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

by: Thomas Kirchner

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 (OTC:TRBCQ). Refer to our other post for details.