Guest Post: Big Money Suffering Performance Anxiety?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Global Pensions reports that hedge fund managers will see some US$50bn coming their way this year with flows coming primarily from pension funds looking to redeploy cash, according to a new report by Barclays Capital:

Pension funds and family will also depose foundations and endowments as the most active hedge fund investors.

Barclays found that pension funds are ready to wind down their cash portfolios and wade back into the markets. They also plan to increase their overall hedge fund allocations while other investors, like insurance companies and endowments and foundations, plan to decrease their exposures.

Investors’ average hedge fund allocation was 2.4% at the end of 2008, down only slightly from 2.6% the previous year.

Barclays managing director Brian Reilly said: “We found that in spite of dramatic changes in the investor landscape, certain investors were ready to deploy their cash balances aggressively once markets stabilized. Managers who develop early relationships with new investors will be the primary beneficiaries of this trend.”

Investors will tend to steer away from highly leveraged, high beta and illiquid strategies, said Barclays. They will also discard the traditional two and 20 model of management fees.

Barclays director and author of the report, Picking up the Pieces, said: “Our work also showed that the best positioned managers were those who explored creative solutions to better align investor and manager incentives. Providing investors with transparency, comfort around the protection of their assets, and a better alignment of incentives was rewarded much more by investors than simply discounting fees.”

At least one pension fund has put stricter standards in place for its hedge fund managers. The California Public Employees Retirement System has asked their managers for better disclosure regarding their holdings and for fees based on long-term, instead of short-term, performance.

Interestingly, while pensions intend to invest more into hedge funds, the hedge funds have come under fire for not spotting market rally:

First they failed to provide a “hedge” against falling markets, now the world’s highest paid fund managers have failed to spot the recovery.

New research on the performance of the world’s hedge fund industry shows clients running for the exit as the credit crunch casts doubt on their once fabled ability to beat the market.

Investors asked for nearly $104bn (£68bn) back from hedge funds in the first quarter of the year, or about 7.4% of the industry’s assets, according to data from Hedge Fund Research. This leaves the industry with almost half of the $2tn of assets it managed at the peak of the ­market in 2007.

Investors withdrew most money from equity funds, many of which have failed to capitalise on the soaring stockmarket. On average these funds gained 2.7% in March, and 5.7% in April. However, this lags behind recent rallies in equity markets: the FTSE100 has gained more than 20% since 9 March – when the markets bottomed – while the Dow Jones European Equity Index has soared by more than 30% over the same period.

Industry experts defended the performance, arguing it is virtually impossible to time the bottom with precision.

“These are very volatile markets, hard to read even for the most experienced manager,” said Huw van Steenis, a financial institutions analyst at Morgan Stanley. “If a manager has made money and controlled risks well, then most investors will be broadly satisfied.”

One reason for the underperformance is that big hedge funds, mostly based in London and the US, are keeping much of their money in cash, fearing the rush of redemption requests from investors may not be over.

“We estimate there were 20% redemptions in the second half of last year, and 10% in the first quarter, this year,” Van Steenis said. “We have evidence that hedge fund redemptions are reducing, although the pruning of portfolios continues to take place. But things have calmed down and people are taking time to evaluate options.”

Hedge funds also face public scrutiny for their role in betting that bank shares would fall – adding to uncertainty in times of crisis – and a European Union directive to regulate them more tightly. Traditionally, unlike other asset managers, hedge funds do not have to disclose their ­strategy to a regulator.

“We are just asset managers, yes we short-sell, that’s publicly unattractive, but this directive is a populist vote-gathering,” said one hedge fund manager, who declined to be named. “Having higher capital requirements will add more costs and will be a disadvantage to small funds, although it may be good for established funds.”

The directive is now being reviewed by each country – although only the UK may show support for the industry since London hosts most European hedge funds.

“The UK would be crazy not to fight; they have the monopoly of hedge fund industry in Europe,” a hedge fund manager said. “For the regulator it is good PR, it’s good to go against hedge funds – but the problems came from the regulated banks. Regulated banks caused this problem, not hedge funds. It’s a bit of a joke this whole thing.” New regulation may raise barriers of entry to the industry – but more scrutiny and transparency may make the industry more legitimated, analysts say.

