While no one hedge fund index is comprehensive. all the reports to date point the same way: the hedge fund industry lost its clients a lot of money in 2008.
While you can blame the horrid results on the dreadful environment across a host of asset classes, a very real sense, the funds became victim of their own success. And I don’t mean via the burgeoning amount of capital that reduced the returns in formerly attractive strategies.
No, what hurt hedge funds was their pursuit of institutional money. In the stone ages, when hedge funds were the province of wealthy individuals, they could do what ever they wanted to as long as it was legal and delivered outsized returns over time. In other words, they did not have to adhere to an investment style.
One of my colleagues, Amar Bhide (then at McKinsey, now a professor at Columbia Business School, at one point in between head of proprietary trading at a Wall Street firm) pondered in depth why hedge funds could outperform. He concluded that it was because, unlike other money managers, who had to operate within comparatively narrow confines (say large cap US equities or emerging markets bonds), they could go wherever they thought the best opportunities lay. And perhaps as important, they had no obligation to be in a particular market.
But the fund consultants that advise pension funds and endowments insist that hedge funds conform to a particular “style”, say event driven (what used to be called risk arbitrage), distressed debt, emerging markets, 130/30, convertible arbitrage, global macro…..you get the picture.
The problem is you have to stay in your style box no matter whether you think the opportunities are great this juncture or not. You are just as locked into your style as the US large cap equity manager. You cannot dabble in another strategy even if (for whatever reason) you have the competence to go there too.
Or consider something more mundane: if you were in a strategy that required you to be long, or limited the degree to which you could short, well by golly, you dare not go net short even if you saw the freight train bearing down on the markets in 2007. You aren’t supposed to trouble your pretty head with shorts, If the smart fund consultant thought his client should have some of his money in short strategies, he’d recommend the allocation and pick the manager. And that in turn limits the client’s and funds’ ability to adapt if the tectonic plates make a sudden move. (But you dear institution with money are supposed to take the long view, not try to market time, and allocate your fund according to some hocus pocus).
Funds that are opportunistic are generally limited to the family office market (and small endowments that are close to wealthy families). The fund consultants steer clients away from them, no matter how good their track record. Their success, after all, flies in the face of the fund consultants’ approach.
From Bloomberg:
Hedge funds lost 18.3 percent in 2008, their worst year on record, as managers misjudged the severity of the biggest financial crisis since the Great Depression.
A gain of 0.42 percent in December lessened the average loss for the full year, according to Hedge Fund Research Inc.’s HFRI Fund Weighted Composite Index. The decline was the largest since the Chicago-based firm began tracking data in 1990…
The decline by hedge funds last year compared with the 37 percent drop in the Standard & Poor’s 500 Index, including reinvested dividends, the benchmark’s worst showing since 1937. Commodities slumped 33 percent, according to the UBS Bloomberg Constant Maturity Commodity Index of 26 contracts.
The worst previous performance by hedge funds was in 2002, when they lost 1.45 percent while the S&P 500 tumbled 23 percent. Hedge funds returned 9.9 percent in 2007.
Among the major investment strategies, equity hedge funds lost the most last year, an average of 26 percent, Hedge Fund Research said. Event-driven funds, which invest in companies going through changes such as mergers and spinoffs, lost 21 percent. Macro hedge funds, which can bet on securities from commodities and interest rates, returned 5.7 percent….
Funds that invest in hedge funds lost 20 percent last year, Hedge Fund Research said. Tiger Select Absolute Return Fund LP, a fund of funds overseen by Morgan Creek Capital Management LLC in Chapel Hill, North Carolina, lost 51 percent in the first 11 months of the year, according to an investor letter.
“They’ve shown not to have added any value above the broad market,” James McKee, director of hedge-fund research at Callan Associates Inc., an investment consulting firm in San Francisco, said of funds of funds. “I don’t think it will be the death of the fund-of-funds industry, but there will be a lot of pressure for change.”
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How about the fact that hedge funds are net long, and that the hedge fund industry, because of its size, had to be net long.
net long in 2008 meant losing money.
bg,
I am not disagreeing, BUT they are boxed in by their strategy dictates.
