Hedge Funds: Back to Basics

With the news getting worse and worse for the hedgies (e.g. Fortress, Thomas Lee, D. E. Shaw), it’s time for a rethink on hedge funds.

For hedge fund investors: You probably went into them believing that they were uncorrelated absolute return vehicles, or pure alpha. Isn’t it funny how correlations all go to 1 in times of crisis? Maybe it’s time to return to your roots and understand the role of alternative investments in your portfolio.

For hedge fund managers: The really successful ones began fifteen or twenty years ago as small, nimble, guerilla investors. Somewhere along the way the guerillas came down from the hills, got big and became the government. Maybe it’s time to return to the hills again.

Investors thought hedge funds were the panacea when the hedgies showed positive returns in the post-Tech bubble crash. Ultimi Barbarorum writes:

Last time we had a bear market, hedge fund fortunes were made. Andor Capital, William von Meuffling, Crispin Odey, Chris Hohn, even Jim Cramer when he was trading, all made out like bandits producing 20-50% returns on the short side in 2000-2002, many after having doubled their money by being long in 1999. This made them look, if not like gods, then at least jolly clever and deserving of an investment. Hedge fund managers were smart, nimble, slightly less eminent versions of George Soros, milking the patsies in the long only community for vast profits. Hugh Hendry would come on CNBC Europe and wow us with his acumen and hibboleth-smashing iconoclasm; everyone was wrong! Only he could see the truth, it seemed. Chris Hohn would rarely have a down month, let alone a quarter, and at the end of the year give half his profits away to charity, that was how much he thought of the armani-wearing, white-toothed, fake-tanned, long only growth managers whose pockets he was picking. The successful hedgies ran maybe $1bn, most ran less, and Andor, the biggest long-short manager, ran about $6-7bn.

Ultimi Barbarorum made the further point that hedge funds got too big and became the market. Size for a hedge fund is not necessarily the answer.

The guerilla returns to the hills?

Not all is lost. Hedge funds do have a role in a portfolio. Don’t forget what they are and what they aren’t:

• Small
• Opportunistic guerilla investors who are able to change their stripes
• Not an asset class

Once the industry started to get institutionalized (not small) with hedge fund indices of various flavors, consultants and HFoFs started pigeonholing everybody (once you were a convertible arb fund you had to stay a convertible arb fund, even if the opportunities went away), the guerilla got pinned down (not opportunistic) and that was the beginning of the end.

What a lot of people don’t understand is that hedge funds were never an asset class, unlike other alternatives like real estate. One of the key characteristics of an asset class is the ability for an investor to construct a low-cost passive index portfolio, with known component holdings and known weights. Hedge funds were originally marketed as pure alpha, or portable alpha vehicles with low correlations to the major asset classes. These are characteristics that you can’t pin down with an index.

Hedge funds have been here before

This is not the end for the hedge fund industry.

AllAboutAlpha reports that hedge funds went through a similar crisis in the late 1960s. The same problems that exist today existed then. Horrible returns, fund blowups – these aren’t new inventions. Hedge fund investors found out what they had wasn’t a contract with a hedge fund manager, but a call option on a management contract. When the incentive fees dried up, the manager packed up and went away.

After the blowup, the hedge fund industry went through a period of contraction and reinvented itself. No doubt we are in for some version of that same story going forward.

Comments

[happysoul77777:]

Well said!

In my opinions, hedge funds have never been an asset class, but a style. When a hedge fund manager made big money in this crisis, but a next manager lost huge, then it indicated the skill or the style but an asset class.

2008 Dec 06 01:41 PM

[Alex Trias:]

The issue may go beyond hedge funds, per se. I'm going with the theory that statistical arbitrage is what's getting pinned down at the moment. Statistical arbitrage works only when trades don't get too crowded. Once the trade gets crowded, the only way to garner returns is through leverage. Take away the leverage, and we all know what happens.

Why is statistical arbitrage really going into the soup? The simple reason is that it adds nothing to the market or to the economy. In the good old days, investors would give some money to a company in exchange for stock, and the company woudl take that money, build factories, hire people, and produce and sell products. It makes sense that the investor would get paid for helping the economy get things done. What does a statistical arb trade do for anyone? Add liquidity to the markets? So what! Add price efficiency? The opposite! Statistical arbitrage has nothing to do with whether a company is valuable, or makes good products, or anything - so trades based on statistical arbitrage really obfuscate information efficiency. So it makes sense the market would deliver negative returns to these folks over time - what's odd is how long it took this time around.

So, here's a new model hedge funds might want to explore: invest in companies with good earnings, get in at a good price, and maybe hedge some of the risk with options if you can get a decent price on those.

No, this will not generate 40% returns a year. Not even close. It's old school value investing with a little less risk. But if the pitch is "invest with less market risk", here's a reasonable way to go.

2008 Dec 06 02:04 PM

[Acronym:]

I agree with you 100% happysoul77777. Not that hedgies are bad or anything it is just that right now we must all pitch in and do what's best for the team that means that all the franchise players need to be at the foul line with the role players and the off the benchers practicing their free throws. Time to get back to the basics, we can look at it as setting a proper example for the rookies. Excuse my sport analogies.

2008 Dec 06 06:31 PM

[notsosmart:]

the wealthy chasing more wealth.let them all collapse.what good are they?

2008 Dec 06 08:29 PM

[steveballmer:]

I'm down $12,587,092,342.76!

I should be complaining huh?

2008 Dec 07 01:02 PM

[blinkmnt:]

When they are good we praise them... !!!! WOW the ones that survive the next 2 years of market action again will get our praise. come on ppl, a hedge fund is for risk averse ppl, stop the back to basic for hedge funds talk.

Let the best one do their job and then when they claim success we all will come back to this forums and again praise them which the crowd.. !!!

2008 Dec 07 04:10 PM

[blinkmnt:]

When they are good we praise them... !!!! WOW the ones that survive the next 2 years of market action again will get our praise. come on ppl, a hedge fund is for risk averse ppl, stop the back to basic for hedge funds talk.

Let the best one do their job and then when they claim success we all will come back to this forums and again praise them which the crowd.. !!!

2008 Dec 07 04:10 PM

[E Nuff Sed:]

Looks like a lot of these hedge funds did not hedge their positions.
The role of hedge funds is to separate the alpha from the beta.

2008 Dec 07 07:38 PM