That article prompted this response in Opalesque by Bryan Goh, First Avenue Partners LLP:

Hedge funds have been accused of missing the equity market rally begun March 2009. Let us look at an example of an equity market such as the European equity markets to see why.

Equity markets are up year to date. The Stoxx 600 for example is up some 6% year to date after a 22% drop followed by a 37% rally. Yet it has been a very difficult market for trader and investor alike. Only the truly brave make big money (I am being polite.)

Sentiment worsened almost linearly and certainly monotonically since September 2008 to March 2009. Then suddenly equity and credit markets turned and rebounded sharply. By late April, commentators began talking about ‘green shoots’ of growth and recovery. I guess even a dab of moss after a nuclear Winter counts as green shoots. Equity markets have behaved erratically. Cyclicals led the rebound, defensives lagged it. This is typical of late stage recessions and recoveries, yet fundamentals are far from healthy.

Markets, however, are driven by fundamentals only until they are driven by psychology. Healthier is sufficient, the market doesn’t need healthy. The Q1 results season has been interesting. In a normal recession, analysts adjust their earnings forecast slowly, exhibiting serial correlation. As a result, companies tend to miss their forecasts and the street then engages in a staged downward revision leading to more and more disappointment. So violent was the shock to the financial sector, repository of stock analysts that earnings forecasts were cut almost indiscriminately. The rebound therefore was set up well in the 4Q 2008 as sentiment drove forecasters to overshoot. In the ensuing rally, low quality companies have outperformed high quality companies and market breadth simply isn’t there.

It’s not a healthy rally, but short-sellers beware, it could well become one.

Within the Stoxx 600, the sector dispersion is high. In the last 3 months, banks, insurers and financial services outperformed. The rest of the sectors cluster quite closely. Telecoms, utilities and healthcare underperformed. Dispersion is moderate with the exception of the banks. The Stoxx Bank Index rose 48% in the last 90 days in spite of the chronic uncertainty over their solvency and profitability. Guilt by association buoyed Insurers to a 26% gain over the same period. Consumer cyclicals made gains in the high teens. In the same period, Telecoms lost 4.25%, Healthcare lost 6.66%. Getting the sector call wrong would be costly.

Within each sector, dispersion was fairly moderate with the exception of banks and resources. Dispersion in the banking sector in Europe

Some big names like Peter Thiel’s Clarium LP, missed the rally:

Earlier:Valleywag landed a slide from hedge fund Clarium LP’s marketing deck. It’s interesting to us because Clarium is Facebook investor Peter Thiel’s fund. Also, hedge funds aren’t allowed to market themselves publicly so this is a rare look.

Quick take-aways:

  • Thiel was down about 2% on the year, as of the end of March.
  • Stocks rallied hard in March. Clarium missed this rally.
  • Hedge funds in general were up +3.2% for April. Clarium missed that rally.
  • The fund lost $2.2 billion in assets between April 2008 and April 2009.
  • A marketing rep at another hedge fund tells us the fund looks more volatile than most, but that the funds historical track record remains impressive.

We talked to Clusterstock’s John Carney and he told us:

Clarium came back a bit in April, rising +1.7% for the month. Which means it is now down just -0.3% year-to-date. But that still means the fund is underperforming. The broader markets were up much more than that. Hedge fund performance overall was up 3.2%

Click to expand the slide:

The NYT reports that another big hedge fund, Raptor, is closing after losses:

James J. Pallotta, a stock picker and former partner of the hedge fund pioneer Paul Tudor Jones, has decided to liquidate his $800 million Raptor Global fund after losses and investor withdrawals last year, he said in a letter sent to investors on Tuesday.

Mr. Pallotta, a co-owner of the Boston Celtics, did not give a specific reason for closing the fund, but wrote in the letter that he had grown skeptical of the “sustainability of certain aspects of the industry’s structure and short-term focus.”

At its peak in mid-2007, Raptor managed nearly $9 billion in assets, but that declined to about $5 billion last August. Like other hedge funds, Raptor took huge losses in the fourth quarter and had a wave of withdrawal requests.

A person familiar with Mr. Pallotta’s thinking said he planned to take a few months off before raising money for a new fund, most likely with a focus on longer-term investments. The person spoke on condition of anonymity because of a confidentiality agreement signed with the fund.

