JOSH FRIEDLANDER, EDITOR, ABSOLUTE RETURN
In his short story bearing the same title as this rant, Hemingway’s fictional persona, Nick Adams, breaks up with his girlfriend by telling her “it isn’t fun anymore”. It’s a crude and juvenile expression of dissatisfaction, but no less true for that.
After several years of mediocre and index-trailing returns, investors in the hedge fund industry may very well be wondering whether the good times will ever return. Some haven’t had any fun at all, instead perfectly mistiming their entrance into an overall less talented or capable group than that of the retiring heroes who had attracted them in the first place.
Wealthy investors were already dumping hedge funds in the early 2000s as the halcyon years of outperformance were replaced by the go-go years of lower gains and ever-aggressive fundraising. But it took the past decade for those investors to shift from being the vast majority to a still-declining minority of hedge fund capital.
In that time, individually self-interested family offices have been replaced by publicly focused institutions, so getting the same brush-off is less likely to be a private affair. Family offices do talk to and influence each other, but pensions file public reports and speak to the mainstream press, exerting a compounded and reflexive peer pressure. Herman Melville’s notion that “it is better to fail in originality than to succeed in imitation” is a quote that you are unlikely to see pinned to some pension chief’s corkboard.
These are government bureaucrats, after all. Taking human nature into account, ongoing mediocre performance by hedge funds could affect the oh-so-crucial trend of increased pension allocations in a way that it has not to date. If institutions represent about two-thirds of the capital in hedge funds, as some recent surveys claim, there is a lot to lose.
Greg Nolan, chief investment officer of Australian superannuation fund CareSuper, recently told The Australian Financial Review that “Hedge funds have not met our expectations and they are expensive,” as the A$7 billion pension dumped its A$100 million exposure. CareSuper followed the €2.4 billion Dutch pension plan of the applied technical research institute TNO, which reportedly wrote in its most recent annual report that it would redeem its 2.9% exposure to hedge funds because “research has shown we can get a comparable risk/return profile with traditional asset classes”.
Those two examples do not make a trend, but it is in light of comments like these that one can understand the very strong objection some industry-backers had last year to “The Hedge Fund Mirage”, which premiered in January 2012 and was still being ardently debated when we invited its author, Simon Lack, to speak at the Absolute Return Symposium in November 2012 (I hasten to add that Lack’s argument first appeared as a column in Absolute Return).
Lack’s message is one that’s hard to argue against unless you consider it your job to sell the concept of the industry. The Alternative Investment Management Association (AIMA), the global hedge fund industry trade association, does consider this to be its job. They were so angered they wrote a 24-page rebuttal. It didn’t help matters that Lack’s book followed the previous year’s widespread losses and underperformance.
AIMA’s rebuttal was understandable. But it was perhaps a bit misguided unless you consider hedge funds to be an asset class. They are not. Defending hedge funds as an asset class is like defending the restaurant industry as a food class for overwhelmingly producing mediocre food. For every Babbo, there are about 800 Olive Gardens (sorry, Olive Garden). We don’t go out to eat at the restaurant industry. We don’t stay at home because the median chicken parmesan sandwich had a bad year. And yet… this does seem to be the way consultants and pensions think about hedge funds.
Lack’s words hurt the hedge fund marketing spiel, because institutional investors make broad investment decisions based on large categorisations. They have equity buckets, and credit buckets, and just as the consultants finally sold them on having something approaching a hedge fund bucket, it turns out that there’s a lot of slop in that bucket jostling around next to the track records of Ray Dalio and George Soros. You don’t want to just close your eyes and reach in. Or, to put this in consultant-speak, you definitely don’t want a diversified piece of this bucket.
Index providers like HedgeFund Intelligence bear a little of the blame (but only a little). After all, you do want to compare one US long/short equity fund against another. That makes sense, like comparing burger joints. What you don’t really want to do is think about composite stats for an entire industry as if they affect individual decisions.