If you were Soros or Steinhart circa 1980, you could go completely into cash if you so pleased, or go short. And a money market yield last year would have looked a ton better than what the vast majority of funds delivered.
These funds are supposed to be reasonably fully invested, hence they cannot go heavily (and I mean REALLY heavy, like over 70%) into cash, and most have style parameters that either prohibit or restrict short (note that this would not be a legal matter, since fund management agreements are drafted so as to be incredibly broad, but a “don’t lose credibility with the gatekeepers, or they will direct everybody elsewhere if you deviate” issue).
I hate to personalize this, but if your humble blogger, who hates investing, does only a very few semi-obvious things, does very little in the way of research of specific ideas, and uses only mutual funds and ETFs (as in no short sales of instruments, futures, or options) did better in 2007 and 2008 than money market fund returns, which in turn was way better than the the vast majority of pros did, it is not a function of my skill. It is a function of how badly everyone else’s hands were tied.
ys,
oh, no I could not disagree more. I did well in 2008, and mostly did so by virtue of a point of view not dissimilar from your own. We may both be relative geniuses by comparison to hedge fund managers, or we may simply have been on the same side of a winning bet.
It is impossible for net assets to shrink in value world wide without the average being negative.
BTW I was not disagreeing with your whole post, just the last paragraph. On the rest of it, of course the older, smaller, nimbler hedge fund industry would have been less likely to follow the herd off a cliff.
But hedge funds hold only a small portion of global investment funds. Their whole raison d’etre is that they are nimble and do not have to go with the herd.
Perhaps more to the point: these funds were selling absolute returns, that they’d deliver positive returns in good markets and bad. But (per your point) they can’t possibly deliver that (save the global macro types, who have the most latitude) if you are obligated to be long (or net long) and are also limited to certain asset classes in markets like the ones we’ve had the last two years.
You would know far better than I, but in finance there seems to be a far gap between companies raison d’etre and their actuality.
It was always fairly easy to sell leveraged risk and make money on the good years (which lasted over a decade.) combine that with an ivy education, good looks, strong personality and social connections, and you are, presto, a hedge fund manager. The track record was automatic.
I actually believe the above, as I try to avoid being a cynic. How is a prudent investor supposed to tell the difference.
Simmons and Madoff may be outliers, but the 1st standard deviation on each side of the mean was smoke and mirrors.
The problem is, many funds have performance metrics that pretty much meant they were not paid for preservation of capital — which is what being in cash implied.
So given a choice of returning close to zero (and not getting paid anything but the 2% fee) and perhaps suffering withdraws, they took the chance to make the “usual”.
They had to go out and make bets, and overall bearish bets took a great deal of courage to break from the herd.
D
Hedge funds is fundamentally unworkable. It’s nothing more than clever bet. It only works if the system is imperfect. So in the beginning is great, but as time progresses, market adjust, information leaks, tricks and bets are revealed.
So ultimately it’s just applied game theory.
If there is a huge hedge fund, It will be a target of another hedge fund betting against that guy’s bet. (which is essentially what a lot of CDS are.)
The whole thing will ultimately equalize after awhile.
They can’t keep everything secret/imperfect system for long period of time, since it involves so many people.
I hate to personalize this, but if your humble blogger, who hates investing, does only a very few semi-obvious things,
The problem with “obvious” things is that they are not so obvious. You need to give yourself more credit.
The clowns running money were vastly overpaid and overrated. Let’s face it: Any monkey with a dart board would come near market performance. It is only in times like these that we separate those that are thinking from those that are just playing the trend.
Style funds are ideal for people or institutions who want to decide their own asset allocations. I don’t see what the point is of knocking such funds for sticking to their knitting. I’d be pissed if my long equity fund decided on their own to move into beaver pelt futures or whatever, that’s not what I’m paying them for. If somebody wanted to use a fund that makes allocation decisions for them I’m sure such a thing can’t be too hard to find.
