It’s been a while since I posted (sorry @AndyLouis") so I decided to come back with something a little different from my previous posts. I’ll continue the E&F posts at some point, but given recent market conditions I thought this was more appropriate. The below is a compilation of thoughts I’ve been having on markets and the hedge fund industry as a whole.
The hedge fund industry isn’t going away
Bloomberg and the Financial Times have written quite a few articles recently that highlight “major” hedge fund closings. Whether it be an old, established firm closing its doors due to bad market conditions or a fund that can’t meet redemptions, the financial media can’t help but shout that HFs are going away. While these articles are great clickbait, they couldn’t be farther from the truth. 2015 did have some funds close, but that happens every year. Too lazy to pull in the data & charts of HF AUM and closings, but 2015 was not a cause for concern that the industry is going away.
Stop comparing HF returns to _______
Stop. Just stop now. Every time I see an article about a HF or HF indexes underperforming the S&P 500 I want to throw something at my monitor. The goal of a Hedge Fund is not to beat a 100% long only index. In fact, the reason lots of large institutions put HFs in an asset class called absolute return is because they are supposed to provide a consistent absolute return, not beat the S&P. Regardless, the financial media & large pensions love to go into the spotlight and talk about the underperformance of hedge funds. If your hedge funds provide consistent positive returns throughout a market cycle you’re getting your money’s worth and more. Stop complaining about relative performance.
Hedge funds aren’t hedging
Going off the last point, more & more HFs aren’t hedging their portfolios anymore. Especially in L/S equity. I cannot tell you how many times I see a portfolio that is 80% net long and calls itself L/S. I’m sorry, but at that point your beta is probably as close to 1 as a Vanguard mutual fund. This is late cycle behavior when managers are trying to chase extra bps by going just a little longer. Unfortunately, they’ll lose a lot more in the next downturn.
Everyone wants to be a hedge fund
A hedge fund is a structure, not an asset class. It’s a comingled fund that typically charges above average fees. I’ve recently seen quite a few long only public equity strategies that are comingled funds with lockups and high fees. What? You’re trading liquid public equities that you could easily exit in a few days of trading and you want 2/20 with a 2 year lockup and quarterly liquidity? Being a hedge fund is the cool thing to do now and long only equity managers are starting to do it. The point of liquidity notice periods is for illiquid investments and the higher fees are for superior returns in a full market cycle. Long only equity investors cannot provide this and therefore do not deserve these fees and structures. Yet, unsophisticated investors who want to sound impressive will invest in these funds, hence encouraging others to do the same.
Things are getting more complicated
This is the last point I’m going to make. I’m seeing more “new” strategies. Funds that do things that don’t make sense or are hard to understand. My favorite was a placement agent who said “returns come from a variety of places” when asked what the drivers of a firm’s strategy was. The strategy made such little sense that even the placement agent couldn’t explain it. If it hasn’t been done in the past, there’s probably a reason for it. Why are you so lucky that you figured something out that all the other smart people couldn’t? Not saying it can’t happen, just very unlikely.
That’s it for my rambling. It’s an interesting time to be an investor. I think we’ll see the landscape change over the next decade where the truly great hedge funds will continue to prosper under the premium structure and more of the lower tier funds will revert to traditional structures or close. More random thoughts to come in the future.
"The point of liquidity notice periods is for illiquid investments and the higher fees are for superior returns in a full market cycle. Long only equity investors cannot provide this and therefore do not deserve these fees and structures."
Could you elaborate, not sure I understand. A long only fund cannot achieve superior returns in a full market cycle?
I guess I should have worded this section better since a few people had qualms with it. I'll use an example to better explain. Over very long periods of time, the net returns of a long only manager and a L/S equity hedge fund may look similar (they shouldn't, but given the large dispersion of returns in L/S equity they might so we'll assume they do). But just because the long term returns may be similar doesn't mean the risk profiles are or that you're getting the same thing year over year. In the end, we care about long term returns but we still have to look at the month to month and yearly returns. Especially in the endowment space when you have grants or expenditures that need funding every year. Yeah, over the long term it'll all even out but if I have to cut a program because our portfolio drops 40% my board isn't going to be happy. I'll pay the extra fees and give up liquidity to know that while I may not get spectacular returns every year, I will get good enough returns.
