Diminutive Nature of Net Returns

81investment's picture
Rank: Monkey | 38

I began thinking about hedge fund returns. Since hedge funds need to maintain liquidity, let's assume a hedge fund only deploys about 85% of its AUM at once. Let's assume 0.2% for fund expenses, a 2% management fee and 20% carried interest:

AUM: $100
Cash Liquidity: 15%
Assets Invested: $85

Fees: 2%
Fund Exp: 0.2%
Carried Interest: 20%

Remember, funds need to maintain liquidity and cannot be fully invested. Let's assume a fund only invests ~85% of its assets. Let's assume a fund has $100MM of AUM. In order to make $20MM (i.e. a 20% return before any fees), it needs to hit a 23.5% return on the $85MM invested. After fees, that 23.5% gross return on invested capital (20% overall) only works out to a 14.24% net return. So in order to hit a 14.24% return, the fund needs their investments to generate returns of 23.5%.

Return on Invested Capital: 50% 40% 30% 20% 10% 5%
Net Return to Investor: 32.24% 25.44% 18.64% 11.84% 5.04% 1.64%

This also completely debunks efficient market hypothesis. This means that funds performing as well as the market are in fact significantly outperforming the market (considering all the fees they take) and the fact that they are never fully deployed.

I have two questions:

a) When you read that Abrams Capital or Baupost have 15% net returns; does this mean since they sit on like 40% cash and only deploy like 60% of AUM, that their returns on deployed cash are like ~40%?

b) For HF people, how much cash does the average hedge fund keep not deployed at all times?

Comments (34)

Jan 29, 2018

Hedge funds are not 85% invested.

Also the ones that do sit on cash are doing it for market timing.

The real beauty of hedge funds is the risks management.

    • 1
Jan 29, 2018

Are you saying it is less than 85%? What is the figure?

    • 1
Jan 29, 2018

On average hedge funds are likely close to 130-180% invested. They can only borrow on Margin or sell stock when they have redemptions.

Mutual funds 97% on average.

Jan 29, 2018

Money needs to be liquid for redemptions and when money comes in it doesnt get spent immediately and also funds need to be liquid for new investments.

Does anyone know how much cash the average hedge fund sits on?

    • 2
Jan 29, 2018

Yes, some funds put up amazing return on invested capital and risk manage by deciding how much to keep in cash. Most funds are long short and run anywhere from 130 - 300% gross (more gross = less net usually).

Yes, some funds have managed to put up huge returns despite keeping significant cash. Tradeoff is these guys tend to be very very concentrated

Jan 30, 2018

I think those guys have a bit of a structural problem now.

It's great having a large amount of cash when we have an economic cycle. Then you deploy cash during a recession and sell into a boom. That is how they beat the market without being fully invested. But the fed has gotten good at delivery stable growth so there's fewer chances to deploy during panic times.

Jan 30, 2018

Actually it's more like stock pickers vs thematic/macro guys at the moment. Good stock pickers had a whale of a time last year, macro not so much.

Offshore liffe

Jan 30, 2018

I don't understand something. If public equity holdings make up even 50% of your net worth, why diversify and have 100 stocks and have dilution in the quality of your ideas, if you can own 5 high quality ideas in different spaces and diversify that way. Worst case scenario, even in a wipe-out on a position (unlikely if you did a great job picking your companies), you only lost at most 10% of your net worth. But in exchange, you now have exposure to a much higher quality idea base and can generate significant out performance. If your finding 5 opportunities trading for 50 cents on the dollar all you need is for one to reach intrinsic value and it makes up for a complete wipe-out. The more positions you have (diversification) the lower the quality of your ideas. They are directly correlated.

For example, let's assume I have $100 of real estate and an overall net worth of $200. I have $50 in two bullet-proof barrier to entry core cash-flowing assets which are unencumbered and the remaining $50 is in 5 very high quality opportunistic deals with substantial leverage. It's hard enough to find 5 great deals. If I tried finding 15, all 15 would be shitty deals and I'm going to under-perform and even if one is good, it will yield immaterial results to increasing my net worth.

Why is concentration a bad thing? It's not like they have 100% exposure to a single stock. We are talking about 10%.

Jan 31, 2018

When discussing diversification, it helps to keep the risk/return profile of each asset the same - this will aid your understanding. If you have 10 similar assets that have low/no covariance, you are able to achieve the same expected return with lower risk through spreading your investment across the 10. This is the benefit of diversification - less risk for the same expected return. In simple terms, the more times you roll the dice, the closer you get to the expected return.

What you raise is more a practical limitation, i.e. what if that subsection of assets is constrained in size to the point that diversification isn't achievable. In such case you would just naturally diversify to the limit of the constraint, which is effectively the same thing you are proposing (investing in all 5 of the good ideas).