We reference composites because we’re writing about the business of hedge funds. Composites let us know the health of the industry in terms of its success producing aggregate returns, earning fees, and attracting investors, but you can’t specify from the general. If you’ve studied logic you’ll recognise this as the ecological inference fallacy, which involves deducing information about individuals based on information about a group.
Of course, there is some utility to thinking about hedge funds in aggregate, although a standard deviation diagram is much more informative than either a mean or median statistic. The percentage of funds to underperform certain benchmarks gives an indication of the overall probabilities one faced in making money. Too many years of low probabilities and investors might be right to abandon hedge funds. If it’s always difficult to find the winners, how much more difficult is it when the pool of winners shrinks? (And it would be nicely ironic were investors to abandon a whole industry based on composite statistics, thereby reducing competition and leading to renewed outperformance by the funds that remain.)
Lack doesn’t argue that individual hedge funds are terrible, but that they have over time collectively underperformed stocks, Treasury bills, and third-grade lemonade stands, while on the whole acting as wealth redistribution vehicles from public funds and rich families to money managers.
Is it so radical to argue that individual traders are great and the collective stinks? Did you ask the median person at your high school to the prom? Only in Garrison Keillor’s Lake Wobegon do we find a place where “all the women are strong, all the men are good-looking, and all the children are above-average”.
AIMA arguably took the wrong tack in fighting Lack’s argument, because even if you win, you lose. Proving that hedge funds collectively are a good investment requires you to insist that hedge funds are an asset class. Convince a few hundred people managing a couple of trillion dollars’ worth of investable assets of that fact and you leave your industry wide open to some very reactive behaviour when the composite statistics don’t look particularly good. Do you really want employers looking at the average GPA of your entire graduating class as evidence of your particular fitness? It’s absurd. That hedge funds have gotten themselves into this illogical hole is profoundly absurd.
All this came to mind when looking at the performance that hedge funds generated in 2012. Did hedge funds recover after 2011, a year in which the median fund fell 0.79%, and 54% of all funds were negative while the S&P 500 had a total return of 2.11%?
Well, sort of. Overall, 73% of all the American hedge funds in our database produced profits in 2012, and the median fund was up 6.49%. But that was compared with a total return of about 16% for the S&P 500 Index. Putting aside for a moment the fairly important question of whether equities are the right benchmark against which to compare hedge funds in aggregate – or whether cash or Libor or something else is a more appropriate reference point – this is not a compelling selling point.
One year of underperformance is bad, two years is worse, but more troubling are the longer-term results.
From very near the absolute bottom of the stock market in March 2009 through year-end 2012, the Absolute Return Composite Index rose a total of 33.38%, an annualised return of 7.8%. Now compare that to the S&P 500 total return of more than 110.62% in the same period, or 21.45% annualised. Only 16% of the Absolute Return database beat that score. You will recognise some of the names, such as SPM Structured Servicing Holdings, which annualised 49.01% in that period, and Pine River Fixed Income, which annualised 34.95%. From the start of 2009 to the start of 2012, those two firms have increased their collective assets by 580%.
But the overall picture is less heartening. The Americas Billion Dollar Club list of firms managing $1 billion or more in assets has increased by just 29% from 2009 through January 2013, to $1.46 trillion, and remains about 13% below its July 2008 peak of $1.675 trillion. In 2012, the top 50 firms in the Billion Dollar Club increased assets 11.3% while the club as a whole increased 9.3%. If the very largest firms are vacuuming up more assets than even the very large firms, it follows that the Billion Dollar Club as a whole is likely to be recovering faster than the remaining smaller firms that make up the industry.
Although we cannot perfectly measure the success of all funds given the difficulty of tracking them, the 2012 new fund surveys held out some hope that not all the cash is going to the biggest players, at least among new entrants. This past year, 71 new funds reached or exceeded $50 million, raising $24.9 billion during the year. That was the highest total since 2007, when 81 launches raised $31 billion. Two-thirds of these new funds were launched by entirely new firms, and they raised 54% of the total.
Let’s hope that it’s the start of something. New or old, taking a considered chance on individual managers is the entire game. If something is going to come to end, let it be all this talk of a hedge fund asset class. That just isn’t fun anymore.