The thing that does seem a bit strange to me about using hedge funds to build a portfolio is how hard it could be to change your allocation. How long would you have to wait to get your money out and into some other asset class if you wanted to make a move?
Anon of 12:41 AM,
You are making my point. If you want to buy, say, the Russell 2000 or the Nikkei or a specific strategy, fine. But the consultants require hedge funds to fit in boxed too. And the whole idea of being a hedge fund, of delivering absolute returns, is in conflict with style adherence.
For instance, no matter how good a risk arb you were, if you held any positions on the day of the 1987 crash, you got killed. You can make the best possible decisions within your strategy, but there are times when the conditions in a narrowly defined strategy are horribly adverse.
“uses only mutual funds and ETFs (as in no short sales of instruments, futures, or options)”
Didn’t you say you were short long treasuries last year?
I lost money shorting LEH, which reminded me not to be too keen on timing and/or individual stocks.
My guess is that your dislike of trading, distrust of euphoric bullshit, and discomfort with delegated investing has served you well.
bg,
I am very loss averse, and so set modest (real, as in inflation plus a certain %) targets, Meeting modest targets and not losing principal sets you further ahead in the long haul than bigger gains and occasional meaningful losses (unless you make super big returns, like up 60 percent or more in a good year, but that is hard to attain even in a really good market without leverage, and leverage as we know cuts both ways).
There are ETFs that permit one to short. The problem is that they tend to decay in value over time, so they are not as well suited for a long term hedge as for short term in and out trading (the kind that is really not my cup of tea). However, they are cheap, save one hassle of margin calls, and if you are playing with retirement money, the only option (the law allows for shorts, options, and futures, but the only IRA custodians who let customers avail themselves of the full scope of permitted instruments, Refco and Intrust, were both shuttered due to embezzlement). The more volatile the underlying trading the faster the value decays. So sector shorts decay faster than broad index shorts. Double and triples decay faster too.
There is only one ETF (to my knowledge) that lets one short Treasury bonds, TBT, which is a double short of the Lehman 20+ year Treasury bond index. It moves like a freight train when it is going against you.
Yves,
cash is integral part of any strategy: investments come and are disbursed in cash. so, regardless of strategy, if the time is inopportune or if the opportunities at hand are murky, you stay in cash. there is no such thing as being invested 100% all the time.
one of the best funds, baupost group, never holds less than 30% cash, buffet as well holds plenty of it.
but as bg pointed, hedgies are the market, at least a big chunk of it, so when the tide turns they look pretty well correlated in performance with the general stock indices.
Why pay 2% to a fund to hold cash?
“The problem is that they tend to decay in value over time”
I have never seen this intelligently written about, but have studied it in detail. The decay is due to the fact that if you keep a fixed amount of money in a leveraged fund (short or long), then amount of the underlying instrument varies. You own more of it when your position is improved, and less otherwise.
The decay occurs if there is pure volatility. If a stock goes from $1 to .90 back to $1, the 2x long goes from $1 to .80 (-20%) back to .976 (+22.2%). This is the decay.
But this is not dishonesty. If there is too little volatility, (i.e. straight line moves) you make out better than great. This happened to me when I held double short ETFs in the recent market crash.
If you believe that there is excess volatility, you can short these 2X etfs. And buy the 1x to hedge. It’s legal. But You might get burned.
You can also rebalance daily and use them as legit hedges (although I think few of us do.)
I’d rather pay 2% on 100% than 2% on the 82% of my money that most hedge funds delivered last year,
Given that you cannot exit a hedge fund quickly, I’d much rather have them go seriously into cash when they didn’t see a course of action in which they had reasonable confidence, rather than be heavily invested regardless of the attractiveness of the opportunities on offer. There are times when it makes sense to take profits and sit back a bit and gather more data.
The average money market fund fee is .75%, so the other 1.25% is the price of the option of having them do something much higher return when it shows up. You are paying for them to be on the prowl.
Good article. Of course, like nearly every good article in the NY Times, it’s published at least a year late.
The rear view mirror at the NY Times is spotless. Unfortunately the windshield apparently isn’t.
This criticism applies equally to all of the MSM. News too late to ever profit by.
