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The End of Hedge Funds? |
rffrydr
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 Posted: Sun Mar 23, 2008 4:30 am Post subject: The End of Hedge Funds? |
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Martin Wolf runs some numbers looking for what's real. --Maybe better not to look too deeply into the well....
| Quote: | Hardly a week goes by without the implosion of a hedge fund. Last week it was Carlyle Capital, with an astonishing $31 of debt for each dollar of equity. But we should not be surprised. These collapses are inherent in the hedge-fund model. It is even conceivable that this model will join securitised subprime mortgages on the scrap heap.
Getting away with producing adulterated milk is hard; getting away with an investment strategy that adds no value is not. That was the point made by John Kay, in a superb column last week (this page, March 11). With the “right” fee structure mediocre investment managers may become rich as they ensure that their investors cease to remain so.
Two distinguished academics, Dean Foster at the Wharton School of the University of Pennsylvania and Peyton Young of Oxford university and the Brookings Institution, explain the point beautifully*. They start by asking us to consider a rare event – that the stock market will fall by 20 per cent over the next 12 months, for example. They assume, too, that the options market prices this risk correctly, say at one in 10. An option costs $0.1 and pays out $1.
Now imagine that we set up a hedge fund with $100m from investors on the normal terms of 2 per cent management fees and 20 per cent of the return above a benchmark. We put our $100m in Treasury bills yielding 4 per cent. We also sell 100m covered options on the event, which nets us $10m. We put this $10m, too, in Treasury bills, which allows us to sell another 10m options. This nets another $1m. Then we go on holiday.
There is a 90 per cent chance that this bet will pay off in the first year. The fund then grosses $11m on the sale of the options, plus 4 per cent interest on the $110m in Treasury bills, for a handsome 15.4 per cent return. Our investors are delighted. Assume our benchmark was 4 per cent. We then earn $2m in management fees, plus 20 per cent of $11.4m, which amounts to over $4m gross. Whatever subsequently happens, we need never give this money back.
The chances are nearly 60 per cent that the bad event will not occur over five years. Since the fund is compounding at a rate of 11.4 per cent a year after fees, we will make well over $20m even if no new money is attracted into this apparently stellar enterprise. In the long run, however, the bad event is highly likely to occur. Since we have made huge profits, our investors have paid us handsomely for the near certainty of losing them money.
The immediate response may be that so naked a scam is inconceivable. Well, imagine a fund that leverages investors’ money by borrowing massively in short-term money markets in order to purchase higher-yielding paper. Assume, again, that the premium gives a correct estimate of the risk. With sufficient leverage, this fund, too, is likely to make profits for years. But it is also very likely to be wiped out, at some point. Does this strategy sound familiar? It certainly should by now.
We can identify two huge problems to be solved. First, many investment strategies have the characteristics of a “Taleb distribution”, after Nicholas Taleb, author of Fooled by Randomness. At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.
Second, the systems of reward fail to align the interests of managers with those of investors. As a result, the former have an incentive to exploit such distributions for their own benefit.
Professors Foster and Young argue that it is extremely hard to resolve these difficulties. It is particularly difficult to know whether a manager is skilful rather than lucky. In their telling example, the chances are more than 10 per cent that the fund will run for 20 years without being exposed. In other words, even after 20 years the outside investor cannot be confident that the results were not being generated by luck or a scam.
It is also tricky to align the interests of managers with those of investors. Obvious possibilities include rewarding managers on the basis of final returns, forcing them to hold a sizeable equity stake or levying penalties for underperformance.
None of these solutions solves the problem of distinguishing luck from skill. The first also encourages managers to take sizeable risks when they are close to the return at which payouts begin. Managers can evade the effects of the second alternative by taking positions in derivatives, which may be hard to police. Finally, even under the apparently attractive final alternative it appears that any clawback contract harsh enough to keep unskilled managers away will also discourage skilled ones.
It is obviously best not to pay the manager, as a manager, at all, but rather to invest alongside him, as at Berkshire Hathaway, Warren Buffett’s investment company. But we still have the challenge of knowing whether the manager is any good. We know this today of Mr Buffett. Fifty years ago, that would have been very hard to know.
What we have then is a huge “lemons” problem: in this business it is really hard to distinguish talented managers from untalented ones. For this reason, the business is bound to attract the unscrupulous and unskilled, just as such people are attracted to dealing in used cars (which was the original example of a market in lemons). The lemons theorem states that such markets are likely to disappear. The same may happen to today’s hedge-fund industry.