So here's a numerical way to explain that. I have a manager that I invest with in early 2008. ITD his compounded annual net return is only a little higher than the S&P 500 over this time period and he's underperformed the S&P 5 of the last 8 years. So you're thinking, why would I keep investing with this person when I can get similar returns from an index fund and have much better liquidity? The answer is performance over a full market cycle. In 2008, this manager was down less than 5% and hasn't had a major down year ever. Additionally, he captures the large majority of the upside and while he doesn't perform as well as equities in a bull market, he does well enough to hit my return expectations. This is what I mean by superior returns in a full market cycle. No matter how great of an investor a long only PM is, he isn't going to be down only 5% in 2008.
I would say I agree with 60% of what you're saying.
Hedge funds do need to be benchmarked against their peer group. You're right that it's stupid against the S&P 500, but they need to be benchmarked against their peer group in order to judge how they performed within their strategy. If they generated 5% annualized positive returns in a bull market cycle, but their peer group generated 20%, then they underperformed. No way around that.
Stating that hedge funds aren't hedging isn't true. Read Goldman's recent hedge fund report that states a bunch of L/S managers are net short now. They can be 80% long, but they can unwind positions and go 50% the next year, which is exactly what we're seeing now.
"The point of liquidity notice periods is for illiquid investments and the higher fees are for superior returns in a full market cycle. Long only equity investors cannot provide this and therefore do not deserve these fees and structures."
----This statement is false. Closed End Funds for equities have generated large returns before with leverage. More importantly, most hedge funds don't generate superior returns in a full market cycle. More often they have one or two superior years during a bull cycle and then have mediocre returns the rest. This roots out average hedge funds, but also makes it more difficult on deciding which ones to invest in. For every Glenview Capital, there's 20 mediocre funds out there.
The term "Hedge Fund" refers to the legal structure of the entity, it has nothing to do with the strategy other then the fact that being structured as a GPLP allows the firm to employ strategies that include, but are not limited to, going short, derivatives and illiquid assets or securities; mutual funds are legally bound to only go long and have a number of other restrictions that preclude them from purchasing certain securities based on risk/liquidity.
A long only GPLP could have merit, but almost exclusively within the smaller AUM range. There are potentially a fuck load of opportunities if your only moving 50M around. If you're long only in the 10 figure range then, yeah, GTFO.
The potential strategies and goals of a hedge fund vary tremendously. There's a large concentration within the absolute return space but that's not all there is. Some funds should be looked at as an "exotic" bet that exposes a portfolio to risk/return profiles that cannot be easily replicated in the market. In other words its a diversification tool and the fund's performance should be analyzed as a portion of a hypothetical portfolio rather than a comprehensive investment solution.
@Esuric Thanks for the finance 101 EMH platitudes. You never fail to come through with some trite academic dogma. I would ask you what your definition of efficiency and liquidity are, but I'm not going to as I could always just search it up on investopedia and get the same answer.
@Esuric EMH was around in the 19th century but people were still making fortunes by arbitraging convertibles in the 1970's. Sure peoples' PERCEPTION of value reflected the most current information, but their understanding of the value of a convertible was not fully developed, except for a relatively small minority who made risk free profits. Please don't try to qualify your argument because no one on this discussion is arguing about markets disseminating information efficiently. You were implicitly, but undeniably, invoking EMH to specifically attack the practice of active Asset Management, which is a fucking stupid thing to do. That argument isn't even theoretically sound, its actually self defeating. If no one practiced active management who the fuck would price securities? or would they just fall into place by accident???? Everyone owns ETFs, all wealth is held in passive strategies....now what? how do prices move to reflect new information???
Its one thing to be aware of economic theory and understand its implications and LIMITATIONS, its another to mindlessly use those theories to make shitty unsolicited arguments. I would actually be interested to hear a novel opinion/perspective regarding market efficiency, but your argument is banal and an affront to intellectual thought. I could open up chapter 1 of an investment text book and read the exact same shit. I could also read any thread on this forum and predict what your thoughts are because they are just so fucking bland.