I'd also comment that your view of the matter is heavily biased around the idea that active management adds value and is able to generate superior risk adjusted returns. I'm not saying this is untrue, but you need to realize that not all investors agree with this, or if they do, they may agree only to a weaker form/lower conviction. For these investors it is therefore much more unlikely that the field of investments that form a particular risk/return profile would be so small in size. Even if it was, they could construct a portfolio that still a achieved the desired risk/return characteristics by investing in assets that don't individually meet these definitions, but do on a portfolio basis by way of averaging. In contrast, your example of diversifying could only add in and average higher/lower risk assets if they also exhibited the same magnitude of excess returns as the original investments you identified. As you described, this is either extremely unlikely or very difficult.

tldr - the benefit of diversifying is still theoretically present in active management, however less available in a practical sense. If you subscribe to this view of the market, you would be naive to select bad assets for the sake of diversity. You would still accept marginally worse ones however, providing the risk reduction compensated for the lose in return.

    • 1
Jan 30, 2018

There isn't really such thing as the average hedge fund. It all depends on strategy.

You say "I'm only talking unlevered long only hedge funds" then you may as well be talking mutual funds for all it matters as the biggest difference is the mandate. LO funds can deploy leverage and hence keep cash whilst hitting high gross and churning returns. They have lockup's and longer scale liquidity e.g M or Q, meaning they can be much more opportunistic.

Now where you are correct is that the return on aum is high. But never forget the impact of 3x leverage and great risk management

Offshore liffe

    • 2
Jan 30, 2018

Thank you big1.

What is M or Q?

Also, I am trying to figure out for myself what the average deal-level returns (I don't know hedge fund terminology, but this is R/E terminology) are for long-only, non-leveraged, value-oriented hedge/mutual funds. The only variable I am missing is what percentage of their AUM is deployed on average. If you know and can share that figure that would be great.

I don't fully understand why everyone is so focused on "risk management" and short-term performance. At the end of the day, as an investor I only invest money which I don't need in the short or medium term and am focused on increasing my net worth over the long-term.
If the intrinsic value of the company isn't changing, who cares if the stock price goes up or down? If it goes down and I have more cash, I buy more, if it goes up well beyond its intrinsic value and it makes sense tax-wise to sell, I sell.

If I buy a building for $80 and I think it's worth $100, but some guy gives me an offer for $50, who cares if he (the quoter i.e. Mr. Market) tells me he thinks its worth less if the economics/fundamentals/intrinsic value hasn't changed? If I get an offer of $200, I sell and if the replica building two blocks over is for sale (i.e. the price goes down) for $50, I buy that. I dont see how investing in the market is any different.

I don't understand the trading mentality.

Jan 30, 2018

Different ways to make money.

Do some reading on portfolio management. It's all part of a diversified portfolio. You buy some index, some RE, maybe some LO, put a bit into PE, and some into HF. The entire idea behind HF is to provide a differentiated return - and for absolute return funds to not lose money - so they won't always over or under perform the market but if the market tanks, then part of your portfolio should profit. It's been a difficult few years due to beta driven markets thanks to QE but the markets can only go one directional for so long. Obviously I'm vastly oversimplifying here.

As for what you get when buying a mutual fund: not the index. Granted a number of quant strats have hurt the idea of mutual funds but One could argue a mutual fund doesn't need to out perform the index to make money. They could simply lose less during a drawdown and be above the index over a rolling five year period.

Offshore liffe

Jan 30, 2018

You really need to read on markers and valuation before starting thread alike this.

To keep simple: valuations for everything are based on forecasts of the future. Different people have different expectations about future value and newsflow can shift this. This applies to every asset class ever.

There is no value investing is good,trading is bad. There is only investing in what you know,how you know, with good risk management, or not.

The advice to buy and hold is literally because for most people this is the most they can sustain given the above. Clearly those who are good can outperform. Take Rentech as the extreme example, iirc they post returns net at +40ann vs the SPX at what...7?

Offshore liffe

Jan 30, 2018

Career risks. The whole system is designed so all the alpha goes to the manager and at best the investor gets superior risks management.

Think about a mutual fund. Say charge 1% management fee. Owns 100 stocks. I'd agree at best they love 5-10 ideas. They are aiming to hit their benchmark and out perform by 100-200 bps. If a mutual fund does that for a few years they will get a ton of assets. The collect 1% of 50 billion.

The multi strat hedge funds are all designed to never lose money. Pass on a 4-6% management fee and take 20% of profits. Give the pension fund a positive return with supposedly the risks management to not suffer a loss.

If someone is good in hedgie land they won't grow to the size of a mutual fund. But they will grow big enough so that they won't produce the huge alpha anymore and and most of it is sucked up with fees.

