Some Masters of the Universe are having their wings clipped. Hedge fund have continued to charge rich fees even as their results not only became more correlated with stocks but have undershot them. In other words, they’ve repeatedly failed to deliver on their raison e-etre: superior results, or failing that, useful diversification.
Investors, who’ve historically been dazzled by the promise of hedge fund alchemy, are finally realizing that what they have bought is dross and have finally decided enough is enough. In late 2014, CalPERS stunned the investor community by saying it was exiting hedge funds. Last month, the New York City pension system said it was terminating its $1.7 billion program. The Illinois State Board of Investments decided to cut its hedge fund commitments by $1 billion in 2016, while AIG said it will trim its $11 billion allocation by 50%. The New York Post reported that the $3.2 trillion industry could see as much as $500 billion in withdrawals this year.
These gloomy forecasts come on the heels of the marquee annual hedge fund conference, the SkyBridge Alternatives at the Bellagio in Vegas. But even a bad year does not look all that bad from Hedgistan. From Institutional Investor:
… industry titans rubbed shoulders with business legends like T. Boone Pickens, political heavyweights such as John Boehner and Hollywood celebrities including Will Smith and Ron Howard. But despite the A-list delegates and luxe environs — some 2,000 conference guests enjoyed lavish pool parties, VIP dinners, private concerts with the Killers and the Wailers, a pop-up salon and free spin classes — the mood this year was almost somber. And it’s easy to see why: After years of mediocre aggregate performance, followed by a terrible first quarter, hedge fund managers are enduring withering criticism from investors. And some of these investors are voting with their feet.
The Wall Street Journal reported that, horrors, the participants were pinching pennies:
One major investment bank told clients they would have to hail cabs to a nightclub venue because the bank would no longer cover limousine service of years past, a person familiar with the matter said.
Tips at the shoe-shining station a few feet from the main ballroom were down more than 50%, to $5 or under in most instances, from as much as $20 one year earlier, a shoe shine employee said.
But more serious was the fact that investors were telling off industry participants to their face. We’ve pointed out that sovereign wealth funds appear to be displacing private equity as the new dumbest dumb money; even they can see that hedge funds are failing to deliver. Roslyn Zhang, head of fixed income and absolute return strategies for China Investment Corporation, which according to Preqin data is the second biggest investor in hedge funds, said she was “sort of disappointed” by the results and later told the Journal that she was culling her list of approved investors and was weighing whether to slash her allocation. As Institutional Investor noted:
Zhang further ripped hedge funds for shorting the yuan, noting that numerous hedge funds have put on the trade regardless of whether it’s consistent with their overall strategy: “They really don’t know much about China, but they just spend two seconds and put on the trade. Should we pay 2 and 20 for treatment like this?,” Zhang said, referring to the industry’s traditional 2 percent management fee and 20 percent performance fee structure.
And this criticism is even more damning when you understand where she is coming from. As we’ve discussed in an earlier post, looking at investments from an absolute return strategy is unsound, since investment results can always be decomposed into beta (market returns) and alpha (manager outperformance). The justification for paying any kind of manager premium is if they deliver alpha. So an absolute return framework is unduly forgiving, and even the hedge fund managers failed to deliver. And some high profile players are acknowledging that fees need to come down. Again from the Journal:
But one prominent manager, James Chanos, said Thursday “fees are too high. I’m surprised they’ve stayed this high for this long.”
Since the crisis, hedge-fund managers have rejected direct comparisons with the broader market returns, saying they aim to reduce volatility and invest elsewhere than simply stocks and bonds. “But guess what happened when a flat market showed up?” Mr. Chanos added. “Everybody got killed. That’s the real problem.”
Chanos was not alone. From Institutional Investor:
“Money goes where it’s treated best,” said [Leon] Cooperman [of Omega Advisors]. “Fees are going down. Maybe the hedge fund structure is the wrong structure.” On the same panel, Kyle Bass, the founder of Dallas-based Hayman Capital Management who shot to fame for correctly calling the subprime mortgage market crash in 2007, said of fees: “There should be a correlation to the risk-free rate. They have to come down.”
While investors are finally recognizing that they have been paying for no performance, the reality is they knew this years ago that the fees were too high and failed to act until now. We called this pattern out in our first post in December 2006, Fools and Their Money (Hedge Fund Edition):
Hedge funds continue to attract boatloads of money, despite humdrum performance. And worse, people who should know better persist in investing in them for the wrong reasons.
In the New York Times a sophisticated institutional investor explains the logic:
This year ”is the third straight year that the global equity markets and long-only managers outperformed hedge funds,” said Christy Wood, senior investment officer for global equities at the California Public Employees’ Retirement System. ”If you threw all these in an index fund net of fees, you would have done better than if you put it in the hedge fund industry.”
So is Calpers pulling back? Not at all. Ms. Wood helps to oversee $4 billion in hedge fund investments and has another $3.5 billion to invest. She is satisfied that hedge funds have delivered exactly what Calpers wants from them: equitylike performance with bondlike risk.
”We are looking for a return stream that doesn’t behave like any others we have,” she said.
Superficially, this argument sounds unassailable (if one ignores the fact that hedge funds have not generated equity-like returns). Calpers likes hedge funds because they offer an attractive and distinctive risk/return profile. But there is no need to pay hedge fund fees (typically 2% annual management fees plus 20% of the upside) for that.
The rationale for hedge funds’ eyepopping fees is that investors are paying for “alpha,” that is, the excess return (meaning the return in excess of the “market” return). Investors are willing to pay for alpha because it is considered to reflect an investment manager’s skill, and managers who can regularly outperfrom the market are rare indeed.
But Ms. Wood is talking about something completely different. Targeting a particular risk/return tradeoff isn’t an alpha proposition at all. It is instead “synthetic beta,” (or “alternative beta”). And synthetic beta can be produced comparatively cheaply.
A 2005 survey (http://www.edhec-risk.com/edhec_publications/RISKArticle.2005-08-10.3923/view, free subscription required) found that 70% of the investors recognized the role of alternative beta in overall hedge fund results. But this knowledge hasn’t yet translated into a recognition that they are overpaying.
But some of the providers do, and are launching clones) to undercut hedge funds. Merrill Lynch introduced its Passive Factor Index earlier this year and claimsGoldman Sachs launched its “hedge fund replication tool,” Absolute Return Tracker Index (http://www.ft.com/cms/s/5b8331c0-82fc-11db-a38a-0000779e2340.html), earlier this month. Experts believe they offer the same risk profile at lower cost.
Now synthetic beta can be very valuable (http://www.allaboutalpha.com/blog/2006/11/16/an-alphabeta-framework/) to investors like Calpers, who are managing retirement funds (they have to worry about meeting specific long-term commitments). But for an institution as savvy as Calpers to be frittering away its assets on unnecessary fees says that hedge funds seem likely to continue to pull in more assets.
The only problem with the long-overdue pullback from hedge funds is that investors are still too eagerly seeking salvation in high-fee strategies that promise desperately needed high returns. But private equity, the biggest competitor for hedge fund dollars, has similarly failed since the financial crisis to deliver returns high enough to compensate for its risks. And that’s before you get to the fact that even the private equity kingpins themselves are admitting that current deals are overpriced and warning that future results will be lower. So based on the hedge fund precedent, will it take investors eight years to start to wake up and act on what their data is telling them?