Finance professionals aren't ignorant of economic theory...... we're just acutely aware of the fact that it has HUGE limitations. I could start listing them, but i'm sure most people on this forum are aware of them, but it might be worthwhile to just start an entirely new thread........ Ill title it "Dear Esuric,".
I didn't say anything about leverage or structured products....I can't believe that you're so desperate to win this argument that you would resort to using straw man arguments. My point was that EMH can't be used as an argument against the entire practice of Asset Management.
Again thanks for the finance 101 lecture, but there was no need for the refresher.
You keep giving evidence that you have no idea wtf is going on. I mean its not hard to tell that you have no experience in the market outside of a textbook. ..... do you even know how the majority of HFT strategies work ???????its actually fucking hilarious that you would use that argument because the vast majority of them have absolutely nothing to do with the actual economic substance of the securities that they trade. If anything, they exploit market structures and incentives and cause market inefficiency.
But you completely dodged my point. Why have so many arbitrage opportunities been exploited in the past - e.g convertible arbitrage? and please don't say "Money managers were taking risks that weren't identified" because as soon as the wider market figured out what was going on the arbitrage opportunity vanished, so it couldn't have been a function of higher risk. My point is that the wider market is not always - actually usually never- the absolute barometer for value and financial risk, some people will always have a better understanding of whats going on, and unlike one of the most ridiculous premises of EMH these people don't have access to unlimited capital and their analysis won't be completely reflected in market prices.
This is really a matter of subjective relativism vs objectivism, but you probably don't realize that. A derivative of the reasoning behind your rigid interpretation of EMH can be the following: The market bets on whether the world is round or flat...... the market says its flat, therefore its flat. BUT THAT DOESN'T MEAN THAT ITS SO. IF THE MARKET SAYS THE PROBABILITY OF APPLE DEFAULTING ON ITS DEBT within the month IS 100% DOESN'T MEAN THAT IS WHATS GOING TO HAPPEN.
Kids not in the industry spew out terms like EMH without even understanding the most basic and small market nitpicks that create inefficiencies.
Case in point, many hedge funds wanted to short Shake Shack (SHAK) out of the gate. The cost to short was over 100%. This artificially boosted the price and created many short squeezes for months as funds awaited future secondaries to increase the float. Funds had to box their shorts which helped create more volatility. We saw 10-20%+ swings and hundreds of millions of market cap moving with absolutely 0 news. What an efficient market!
But then again, Esuric is a Big 4 employee so obviously he's already accounted for all of this and more when he's tutoring the world on financial economic theory.
I agree with a lot of things said in this conversation. Here's what I believe as someone who has covered HFs and been at one.
The hedge fund industry has gotten too large - as a % of markets, in terms of number of smart people, in terms of net fees being extracted.
The fee structure needs to change and is changing - 2% / 20% was fine when risk free rates were 6%. Risk free rates are now zero, paying 2% fixed in that environment won't fly. In addition due to passive investing, there is tremendous fee pressure and need for transparency. Return expectations are much lower going forward - again due to rates, valuations and risk premium available. This means sharing 20% of 6-8% expected return versus 20% of 10-15%.
The LP base is different now and has new demands on hedge funds. With more performance pressure from transparency in the industry hedge funds can't underperform for too long versus others and / or their benchmark. Any underperformance leads to redemptions. This creates herding into and out of markets. If everyone is selling, you need to make sure you sell first. If markets are ripping higher, you need to get long before everyone. It matters less what you think might happen over a year, because you are measured quarter to quarter.
The industry is so large now, that it isn't about performance its about asset gathering. Its impossible to outperform when you manage $10bn or more, and any incentive you get when you are $1-5bn pales in comparison to the mgmt fee you can earn at $5-10bn. So the goal is to introduce a lot of strategies, market like crazy and grow AUM. Basically hedge funds will become and are becoming more like mutual funds.
Happy to talk more, DM me.