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Monday, May 16, 2016

Emperors New Clothes' Time for Hedge Funds

The recently conclued SALT conference of hedge fund managers in Las Vegas this year has generated much press. It seems this year it was like a meeting at the Versailles Palace on the eve of the French Revolution It was a sharp contrast to the Berkshire Hathaway annual meeting where 1000s of individual investors gathered to hear common sense on investing from Warren Buffett and Charles Munger..including some sharp criticism  of hedge funds and strong recommendations for investors to choose low cost index funds for their stock investing.

From the WSJ

Hedge Fund Star: We Are ‘Under Assault’

Leon Cooperman of Omega Advisors sums up the mood at the annual SALT conference in Las Vegas

LAS VEGAS—Some of the most famous minds in investing convened here this week for an annual celebration of the hedge-fund industry. But, feeling the weight of years of underperformance and an uptick in client defections, the mood was anything but festive.
Longtime hedge-fund manager Leon Cooperman openly questioned whether it made sense to continue on after redemptions from his firm, Omega Advisors.
Major hedge-fund clients, including China’s sovereign-wealth fund, aired doubts, positing that 90% of hedge-fund managers probably weren’t skilled enough to navigate the markets.
And it had been hard enough to get some of the attendees to even show up. The slump in the industry—highlighted by the largest exodus of investors since the financial crisis—damped interest in the SkyBridge Alternatives Conference, commonly known as SALT, according to Anthony Scaramucci, the event’s organizer and founder of SkyBridge Capital, which puts $13 billion into hedge funds.
“There is a decided pessimism in the hedge-fund community,” he said, while predicting the industry would survive. “A lot of guys opted out of coming, frankly, because of performance issues.”...The mood was a far cry from previous years.  since the start of the bull-market run in early 2009, a more traditional mix of stocks and bonds bested a broad hedge-fund index in 22 of 28 quarters, according to a Wall Street Journal analysis of data from research firms HFR Inc. and Morningstar Inc

It sees the conference organizers didnt quite have their story straight on attendance..not too good a sign about how they do on reporting fund manager performance:

A SkyBridge spokeswoman later said 2,100 people registered for the conference, up from 1,800 the year before.

You can find comprehensive reporting on hedge fund performance here

What Do Hedge Funds Really Do ?

One thing that is certain is that hedge funds dont do much hedging. They also dont necessarily have very unique investment strageies.

One widespread strategy is called merger arbitrage NYT:

Historically, merger arbitrage has been the calm hinterland of the investing world. Traders usually buy up shares in the company that is being acquired; those shares tend to trade slightly below the buyer’s offer price, often by just pennies. Once a deal is done, that gap closes, and arbs will make money on the difference. (Some trades involve hedging through the acquirer’s stock as well.) Such trading has been considered low risk for small returns.

The information about these transactions is public (or "curiously" all the arbs seem to know the terms of mergers yet to be announced)..meaning that all the hedge funds using this strategy pile into the same trades.

Lately many proposed mergers have not come through leaving much blood on the streets where hedge fund managers reside. Nothing very unique in manager skill in this strategy so it shold not be surprising that when the deals fall about the "top perfroming managers" have turned into dismal performanc. Among major deals that have fallen through recently due to regulatory or court rulings or just market forces have included Office Depot/Staples,  Allegran and Pfizer (that deal alone was valued over $150 billion), Halliburton and Baker Hughes and Energy Transfer and Williams Company. The total value of these broken deals involving was well over half a trillion dollars.

While last year set a record for the amount of money spent on corporate mergers — $4.7 trillion — this year is so far setting a very different record: the dollar amount of deals that have come undone....Broken deals have whipsawed hedge funds that focus on merger arbitrage, a type of trading that places bets on the likelihood that deals will be completed. As one “arb,” as traders in merger arbitrage are known, described the current mood of the industry: Every day is like showing up unsure of whether to wear a helmet or a diaper.
You’re definitely seeing a hangover from the M.&A. party from 2015,” said Aly El Hamamsy, a partner in Cadwalader, Wickersham & Taft’s mergers-and-acquisitions group, which occasionally advises arbs. “Things will stay interesting for a few months at least.”
Anxiety is higher than many arbs say they have experienced in years. Merger arbitrage was the worst-performing investment strategy in April 
And it seems hedge funds using the merger arbitrage strategy are now loking at ways to hedge their risk by actually doing more research before jumping into trades:
Taking a cue from these troubled deals, some investment funds that do merger arbitrage trading are working with lawyers to pore over agreements to make sure they are placing trades on deals that are not likely to come apart.

Macro strategies 

Another strategy that has performed poorly of late has been "global macro" which involves trading based on forecasts of global economic events. It shouldnt be much surprise that the world is more complicated and difficult than it seems and exceedingly difficult to forecast. Reversals in trends in oil prices and the dollar among other developments caused losses for these funds. the hedge funds research institute index of macro strategy hedge funds shows a 5 year return of .23% vs 4.7% for the total world stock index and 10.9% for the S+P 500

Hedge Fund Managers turn out to be not much different than other investors.

Despite their reputation for being sophisticated n their research and investing it turns out that hedge fund managers behave pretty much like everyone else showing all the pitfalls n their strategies. They tend to pile into the same trades as others, often simply because it has become a "hot trade" and then show reluctance to adjust to new information that challenges their assumptions. Since the hedge funds take large often leveraged positions when things go bad and they all attempt to reduce the trade at the same time prices drop sharply, liquidity dries up and the losses mount.
The poster child for this scenario has been Valeant. Bill Ackman considered one of the hedge fund geniuses took a huge position in this company. At an annual event open to all willing to make the appropriate charitable contribution (or following the news reports and gossip afterwards) Ackman joined other top managers in pitching their single best idea. Ackman's pitch : Allegran.