Seems the stock market was the fore bearer to the kids Pokémon card game. Infinite card combinations to those that can buy the hard to get packs, with the best Pokémon in them or are just obsessed with the game.
Big kids game to be played out with non/small time players knocked out for a warm up. Competition gone horribly wrong, absolutely no compassion for fellow humans in the rules. If this game is how the world greases its wheels, were done for, cannibalism of each other for selfish consumerism/social elevation .
The big boys change the rules every time they start losing too lol. Where is the Rule of Law or Constitution any more lol or are they like the bible and just head scramblers for the big boys to use on the suckers and soften them up for their supper.
No wonder I like George Carlin so much, “The American Dream”, they call it a dream because you have to be asleep to find it. So much blind faith running around these days. Everyone looking up for solutions and not in the mirror. The ones that can actually effect change for the betterment of all are holding on to THEIRS with icy death grips lest their status is diminished and fall back down the ladder in to obscurity. No wonder these types of people commit suicide rather than fall or pretend madoff like that every thing is normal until the jig is up. Then make plans to hold onto their loot, till release from prison. Madoff should be charged with terrorism and manslaughter, the chair or lethal injection is to good for him and his kind, I say public hanging old west style.
When is white collar crime going to be treated with the same social yard stick as burglary, stealing, or manslaughter eh? The ones educated at Ivy league schools should know better than the common person, their actions and there repercussions, so the crime is elevated by forbearance of thought.
Skippy
I’m not sure that I agree. If style lock-in was the only problem then multi-strategy funds should outperform. Is this the case in the long term? AFAICS last year they were also down about 20%.
Regarding the reported 18% loss for hedge funds in aggregate, I wonder what the real number is — after applying realistic valuations to many hedge funds’ illiquid holdings (instead of marking to fantasy — “sidecars”, anyone?).
Also Yves, although I understand and somewhat agree with your “style box constraint argument”, I think it lets the hedgies off too easily. I cannot recall even one prominent hedge fund complaining that they couldn’t go big to cash, the prudent move given the emergency conditions in the 2008 markets. Couldn’t Citadel, et al, have taken the lead here, instead of losing 50% plus? They could even have volunteered to cut their fixed fees for a year while in cash… No, you are letting them off too easily.
So Yves at 12:03 on the comparative success of conservative endurance, boy that sooo reminds me of _Glengarry, Glenross_ if you’ve ever seen it. (You’d love it if you haven’t.) Four salesguys have to beat a bad set up. Super-manuvreable pro aces it. Two ‘strategizers’ blow themselves up. Joe Schmoe makes it over the line just plodding along doing basic business. Sometimes, it pays to do it right rather than do it ‘smart.’
the average long run return after fees for hedge funds was 0 before the crash and it is now -ve after the crash. I wonder if the negative 50 billion is in those numbers
So Yves and bg, I love to follow knowlegable folks talk shop; one learns the most interesting things.
And skippy, you mean to say you didn’t know that the penalties fit the _class_ of the offender not the class of the offense?? The whiter you and your shoes are, the lighter your treatment. It’s in the national constitution, not the Constitution of the Republic. Looting with a blackberry, rape, murder, genocide . . . it’s all relative to your standing. If you’re wealth class American, it isn’t even a crime unless another of the same of higher status gets their ass caught in the crack. Mozillo is still walking around, and Milken is a power again. Phoolan Devi had a solution for that kind of thinking, but it comes with somre real blowback, too. Like I said, it’s the society that’s sick . . . .
There must be a survivor bias in the reported average. I bet the real performance was much worse as funds that were reporting the year before are not around anymore because of poor performance.
