A Shakeout in the Hedge Fund Industry?
(September 12, 2010)
Dear Subscribers and Readers,
Let us begin our commentary with a review of our 12 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172;
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863;
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points;
10th signal entered: 50% long position SOLD on March 29, 2010 at 10,888, giving us a loss of 1,284 points.
11th signal entered: 50% long position SOLD on April 27, 2010 at 11,044, giving us a loss of 819 points;
12th signal entered: 50% long position initiated on May 21, 2010 at 10,145; giving us a gain of 317.77 points as of Friday at the close; the DJIA Timing system is currently in a 50% long position.
By many accounts, the global hedge fund industry manages about US$1.5 trillion of assets. Assuming the average hedge fund utilizes 3x leverage (which is excessive for long-short equity hedge funds; but not so for most fixed income or global macro strategies), and assuming the average hedge fund has an annual turnover of 4x its capital, there is approximately US$18 trillion of “efficiency capital” actively looking to produce some kind of “alpha” each year—not to mention the trillions that are invested in actively-managed equity and fixed income mutual funds (PIMCO, BlackRock, Capital, Fidelity, etc.). US$18 trillion is 126% of U.S. GDP; or 110% of the Euro Zone's GDP. Seriously—in today's world of infinitely smarter central banks (does anyone seriously think the Bank of England or the British government would make the same mistake that it did in 1992 when it desperately tried to stay in the European Exchange Rate Mechanism?)—how much “alpha” is there to be generated, given the vast size of the hedge fund industry?
Any hedge fund investor would understand that the most popular hedge fund performance indices contain all kinds of biases—including backfill bias, survivorship bias, and the fact that many horrible funds have never reported their performance numbers. Many indices are also not investable—those indices/funds that are investable typically have substantially lower historical performance. More importantly, the hedge fund industry generated most of its “alpha” in the 1980s and 1990s—when many of these strategies (such as the carry trade, swap-spread arbitrage, etc.) were not well known and difficult to mechanized. Furthermore, a recent Financial Times article reveals the lopsidedness of hedge fund returns—with the all-time top 100 hedge fund managers making 75% of all returns since they were founded. Not surprisingly, the remaining 7,000 hedge funds have mostly disappointed. With a staggering US$18 trillion of efficiency capital in the hedge fund industry, combined with trillions more in actively managed mutual funds and much more sophisticated central banks and governments, there is just not a whole lot of alpha opportunities going forward. In such a scenario, a “2 and 20” fee structure suddenly seems to be more of a rip-off, especially if one is investing through a fund-of funds overlay.
To make things worse (at least for hedge funds), investment consultants and advisors have grown much more sophisticated in dissecting returns between “beta” and “true alpha.”. I am going through the Chartered Alternative Investment Analyst (CAIA) Level II materials (my CAIA level II exam is on the 22nd), and I am amazed at how smart performance analysts have become in terms of recognizing “plain vanilla” hedge fund strategies versus those truly innovative strategies. The performance analysts claim that only the gains generated from the latter could be regarded as true alpha. For example, the CAIA materials now clearly recognize that currency managers have historically utilized four main strategies as sources for their returns: 1) a carry trade strategy, 2) trend-following, 3) value factor (such as buying “undervalued currencies” as measured by Purchasing Power Parity, and 4) volatility factor through options or other derivatives whose prices are sensitive to currency volatility. Historically, investment advisors measured excess returns (i.e. alpha) by comparing the returns of currency funds with the base country's risk-free rate. That is no longer the case, as so-called excess returns are now broken into four beta components mentioned above through a multi-factor regression model. In other words, a trend-following strategy in the spirit of Richard Dennis' “The Turtles” or a classic Yen carry trade strategy would yield little to no alpha under today's performance measurement framework. Think of it this way: If a strategy could be totally mechanized by a high-quality computer workstation, investors should not pay up for the strategy, as it requires no manager skills other than the initial programming of the strategy itself (assuming it is nothing groundbreaking). This is the way that managers should be paid. Again, I ask the question: How could one justify a “2 and 20” fee structure for the US$1.5 trillion hedge fund industry? The answer: You can't.