Now consider the financial sector as a whole: it is, again, hard either to distinguish skill from luck or to align the interests of management, staff, shareholders and the public. It is in the interests of insiders to game the system by exploiting the returns from higher probability events. This means that businesses will suddenly blow up when the low probability disaster occurs, as happened spectacularly at Northern Rock and Bear Stearns.
Moreover, if these unfavourable events – stock market crashes, mortgage failures, liquidity freezes – come in stampeding herds (because so many managers copy one another), they will say: “Nobody could have expected this, but, now that it has happened to all of us the government must come to the rescue.”
The more one believes this is how an unregulated financial system operates, the more worried one has to become. Rescue from this crisis may be on the way, but what about next time and the time after next?
*Hedge Fund Wizards, and The Hedge Fund Game, January 2008 |
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The End of Hedge Funds? Replies |
rffrydr
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| Posted: Wed Dec 09, 2009 10:47 am Post subject: |
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Well...maybe just exaggerated:
| Quote: | | .....More than 1,000 participants attended the group's annual Collateralized Debt Obligation conference before the credit crisis hit two years ago. The group has since canceled its annual CDO and CLO conference and focused on alternative investments. |
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HenryTo
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| Posted: Wed Dec 09, 2009 12:19 am Post subject: |
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Again, the death of hedge funds has been greatly exaggerated:
| Quote: | Pension funds seek alternatives in hunt for yield
* Allocations to hedge funds, PE, emerging mkts growing
* Calpers spearheaded move into alternative investments
* Numbers down at Alternative Investment conference (Adds details on fund assumptions in fifth graph)
By Walden Siew
DANA POINT, Calif., Dec 7 (Reuters) - Large public pension funds in New York, California and Ohio are looking increasingly to alternative investments in hedge funds, private equity and emerging markets in a global hunt for yield, senior managers and trustees said.
The global credit crisis has put a squeeze on money managers who must try to boost returns by looking at nontraditional investments that are a growing allocation in some portfolios, in some cases making up more than a quarter or more of fund holdings.
"We're going to act prudently and be hesitant to rapidly increase our assets to alternatives, but we're pretty much of the opinion that that's where you have to be," said Joe Alejandro, treasurer of the New York City Patrolmen Benevolent Association, during an Alternative Investment conference on Sunday.
The U.S. recession has hit states including Ohio hard but alternative investments in areas such as real estate and casinos may present opportunities, added J.P. Allen, investment committee chairman of the Ohio State Highway Patrol retirement system.
Allen said many funds have assumptions of 7 percent to 8 percent return and his fund is expected to beat those assumptions this year.
"When things are bleak, now is the time to buy, when there's blood on the street," said Allen, who said his fund benefited from real estate and timber investments in 2008. It has since pared back on some of those investments, he said.
The California Public Employees' Retirement System, or Calpers, the world's biggest public pension fund with over $200 billion in assets, spearheaded the move by public pensions into alternative investments.
Calpers invested in private equity, high-end vineyards and hedge funds in the late 1990s and early 2000s. But not all of those investments fared well. A $500 million equity investment in Manhattan's Peter Cooper Village and Stuyvesant Town, a sprawling apartment complex, has drawn criticism.
The venture's partners are now close to defaulting on $3 billion of debt and the equity has been wiped out. For more see [ID:nN2250368].
New York's Alejandro said his current allocation is about 70 percent equity and about 25 percent in bonds and alternative investments, which he would like to increase to between 30 and 35 percent. He said he has made a push for greater investments in hedge funds of funds, private equity and real estate to the new comptroller, who starts in January.
About 350 hedge fund managers, trustees and treasurers attended an Alternative Investment conference that began on Sunday held at the Ritz-Carlton in Dana Point, California, sponsored by the Opal Financial Group.
That's down from about 400 participants last year, organizers said, and a sign of how the market for complex investments has shrunk.
More than 1,000 participants attended the group's annual Collateralized Debt Obligation conference before the credit crisis hit two years ago. The group has since canceled its annual CDO and CLO conference and focused on alternative investments.
Keith Rodenhuis, trustee of the $7 billion Orange County Retirement System, said he holds about a 10 percent allocation in real estate, 7 percent in "absolute return," which includes hedge fund positions, and 5 percent in private equity.
