The State of Hedge Funds: How We Got Here and Where We're Going

Rosy forecasts were in short supply at the first annual Wharton Hedge Fund Conference. The shock of last year's worst-ever performance still reverberates through the industry. Career plans of students at Wharton are the best indication we have seen to date of how bad things have become for hedgies: one Wharton professor reports that last year, two thirds of his students wanted to get a job in a hedge fund. This year, only one student admitted to hoping for a hedge fund career.

Ray Iwanowski of Goldman Sachs traces the origins of the hedge fund problems back to the summer of 2007, when some quant funds started to struggle as their trades turned out to have been too crowded. We would go back a few more months and take the market slump of February 27, 2007 as the beginning, when HSBC (HBC) wrote off much of its acquisition of Household.

Speakers and panelists list several causes that led us to where we are now:

1. Exuberance of expectations: investors were disappointed relative to inflated expectations for hedge fund returns. In reality, hedge funds have outperformed other asset classes, with hedge fund indices down 15-20%, depending on whom you ask, and the equity markets down closer to 40%. (Iwanowski)
2. The broken promise of absolute returns in any market environment. Investors should have considered the diversification benefits of hedge funds rather than return targets. Brian Altenburg of Bank of America makes this argument. Christopher Geczy of Wharton even went so far as to call the notion of absolute returns “laughable”.
3. Liquidity was oversold. Portable alpha was in fact portable beta. (Geczy)
4. Style drift. Many managers left their core strategies and started investing in strategies that they were not expert in, in particular private equity. (Altenburg)

We would question how much blame should be put on investors' expectations. The absolute return argument and inflated expectations were happily fed by the hedge fund industry as long as it brought in assets. Emphasizing now the diversification and low correlation benefits is a classic example of cherry picking. Had we seen a different outcome with strong performance in all asset classes that is fully correlation then we would be talking about absolute performance today and dismiss correlation as irrelevant.

Panelists had a somber outlook for hedge funds:

1. The hedge fund industry will return to the 1990s. Manager skill will matter again. Hedge funds that consist of two traders and a Bloomberg will disappear, observed Michael Douglass of Gerber/Taylor.
2. Fee compression will become widespread. Leveraged beta strategies will no longer be able to command a 2/20 fee structure just for giving investors access to leverage.
3. Capacity will become a focus of the industry. More due diligence will be conducted on liquidity of strategies and the ability of managers to exit. Capacity has already expanded somewhat due to the exit of many hedge funds, fund redemptions and also the cessation of proprietary trading activities by investment banks.
4. The only uplifting prediction was made by UBS's Joe Scoby. He sees more activist investors unlocking value by pushing for operational improvements in undervalued companies.

Finally, speakers gave a few useful investment tips:

1. Convertible arbitrage is beginning to recover, and the best performance will come from allocations to distressed debt funds, says Jewel Huijnen of J.P. Morgan.
2. Equity looks expensive relative to debt. The leveraged loan market is priced for a 27% default rate. Investors should be short equities and long high grade credit, says Scott Logie of Carson Capital. Ned Zachar of KLS Diversified Asset Management recommends staying in cash for now.
3. David Nelson of Altima One World Agro Fund recommends short term trading. He recommends Brazilian and Australian ag stocks but warned that the trade is for the short term only. His firm reduced exposure to that same trade only two weeks ago and is now putting it on again. David did not name the firms, but we are sure you can find them with some digging.
4. Marc Lasry of Avenue Capital listed his investments in Trump Casino (TRMP), US Air (LCC) EETCs and Tribune (TRBCQ.PK). Refer to our other post for details.

Comments

[Annualgain:]

I believe that 2/20 has to go away. I also think that fees for long-only strategies will be compressed.

Feb 22 01:09 PM

[HiSpeed:]

It seems to me that talent in America would make a much greater contribution to the country outside the career of simply running money (Hedge funds, et al).

One can still become a millionaire with good ideas, working smart, and saving/investing in competently businesses (although I would be remiss if I didn't admit that a little luck occasionally helps, too).

That said, in the "Greed & Fear" cycle, we are clearly in the Fear part.....

Feb 22 03:11 PM

[Donald Johnson:]

Will hedge funds put more emphasis on market timing, hedging and being flexible in volatile markets? That seems to be the implication of more short-term trading.

Does this mean hedge funds will de-emphasize research, deal making and highly leveraged deals?

Will hedge funds try to create debt-free deals by buying highly-leveraged companies, say the NYT, and turning them into cash cows, if not growth companies? Will pension funds, et al, invest in such strategies?

Feb 22 08:10 PM

[James H. Wang:]

In many ways, this is a good thing. The scenario brought up in the article:

"Hedge funds that consist of two traders and a Bloomberg..."

... is part of why we have the problems we do today.

Hedge funds are successful when they can use their strategies without either hugely moving the market themselves (because they're too big) and when they can gain the full or near full benefit of trading on them (the market must not be too crowded).

When this disappeared, it's where you ended up with massive leverage to make up for the minuscule returns in a then-crowded market. It's where you had managers "style-drifting" in large part not because they got "curious" but because their area of expertise no longer had stellar returns.

As a result, the system took on more and more risk, seeking higher and higher returns in an ever more crowded market. And basically became a time bomb that's now blown up.

"The hedge fund industry will return to the 1990s. Manager skill will matter again."

Finally.

Feb 22 08:40 PM

[ROLEXDAYTONA:]

Hedge funds do what they are best at, you earn your money, they gamble it.
I would require hedge funds to be regulated same as mutual funds, at least investors would be able to decide , not just buy cat in the bag.

Feb 23 05:50 AM

[Old Trader:]

From what I've read, the earliest hedge funds DID successfully pursue an "absolute return strategy". At that time, there WAS no other strategy. It was only as time went on, and different styles/strategies evolved, that it became apparent that varying styles didn't suit all market conditions.

Feb 23 10:26 PM