I don’t know about this Yves. I have dealt with the some of the biggest losers in that Bloomberg article and there were a couple things that always made me think they were shysters:
1. They claimed high fees were justified by manager “talent”…(come on, if it were talent, they should be happy to structure their compensation structure differently)
2. They claimed that long-only style boxes were part of the cause of alternative managers outperformance in recent(pre-2008) times, i.e. “What is Smid? Better to invest in xxx hedge fund strategy that generates absolute returns than a part of the equity universe diced up by consultants”
3. They never, ever talked seriously about the potential for downsides. They pushed alternative investments as investments institutions should have in place of traditional equity and bond portfolios–as super investments only the big boys got to play with and be eternally rewarded with juicy returns. They should have had some inkling that all the problems in traditional long-only management COULD be a factor in their industry. I mean really, “absolute returns” has to be the silliest bit of investment marketing ever and I don’t think their sincere belief in that idea makes it forgiveable.
Sorry for something of a non-directed rant, but I do think you have carried more water for these clowns than you should have.
There are so many well-documented biases in the numbers that skew them higher that the true number is undoubtedly much lower. I wouldn't be surprised if they lost about 40 percent on par with the S&P. It's not only survivorship bias but a self-selected sample bias, a questionable-numbers bias and an instant-history bias. Frankly I don't know why anyone wastes their time with these numbers; in doing so they're just doing PR for the hedge fund industry.
For more evidence these hedge fund numbers are completely worthless see this excerpt and following link:
"It should be obvious that the industry-reported returns should be viewed skeptically. One study ["A Critical Look at the Case for Hedge Funds," by Richard M. Ennis and Michael D. Sebastian, Summer 2003 Journal of Portfolio Management] examined the overall bias in numbers for the 1992–2002 period by comparing the reported 7.1% average return on the Hedge Fund Research Fund of Funds Index, which is the return earned by actual investors in funds of hedge funds, to the Hedge Fund Research Composite Index's reported average return of 11.3%. The 4.2% difference suggests a large bias in the industry's numbers. Moreover, the 7.1% return earned by actual investors was less than the 8.5% return on the S&P 500 and the 7.3% return on the Lehman Aggregate Bond Index over the same period."
http://www.axlrosen.net/stuff/hedgefunds.html
“No wonder these types of people commit suicide rather than fall or pretend madoff like that every thing is normal until the jig is up. Then make plans to hold onto their loot, till release from prison. Madoff should be charged with terrorism and manslaughter, the chair or lethal injection is to good for him and his kind, I say public hanging old west style.”
[Skippy, if I remember my earlier reading(s) you are an Aussie. I have a friend that owns a small estate in Noosa. An outstanding man (former Royal Navy). Was in the stainless steel business in Brisbane.] Your quote is outstanding! Literary justice!! (that is how the snow ball starts). You would make an outstanding American cowboy!!
(You to Mr. Richard Kline).
These two are real gentlemen.
Personally, I would never invest in a hedge fund, at least one with the conventional fee structure.
And while I agree the published returns overstate the picture, the numbers even in good years were underwhelming given the fee structures. You had maybe low double digit returns (at best, sometimes high single digits). Sorry, for those kind of fees, to get my money, you’d need to deliver in the upper 20s or more a lot of the time and not give up very much in a bad year.
Now having said that, I am willing to concede there might be an exception or two out there (for instance, I know some old codgers who have a pretty good sized fund despite being absolutely dreadful marketers, and are old enough that they have seen cycles I haven’t seen).
And -18% returns, whether overstated or not, flies in the fact of their absolute return sales pitch. I find it damning on its face. In a year like last year, one might be able to defend modest losses, but not of that magnitude.
To me, the 18% loss figure already says the industry emperor had not clothes. The fact that the real numbers are probably worse is gravy.
Another indicator that the industry is not all it was cracked up to be, even in the good years, was that talk (which we featured here) had started as to whether hedge funds were selling alpha (manager outperformance) or alternative beta. As industry data started to be assembled and published (revealing that the average fund did not produce the 30% or higher returns that the great unwashed public might have though was normal), the pitch among funds (and the fund consultants) was the the funds were providing “synthetic” or “alternative” beta, that is, uncorrelated returns that were a useful addition to a portfolio.
Utter crap. You can create alternative beta of all sort of flavors synthetically (that is, via derivatives). You do not need to pay 2 and 20 for that. The fact that even in the good years they were having to find creative justifications for their fees was a pretty strong warning sign that too much money was chasing the strategies defined by the consultants, and whatever opportunities they might have presented at one point in time was being arbitraged away.