Rodenhuis said his fund boosted "real return assets" to 13 percent from 10 percent, involving investments in commodities and timber. The fund cut back investments in international fixed income to boost those real return assets, he said.
The fund is looking to allocate from zero to 5 percent in opportunistic investments such as distressed mortgage funds.
"We're hoping that slowly climbs back," said Rodenhuis, who also sees opportunities in energy, green technology and local medical technology, as "Orange County is a hotbed for medical technology," he said.
Ohio's Allen said many retirees took hits in the wake of the global credit crisis, but alternative investments in timber and real estate in 2008 helped offset losses, although he has since sold some of those assets to book profits. |
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nodoodahs
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| Posted: Sun Nov 22, 2009 3:08 pm Post subject: |
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| rffrydr wrote: |
| Quote: | | ....Politicians’ remarkable investment acumen is equally bothersome. Members of Congress outperformed the market by an astounding 12 per cent a year from 1994 to 1998, according to a study by economist Alan Ziobrowski. |
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Well, if I had a hand in writing legislation that influenced the profits of major corporations, or in earmarking pork for different projects in different sectors, I could probably make better "investment" decisions than I might make otherwise ...
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rffrydr
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| Posted: Sun Nov 22, 2009 12:59 pm Post subject: |
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Seeking Alpha? I'm from the government. I here to help you:
| Quote: | | ....Politicians’ remarkable investment acumen is equally bothersome. Members of Congress outperformed the market by an astounding 12 per cent a year from 1994 to 1998, according to a study by economist Alan Ziobrowski. |
http://www.ft.com/cms/s/0/221cb406-d605-11de-b80f-00144feabdc0.html
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nodoodahs
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nodoodahs
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| Posted: Tue Nov 17, 2009 9:44 am Post subject: |
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I agree with you 100% on it not being worth what used to be paid for it.
The more I research, the more that I don’t think ANY managed investment is worth more than a percent or two off the AUM. In the way that the terms are used today (vernacular), I don’t think that “alpha” exists – only “strategy beta” along with other sources of “beta” (liquidity beta, kurtosis beta, etc.). Note that the vernacular is divorced from the statistical meaning of the terms.
However, what it’s worth depends on who’s paying. It’s not worth it to me (or you), but it reminds me about an old joke concerning expensive services in an old profession; somebody is probably willing to pay somebody 2 and 20 for a product they could get in a fund or ETF today for 1.5 and 0.
I also agree that there’s a time in the market for anything, and that the relative value strategy is probably “safe” for a few years, having blown up recently.
That said, personally I don’t like the higher-order moments and would avoid these things like the plague, especially in the hands of a manager whose incentives aren’t the same as mine (running a fund is owning an option).
Frankly, there’s enough high kurtosis and negative skewness in equity investing. I don’t need more!!!!
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HenryTo
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| Posted: Mon Nov 16, 2009 9:35 pm Post subject: |
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| There is a time for everything - and I would not mind putting funds into a relative value fund in this environment once I've evaluated the management team, track record, risk management systems, etc. That said, these kind of strategies are not worth paying close to 2 and 20 anymore. If it's a black box in a relative value world, I would pay 1.5% of assets at the most with no incentive fees. |
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nodoodahs
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| Posted: Mon Nov 16, 2009 8:31 pm Post subject: |
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| nodoodahs wrote: |
Edit to add: the optionality implied in running the HF structure pretty much insures that low-standard deviation and high-kurtosis, strongly negatively skewed strategies will be the PREFERRED strategies. 99 times out of 100 they produce smooth non-correlated returns and the FOFs love them. The one time it blows up, well, close the fund and start another one. |
Speaking of which ...
http://www.ft.com/cms/s/0/331bae80-be93-11de-b4ab-00144feab49a.html?nclick_check=1
| Quote: | Meriwether setting up new hedge fund
By Sam Jones in New York
Published: October 22 2009 00:03 | Last updated: October 22 2009 00:03
John Meriwether, the hedge fund manager and arbitrageur behind Long-Term Capital Management, is in the process of setting up a new hedge fund – his third.
The move comes barely three months after Mr Meriwether decided to close his second fund manager, JWM Partners, which was wound down after clients saw the value of their investments fall by more than 44 per cent over the course of the financial crisis.