Apparenly other investors didnt do much more research other than listen to Ackman's speech and followed Ackman into thte trade. As the NYT reported:
Not coincidentally, big names like Paulson & Company, Viking Global Investors and Brahman Capital have also lost billions, collectively, by betting on Valeant — underscoring a growing phenomenon of hedge fund groupthink. It is a reflection of big-dollar investors chasing too few ideas and getting tripped up when things turn poorly for a company they have set big markers on.
“The bottom line is, hedge fund herding is not going away anytime soon,” said Andrew Karolyi, a professor of finance at Cornell University. “If anything, we are now seeing the early signs that this type of hedge fund herding is spilling over into herding of large institutional investors. To the extent that that spillover grows and expands, then we will be concerned.”
Hedge funds piled into Valeant as the stock soared more than $200 a share last year, even as warning signs about the company’s leadership and business practices began to appear. The stock is now trading around $36 a share, as Valeant prepares to install a new chief executive and races to meet a deadline to file a delayed financial report.
Despite their teams of "highly skilled" and highly paid analysts it seems the hedge funds cut lots of corners follwing the herd (much like the least successful of individual investors.Another exampe is  Sun Energy touted by another "top hedge fund manager" David Einhorn at another conference in October 2014 when the stock was trading in the mid teens....the company declared bankruptcy  and its stock is now trading at 17 centrs. Other top ranked hedge funds including Greenlight Capial, Glennview Capital and Omega Advisors piled in. Omega Advisors run by long time hedge fund star Leon Cooperman recenly told the SALT conference the industry is "under attack" and mulled leaving the industry in te wake of large redemptions from his fund.
How could this happen ? It seems these top hedge fund managers managing billions of dollars and receiving fees that make them among the highest paid and wealthies people in the world behave much like individual investors trading investment ideas at a cocktail party:
That so many hedge funds remained bullish on Valeant despite months of turmoil — as questions were raised repeatedly about its accounting practices — reflects the difficulty managers sometimes have with changing course.
We all get lazy and when an idea seems to be working — inertia tends to take over and you stop paying attention,” said James Chanos, the founder of Kynikos Associates and one of Wall Street’s best-known bearish investors. “That’s on full evidence with Valeant and SunEdison too,” he added"
With this track record it is not surprising that institutional investors are rethinking their hedge fund investments discovering that the emperor indeed wears no clothes. A combination of simple index funds and ETFs including those that easily and inexpensively access alternative weighting strategies such as value and momentum...strategies which actually would often profit from the foibles of the "genius" hedge fund managers.
The head of China's investment Company had some pretty harsh words for the hedge fund industry on their investment strategy both generally and with regard to investing in her home country. Leading to a shouting match among some of the wealthiest men (yes the rest were all men) in the world.

Hedge Fund Managers Ditch Decorum in Shouting Match Over China (bloomberg)

China Investment Corp.’s Roslyn Zhang and others found themselves on the defensive on Wednesday’s panel. The CIC executive said hedge fund managers, many of whom have never been to China, were succumbing to a “herd mentality” in betting against the yuan.
“They really don’t know much about China but they just spend two seconds and put on the trade,” she said. “Should we pay 2 and 20 for treatment like this?” she said, referring to industry fees, traditionally 2 percent of assets and 20 percent of profits.
On the performance and skill of hedge funds the Chinese official pulled new punches in pointing out that the Kings of Finance may be not nearly as skillful as their reputations suggest: WSJ

China Wealth Fund ‘Disappointed’ in Hedge Funds

One of the biggest backers of hedge funds is having second thoughts.
“I have to say, the past few years I’m sort of disappointed with the performance, to say the least, of the industry,” Roslyn Zhang, managing director overseeing hedge funds for China Investment Corp., said at the hedge-fund industry’s annual SALT conference. CIC is the sovereign wealth fund for the world’s most populous nation.
The CIC official later told The Wall Street Journal in an interview that she was booting managers from her approved list and beginning the process of evaluating whether to slash the fund’s investment in hedge funds overall.
That amounts to a rather terse rebuke of the industry at this usually-buttoned up annual confab. China’s sovereign-wealth fund is one of the world’s biggest investors in hedge funds; it has more-than $20 billion in its “absolute return” investment category, which includes hedge funds, according to its annual report.
Much of the hedge-fund industry’s growth and hefty paydays in recent years have been thanks to a constant spigot of new money from deep-pocketed investors like Ms. Zhang.
 “Many people blame Chinese retail investors [for a] herd mentality, but I see the herd mentality among hedge-fund managers now almost everyday,” she said.
Hedge fund managers much as is the case of individual investors may very much reside in Lake Wobegon where everyone is above average
She sad she was looking for more “skillful” partners to navigate markets than she had found so far among hedge funds.
“My experience with the hedge-fund industry is probably only 10% of managers are capable of adapting to the new reality. But I’m sure 90 percent of hedge-fund managers think they are the 10%.”

Individual investors investing in hedge funds usually invest in "funds of funds" adding fees on top of the fees paid to the hedge fund managers. They seldom if ever pay less than "2+20" fee structure(2% of assets under management+20% of profits) sometimes even pay more while larger institutional investors at times can negotiate discounted fees. This of course drives investor performance even lower

Institutional investors often hire high priced consultants to choose funds and these consultants are prone to chasing performance by moving their clients in an out of hot funds.

With the poor performance of hedge funds and the availability of capital weighted and alternative weighted strategies for .20% or less not hard to understand why the hedge fund industry fees "under assault". 

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