But thanks for the links to the research. I am aware of the survivorship bias issue, but did not have any links to provide other cautionary information about returns.
Something is wrong with you all bloggers on this particular topic.
-18% return is an outstanding achievement compared with the stock/bond market losses this year. So, if these numbers are true ( and they most likely are not, given the oapque nature of these funds and their valuation methods), then you all (including Yves) should be applauding them, since they have been quite stellar in their past reporting also.
So was Madoff till the jig went up.
So, some of you who may be astute enough to question these numbers need to figure out “what gives here?”, before the hedge fund industry goes the way of Bernie Madoff. After that happens, no one will call you astute.
Very few were astute enough to call Madoff’s ponzi scheme before he himself turned himself in ( because the jig was finally up and he was ready to be exposed anyways since he was not going to be able to meet the redemption calls).
missing the point,
I disagree wholeheartdly. These funds sold absolute returns. Single digit losses might have been defensible in a year like last year, double digit no. Any position should be put on with the equivalent of a stop loss. Admittedly, on some days, those could have been blown through via exceptional volality, but there was clearly insufficient thought and attention to risk containment. The funds management company has bad incentives. As a commenter above pointed out, they are rewarded for putting on risky trades even when caution would suggest going into cash and waiting till one could find misvaluation. John Dizard in the FT more than once last year pointed to arbitrages that persisted for weeks and months rather than the usual minutes. Had fund kept more powder dry, there were plenty of attractive trades on offer.
I am just a retail chump. bg (with all due respect) is too. I trade in a completely unadventuresome fashion in a seven figure family portfolio. Everything I do is a dumb as dirt: no shorts except via ETF shorts (which have serious shortcomings), no futures, no options. nothing not traded on US exchanges. I was up more than if I had been in cash (ie better than money market returns) in both 2007 and 2008. Unlike the pros, who get paid to do this all day, have access to technical and fundamental research, can get input from traders on order flow, have research staffs, and spend all day doing this, this is a side activity on which I spend very very little time. bg I think is more active and does more homework, but had similar results. Another fellow in my e-mail correspondent circle (he admittedly was a money manager and does much more exotic stuff and also gets more research, so he is a quasi-pro) was up 3%.
If a retail chump like me can do so much better, there is NO basis for defending the pros’ performance. None.
@Waldo,
In fact I am an American born and raised, my family goes way back in American time, grew up in Arizona (still wear cowboy boots). Served 5 years in the Army in Elite units, finished my degree in Administration and worked for 2 International Company’s, till I realized it was not for me. Since then have traveled and worked in niche construction markets and as a subcontracting administrator in Industrial Construction.
My ethos is simple, ethics before profit, fare but firm, do the job right/(don’t try trickery to inflate the job costs half way down the road), don’t leave a mess for others to clean up and admit your failings to your self and others.
I have lived in Australia with my wife (Aussie Lady) and four kids since 1995, still love my birth Country and saddened by the state of the union. I do share a common thread with Mr. Kline in these matters, social license/trust of the people, has been trampled like never before and on a massive scale.
The only way to restore this trust, IS PUNISHMENT of the the complicit, Nuremberg style. Give Elisabeth Warren a GUN and a BADGE, she will sort this out pronto. We can fund the proceedings with a claw-back of the TARP funds from the lier’s and deceivers. Any funds left over should be spent on helping people till this market mess is sorted out. The good citizens of America should not have to suffer for the crimes committed against their trust and person by the Political leadership or Banking/Investment leadership, full stop. Claw back their fraudulent gains and then some more, then off to Gitmo, NO JOKE.
I would offer the suggestion that “doc darkness Holiday” be the warden, where a likeness of his self is projected onto huge screens located in ever corner of the prison and reminds them in his own unique way, their abject failings as human beings.
Skippy, The pirate, of the Crimson Assurance Company.
On the note of your friend, think I know of him, crossed paths. Funny was just in Noosa at my brother in-law house (down by Hastings St.) for Christmas, small world hay.