JWM Partners was set up soon after the collapse in 1998 of Mr Meriwether’s first – and most infamous – fund, LTCM, which triggered a wave of panic across the world’s markets and prompted the US Federal Reserve to take the then-unprecedented step of orchestrating a multi-billion dollar bail-out.
Mr Meriwether’s new venture, named JM Advisors Management, will, like both of his previous hedge fund management companies, be based in Greenwich, Connecticut.
People with knowledge of the situation say the fund has not yet started accepting outside investments, however. According to HFMWeek, an industry publication, the fund will open to investors in 2010.
The fund is expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s.
The strategy, described by the Nobel Prize-winning economist Myron Scholes as being akin to a giant vacuum cleaner “sucking up nickels from all over the world”, can be highly successful in periods following market dislocations.
Relative value trades profit by betting on unusual pricing relationships between securities, anticipating a return to an historically modelled “normal” state between them.
Traders say the strategy has the potential to deliver huge returns in the current market, with many banks’ proprietary trading desks having scaled back their operations and far fewer hedge funds in existence.
Their absence is leading to “inefficiencies” according to many market participants.
The swap spread on 30-year Treasury bonds – the difference between the cost of a 30-year bond and the cost of an interest-rate hedge against it – is still negative.
However, as Mr Meriwether’s experience shows, relative value strategies are not without their pitfalls.
The strategy typically has a high “blow-up” risk because of the large amounts of leverage it uses to profit from often tiny pricing anomalies.
At its peak, LTCM borrowed 25 times more than it had in investor’s capital in order to ratchet-up its returns.
JWM boasted a more conservative 10 times leverage ratio.
The hedge fund industry average is estimated at between two and three times.
Copyright The Financial Times Limited 2009. You may share using our article tools. Please don't cut articles from FT.com and redistribute by email or post to the web. |
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nodoodahs
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| Posted: Mon Nov 16, 2009 10:06 am Post subject: |
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In mean-variance analysis, we speak of a “risk premium” whereby the larger volatility is compensated for by a larger mean return.
What Henry is fond of pointing out is that HF returns can be higher than simulated using “beta factors” because many of them make their money by providing liquidity.
Liquidity-providing strategies are very similar to option-selling strategies in their statistical properties. Compared to equity indexing, the standard deviation of these strategies is low compared to the mean, but the skewness is very very negative, and the excess kurtosis is extremely high.
Some points to think about:
(1) is “liquidity” simply another beta-factor?
(2) should the “risk premium” category include “kurtosis premium” in addition to “volatility premium?”
(3) are our typical evaluations of risk-adjusted return all wrong, with HF returns being significantly worse on a risk-adjusted basis than their Sharpe ratios would have us believe?
Edit to add: the optionality implied in running the HF structure pretty much insures that low-standard deviation and high-kurtosis, strongly negatively skewed strategies will be the PREFERRED strategies. 99 times out of 100 they produce smooth non-correlated returns and the FOFs love them. The one time it blows up, well, close the fund and start another one.
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rffrydr
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| Posted: Tue Nov 10, 2009 7:21 am Post subject: |
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Maybe never a greater desire to go "both ways." They've proven while not so good at "hedging" very adept at selling. This seems incredible. And now they'll be regulated. We'll see how they fare against Private Equity in this brave new world.
And, yes that will be a emerging theme, "risk assets." We've already seen it with the average investor. This market is shedding the "Greed born of Fear" decade beginning to take risks again.
Venture capital however will probably fare less well than expected here however. Nothing is obvious. 
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HenryTo
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HenryTo
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HenryTo
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| Posted: Mon Aug 03, 2009 10:03 pm Post subject: |
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If a fund is willing to reduce their fee structure from "2 and 20" or higher, it is not worth investing in. How could they hire the talent? Better go with a HF replication strategy or a mutual fund that adopts an absolute return strategy.
An industry with $1.5 trillion in AUM cannot all charge "2 and 20." And given the law of the financial markets, only a slight minority should be able to charge that over a market cycle. |
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rffrydr
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| Posted: Mon Aug 03, 2009 9:26 pm Post subject: |
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2 and 20 out the window with CalPers and other big pension money coming in after route and bringing reductions with them. At least one still getting 50! And, my kinda of revamp, one only collecting after principle's first doubling.
http://tinyurl.com/m3o6z4
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rffrydr
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