A spokesman for Mr. Pallotta declined to comment on his decision.

The move is surprising because Mr. Pallotta ended a 15-year partnership with Mr. Tudor Jones on Jan. 1 to form his own firm. As part of the separation agreement, Raptor was spun out of Tudor Investment Corporation as an independent business, and Mr. Pallotta took several veteran traders and portfolio managers with him.

The hedge fund industry shrank substantially in the last year as investors withdrew capital and firms took heavy losses. Hedge fund assets fell to $1.4 trillion at the end of 2008, from a record $1.9 trillion at the end of 2007, according to data from Hedge Fund Research Inc., which is based in Chicago. Last week, the longtime hedge fund manager Arthur J. Samberg told investors he was liquidating his $3 billion firm, Pequot Capital Management. In May, Satellite Asset Management, a big New York hedge fund founded by protégés of George Soros, said it was closing after poor performance led to a rush of client withdrawal requests.

Unlike many of his counterparts in the hedge fund industry, Mr. Pallotta decided not to stop his clients from withdrawing their capital, which forced him to sell assets as stock prices were falling. He started the year with about $1 billion in assets under management and has decided to keep most of it in cash, resulting in flat returns this year.

Since its inception in 1993, Raptor said it had returned an average of 13.9 percent a year, including the flat performance this year, compared with a 6.5 percent return in the Standard & Poor’s 500-stock index over the same period.

Mr. Pallotta said in his letter that investors would receive about 75 percent of their investment in cash in early July and 15 percent in assets. Clients will receive their remaining investments in the fund “as soon as practicable thereafter,” he wrote.

Once the liquidation of the Raptor funds is under way, Mr. Pallotta plans to step away from day-to-day management of the firm and focus on developing a new investing strategy that better aligns the interests of investors and managers with superior risk-adjusted returns over time, he said in the letter.

Tim Barakett’s Atticus Capital drastically scaled back its portfolio in Q1 following sharp losses in 2008.

But not all hedge funds are hurting. Billionare Carl Ichan’s hedge fund jumped 7.3% last month and Brevan Howard Asset Management, Europe’s biggest hedge fund firm, more than doubled its operating profit in the year to July 2008, helped by a strong performance from its flagship fund.

Interestingly, the Times reports that Brevan Howard’s strong performance in 2008 can also be attributed to a decision by Alan Howard, the firm’s co-founder and biggest shareholder, to switch many of the firm’s funds under management into cash early last year after concluding that credit markets in the United States and Europe were likely to seize up. By the end of the year, about 85 per cent of funds under management are thought to have been in cash.

[Note: While I still believe small is beautiful, some of the bigger funds are a lot smarter than others, focusing on capital preservation.]

Finally, Tech Ticker discusses performance anxiety: big money now praying for a pullback:

With the market seemingly in free-fall earlier this year, a lot of investors couldn’t take the pain and sold at the bottom in March. What made this cycle unique is it wasn’t just the small retail investors who panicked, as is often the case. A lot of big money managers also bailed, and now find themselves praying for a pullback, says Joseph Besecker, chairman and CEO of Emerald Asset Management, which oversees about $1.7 billion.

Having “broken their own rules,” a lot of these institutional fund managers, notably pension funds, are now in a “quandary,” Besecker says. Their high levels of cash should “put a floor” under the major averages, he says, especially if the rally continues until quarter’s end, when performance anxiety will become acute among those underweight stocks.

I agree with Mr. Besecker. As markets keep grinding higher, pensions will start nibbling more into stocks, providing support under the major averages.

The problem is that once again pensions are late to the party, missing the rally. If a pullback does not materialize, they run the risk of underperforming the overall markets.

I’d reckon there is a whole lot of performance anxiety going on right now at most big money funds. Let me say it again, small is beautiful.

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  1. Brick

    What you seem to be suggesting is that pension funds are not agile enough and miss opportunities. If pension funds do go all in now then the current rally could well be sustainable for a good period. The problem is then that equities become completely out of line with fundamentals and at some point another crash will happen. Hedge funds know this and are to some extent being defensive having learnt their lesson. Pension funds seem to be increasingly either bypassing the hedge funds or going direct to banks and into ETF's. My worry would be that when and as pension funds go into the rally they are not going to be properly hedged and the losses will be greater this time round. Risk is shifting from hedge funds to pension funds and banks.