There was one macro fund that had a 50% up uear recently. It was after they returned all the pension fund money and got rid of those risks requirements while also got small enough to the point they could boost alpha.

Most funds prefer to get bigger because it's more stable income. 2 and 20 on a 10 billion fund pays about the same if not better than up 50% on 1 billion of partner money. But with the bigger fund you start to just do what's necessary to keep the fees rolling in without taking the risks you lose the funds.

I think pimco even does the same thing. Charge 80 bps in a few hundred billion and try to extract enough edges to justify the fees. A lot of how they do that are similar to the trades ltcm did and not taking directional risks. Just less leveraged and trying to extract a bit more than their benchmark.

    • 1
Jan 31, 2018

So your basically saying what my hypothesis concludes:

The bar of success has been considerably lowered if you can remove the fee component.

Your saying the industry is just a profit maker for the manager and the employees working at the firm (fees, promotes, etc.) there is no out performance for investors.

Best Response
Jan 30, 2018

LPs care A LOT about drawdowns and volatility. They use such metrics as measures of success of a fund's strategy.

If you make a value bet, there is a certain amount of risk that you are taking on when you make that bet. If you can find a way to reduce the risk of that investment via hedging/shorting/etc. in a way that reduces your volatility and average drawdowns even if you sacrifice some amount of expected return, that is often the right call to make.

I don't know anything about real estate but in public market strategies, 20-30% drawdowns can happen and they hurt. A lot. Finding ways to minimize those drawdowns even if it means sacrificing expected long-term return is quite valuable.

There's a reason that market neutral strategies exist. They will underperform the SP500 in the long run but if you're looking to minimize the volatility of your overall portfolio while still making $, they're a good place to be as they'll often make money or at least significantly outperform during crises. Hedge funds are generally just one aspect of an asset allocation strategy.

Huge pension funds, fund of funds, and even HNW investors often look to minimize their exposure to equity market risk without straight up holding cash. To do this, they will hand over $ to hedge funds who know how to do that.

    • 4
Jan 31, 2018

I still dont understand why anyone would give up long-term returns in exchange for short-term out-performance.

In real estate it doesn't matter much (at least for me).

We are balance sheet investors with no external capital and a long-term investment horizon; so there is no marking to market on a daily, monthly or even yearly basis. We are judged off of NOI, yield on cost and execution on our business plan.

We care somewhat, but not a ton, if Mr. Market decides its worth less. We only care if the fundamentals (i.e. the long-term stream of cash flow generated from the property) have changed. We really only listen to Mr. Market if he will give us an offer (i.e. a 3% CAP-rate for a property we think is worth a 5% CAP-rate); so we obviously sell it and swap it for a 5% one. Other than that, short-term gyrations dont really bother us.

Jan 31, 2018

Let's say you have two potential investment strategies.

Strategy A) 9% expected annualized return with 20% volatility.
Strategy B) 10% expected annualized return with 40% volatility.

Strategy A is far, far superior. That 1% of additional return is simply not worth all the additional volatility that you experience along the way. If you are a pension fund, you want to be able to pay out to pensionees no matter what the market environment is.

It seems to me that your attitude is that volatility should not be an important factor when considering an investment strategy. If that is your attitude, I'm sorry but that is absurd.

    • 3
Jan 31, 2018

Everyone has their "margin capital" and economic "capital". There really are not many "balance" sheet investors willing to take 40% drawdowns if for no other reason than avoiding the drawdown allows them to reallocate into a new opportunity.

Even if I have a billion And live on one million a year I don't want 40% volatility.

    • 2
Feb 1, 2018

Hi 81investment, it's good that you are curious and asking questions. Have you taken introductory probability?

There are a few things going on here. First, the distribution of returns for a given investment strategy (or stock) matters a lot in portfolio construction. Expected value, standard deviation (volatility), and max drawdown are just some common summary statistics that capture aspects of a probability distribution. But they don't capture everything (for example, consider regulatory risks specific to a given industry, natural disasters, etc...)

In addition, it's rare that we know the distribution of returns ex ante. Therefore, estimation error is a bigger deal for strategies with high volatility relative to expected return. This is one point in favor of fundamental investing: it's easier to have confidence in the long-term returns of a stock that you really understand than, for instance, bitcoin.

Now let's say somehow we ignore the above points and are just choosing between two portfolios, A or B, and we know the return distributions for certain ex ante. Suppose we look at the distribution of returns at a few points in time: (t_1,t_2...t_30) (could be year1, year2...year30). It could be the case that if all you really care about is returns at t_30, and A has both higher expected return and lower risk at t_30 than B, then you could disregard return characteristics in earlier time periods.

    • 1
Mar 15, 2018