I expect some kind of shakeout in the hedge fund industry in the next 12 to 18 months. Whether it is in the fixed income, long-short equity, global macro, convertible arbitrage, or distressed securities strategies, I do not know (my guess is fixed income and long-short equity). But it will come, and when it comes, “weird things” will occur in the financial markets (i.e. things which occur relatively frequently in the financial markets but which the professors reject in their textbooks—including “liquidity events” such as the classic Northern Pacific Corner of 1901, the Panic of 1907, the Crash of 1929, a 29.7% crash in large company stocks (per Ibbotson) in September 1931 on the heels of a wave of bank failures when the Fed was forced to raise rates to stem the outflows of gold to Great Britain, the October 19, 1987 crash, etc.). There will be significant buying and selling opportunities, but until that happens, subscribers should tread carefully when it comes to utilizing leverage.
As for the U.S. stock market, the technical conditions have continued to improve. For example, the Dow Industrials is sitting right at its (upward trending) 200-day moving average, while the Dow Transports is decisively above its 200-day moving average. The NYSE Common Stock Only (CSO) Advance/Decline line has matched the action in the U.S. stock market, while the NYSE CSO McClellan Summation Index has also been generally trending up since early July. Despite this strong technical condition, our liquidity indicators are still relatively weak—and thus not supportive of a sustainable rally yet, especially given the uncertainty surrounding the European sovereign debt crisis and leading into the September 21st FOMC meeting. For example, the amount of “investable cash on the sidelines” versus the S&P 500's market cap – has declined dramatically since its February 2009 peak, as shown in the following chart:
Note that we have updated the numbers using the most updated numbers as of last Friday. As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has consistently hit new lows since February 2009. This somewhat changed since the end of April – with the ratio rising by 2.43% during that time (from 32.29% to 34.72%). However, this ratio has come down too far, too fast, and is still low relative to its readings over the last two years. The reading of this liquidity indicator is thus not conducive to a sustainable rally, but of course, whether the market will embark on a sustainable rally will depend on the Fed's actions on September 21st.
Let us now discuss the most recent action in the U.S. stock market using the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from July 2007 to the present:
For the week ending September 10, 2010, the Dow Industrials rose 14.84 points, while the Dow Transports rose 13.78 points. After consolidating last week, the Dow Industrials is holding at its 200 DMA, while the Dow Transports is still decisively above its 200 DMA. While the technical condition remains solid, subscribers should be concerned about “whipsaw risk,” as the market has been really volatile and “indecisive” over the last couple of months. Combined with the lack of bullish signals from our global liquidity indicators and the lingering default risks for Greek sovereign debt, the market action should thus remain tough going into the September 21st FOMC meeting, it not into October. We will remain 50% long in our DJIA Timing System, and should eventually shift to a 100% long position depending on the market action and fundamentals in the coming weeks.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators decreased from a reading of -5.6% to -6.8% for the week ending September 10, 2010. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
The four-week MA has declined three weeks in a row, and is now at its most oversold level since late July. However, this sentiment indicator is still not that oversold compared to the readings over the last couple of years. We will thus wait for a more oversold reading before shifting to a 100% long position in our DJIA Timing System, and would do so only once our liquidity indicators improve. In the meantime, the action of the U.S. stock market will likely remain tough into October.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
The 20 DMA decreased slightly from 101.3 to 101.0 last week, while the 50 DMA reversed back to the upside from 103.9 to 104.8. The 20 DMA also remains below the 50 DMA, although we would not read too much into this as both the 20 DMA and the 50 DMA are very oversold. However, since our liquidity indicators are not supportive of the bullish case, the market will likely be mired in a consolidation period into October. We will thus only shift to a 100% long position once liquidity conditions improve or if the stock market becomes more oversold.
Conclusion: I expect another shakeout in the hedge fund industry sometime in the next couple of years as investors realize how little alpha opportunities a US$1.5 trillion industry could produce, given the excessive fee structures. I expect this shakeout to occur in the long-short equity or the fixed income space (as these two strategies are among the most crowded and most “efficient” among all the different hedge fund strategies). A shakeout could come in all forms or sizes. It could be a general market crash, or a relentless bull market where investors opt for equity index funds again in lieu of hedge fund or actively managed funds. It could also result in a scenario similar to that of the August 2007 “quant crisis,” where the most heavily shorted stocks by quant funds rose while the most heavily bought stocks declined. Being able to spot contrarian opportunities would never be as important.
As for the stock market, we remain on a wait-and-see approach in terms of our DJIA Timing System given the challenging liquidity conditions. Until our global liquidity indicators improve or until the U.S. stock market becomes more oversold, we will stay with our 50% long position in our DJIA Timing System. Subscribers please stay tuned.
Henry To, CFA