  2. Hugh

    Isn't this rather typical of a sucker's rally. The fundamentals stink, but the market goes up enticing (Hey, come on in the water's fine!) some and pressuring others (Gee, you're underperforming. You must not know what you are doing.) These new entrants are very much like the greater fools in a bubble. Their money will extend the life of the rally overriding the reality of the fundamentals for a while. But then the new money will trail off. There will be a precipitating event and a fall. The smart money will quietly head for the exits. There will be assurances that this was just a hiccup and that markets have taken it into account. Big slow movers like pension funds will stick because they can't get out quickly enough anyway and so decide to ride out what they will tell themselves is a passing storm. Then there will be another event and possibly a third. But there will be a BNP Paribas or Lehman moment, and it will be over. Those who stuck around will lose their shirts, again.

    I asked Leo yesterday if he could see such a defining moment for the collapse of the pension funds. I think the end of this sucker's rally whether it is in 4 months or 16 will be that moment.

  3. Leo Kolivakis

    Hugh wrote: "I asked Leo yesterday if he could see such a defining moment for the collapse of the pension funds. I think the end of this sucker's rally whether it is in 4 months or 16 will be that moment."

    >>The collapse has already happened. it will take years for pension funds to recoup their 2008 losses.

    But the dips ARE BEING BOUGHT in stocks, which is bullish in the near term. Pension funds risk underperforming so they are beginning to deploy capital.

    All this to say, this sucker has got legs.



  4. Hugh

    Leo, I think we are talking at cross purposes. You could say that the housing bubble collapsed back in 2006 because mortgage writing companies were showing stress even then and some of them went belly up in January 2007. Then there was a Bear Stearns or two that had problems in June. But it wasn't until the BNP Paribas funds were frozen that we had a defining event that said the housing bubble in now truly over.

    So I understand that pension funds are having massive problems now, but I am still awaiting that defining event for them.

  5. selise

    sort of an aside, but the links may be of interest….

    nationally the housing bubble did bust the summer of 2006 (with regional variations). see for example:

    * house prices via case-shiller for peak in summer of 2006.

    * foreclosure rates via gao reports:

    October 16, 2007 – GAO-08-78R Default and Foreclosure Trends. see page 21 and page 23

    December 4, 2008 – update GAO-09-231T

    both subprime (and prime although from a lower base) foreclosures began increasing in q3 2006.

    * end of housing bubble was even reported the msm at that time. for example:

    August 25, 2006 – Fortune – Getting real about the real estate bubble


    the summer of 2007 strikes me the point at which the financial crisis seriously began, but i have not looked into the details of that so much.

    imo, this view is supported by the timing of the separate credit peaks and busts for household and private firm borrowing. see the second figure in brad setser's recent post: Borrowing by Households and firms as a percent of US GDP

  6. Leo Kolivakis

    Hugh wrote: "So I understand that pension funds are having massive problems now, but I am still awaiting that defining event for them."

    What do you mean by "defining event"? Private companies go bankrupt and the PBGC takes over their pensions, partially funding those liabilities.

    If public sector pensions do not have sufficient funds, taxes will be imposes, benefits cut and contribution rates increased.

    The only blow-ups that might occur in pensions is in their stock, private equity, real estate and hedge fund portfolios. I am also worried about portable alpha strategies using OTC swaps which exposes pensions to counterparty risk.

    If this occurs, it will add to deflationary headwinds. That is why monetary spigots are working hard to reflate assets and the economy.



  7. Hugh

    By defining event, as I said, I mean like the freezing of the 3 BNP Paribas funds on August 9, 2007for the housing bubble or the fall of Lehman on September 15, 2008 for the financial meltdown.

    Such a moment I would think would happen if one of the larger state pension programs blew up or if the PBGC went bust. It would mark the point where the public perception would change from the pensions have problems to the pensions are problems like the banks and the housing bubble.

  8. Aki_Izayoi

    The reason Clarium underperformed is because they did not put on reflation trades. Clarium takes a deflationary point of view, and (as far as I know) positioned their portfolio to profit from deflation.

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