Lack of Regulation = Explosive Growth
On growth: Many are saying it’s good, many more are worried. Growth in both assets under management (before and after the use leverage) as well as the number of actual funds to choose from are indeed incredible. Some of the growth, I would admit, is in questionable areas.
For example, the concept of F3, or “funds-of-funds-of-funds.” When you think about the logic, the “fund of funds” is the relatively simplistic way to build the hedge fund component for a diversified portfolio. I see it as synonymous to the mutual fund instead of directly picking stocks. We have seen globally the manufacturing of multimanager mutual fund packages where a distribution oriented financial services firm organizes some form of asset allocation package that leads to a selection of mutual funds to match the investor type.
The term “wrap program” is appropriate, however, the aggregate cost structure I think is prohibitive in so many ways. On the hedge fund side, having someone pick a group of “funds of funds” as is the case of an F3 would be counterpart to the wrap program. If the costs are a drag on performance in a wrap program, how much of a drag are they on an F3. It brings a fresh perspective to the term “negative alpha”.
I really wonder when the regulatory environment will be such so that the industry moves beyond the current fog. Registration or not? Based on a certain minimum investment amount or other constraints to form some agreed upon accredited investor rules? Until questions related to regulations are more concrete, we will continue to have strong growth from startup firms as the barriers to entry remain quite low. As an industry participant who has always been involved with very small and entrepreneurial investment management firms, I’m not asking for high barriers to entry. I just don’t like driving in fog.
ETFs Also On the Rise
Speaking of fog and low barriers to entry, it is becoming very clear to me that has never been more difficult for investors to build a hedge fund portfolio. Certainly, with nearly all asset classes going straight up for the past four years except for the occasional bump on the road (this summer being the main one), it has been tough for the highly active manager. Perhaps this is why we are seeing the synchronized growth at the other end of the investment spectrum.
Like hedge funds, exchange traded funds [ETFs] have grown both in total asset size as well as in the number of total instruments. For the forward-thinking investor using a “portable alpha” view of portfolio construction, the growth of available instruments globally both on the beta side as well as on the alpha side makes it possible. The problem is that both ends of the spectrum are deviating from the original purpose.
Pure beta: On the one hand, gaining broad market exposure and the related market risk therein (beta) should be acquired at the lowest cost possible. For institutions, this is through derivatives such as futures and swaps. For retail investors, ETFs, futures and options are reasonable choices. However, regarding ETFs, we are seeing an evolution in the industry where new offerings focus less on broad exposures at low cost and instead bring access to highly niche areas at relatively higher costs. I am a fan on some of the new exposures available from ETFs (gold, alternative energy, etc.) and have written extensively on new offerings in less traditional spaces, but I am still a bigger fan on ETFs and the fund companies that manufacture and promote extremely low cost alternatives. Thus, I am a big fan of Vanguard when their fund is available for a particular asset class.
The divergence in the ETF industry towards very broad/low cost funds versus very narrow/higher costs funds is good. For those focused on the separation of beta and alpha, they will likely focus on the former. Asset allocators and those who like to play their macro calls will employ the use of ETFs that allow quick exposures to areas like water and international real estate.
Pure alpha: Many complain that the problem with hedge funds is their fees. I generally don’t agree, although I’m not the biggest fan of the retailization of hedge funds. The argument for hedge funds with regard to fees can be found here.
Bottom line: Mutual funds and traditional investments provide more beta than alpha but the MER you pay does not differentiate between the two. A fund’s performance that is driven due to beta (market risk as opposed to manager skill) should come at a cost closer to ETFs than that of the typical managed fund.
That’s fine but when this line of thinking moves over to hedge funds it should not be a strong argument as many (not all) hedge funds aim to “perform well in both good and bad markets”. In other words, for such funds, they should be market neutral, or what I think is the correct term: beta neutral. If a hedge fund is truly beta neutral, then its performance is based truly on the manager’s skill rather than the oscillations of the market. In this case, many would agree that there is good value as you get what you pay for.
Hedge Funds Generally In Step With Markets
But how many hedge funds exist in this beta-neutral manner? In general, I would say not many. In a previous piece I showed a chart plotting the growth of two hedge fund indices with the S&P 500. In general, I surmise that in aggregate, hedge funds behave like the market more often than many investors would believe to be true.
In the shorter term, single hedge funds or even fund-of-funds may be able to provide strong diversification benefits from long-only market exposures. However, the chart shows that in the longer term, hedge funds only deviates from market returns in times of extreme drawdown. In a way, that’s great. Both the HFR Index and the Credit Suisse-Tremont Index were flat when the equity markets fell in 2000-2002. The problem is that during the periods outside of 2000-2002, the hedge fund indices move in step with the markets, albeit with considerable outperformance in the three years leading to the top versus the S&P 500.
Still, when you look at the last four years, hedge funds in aggregate perform too much like the broad equity markets. This is also very true in Canada. Generally, hedge funds did not seem to protect well this past summer so they will have to prove themselves when the next major down market occurs. I am very interested to see what happens when the next 15% or greater correction occurs. Many strategists are calling for something in this range for the first quarter of 2007 but for their to be a rebound rather than an extended drought. If something close to this occurs, we could have a repeat of this summer where there was a synchronized drop in nearly all asset classes as well as strategies including most hedge funds.
That’s the caveat. The opportunity, however, remains in that there are hedge funds and even fund-of-funds that are very much beta-neutral. So, for the investor looking into hedge funds, digging through the data to monitor beta neutrality as well as correlation analysis with various asset classes (and of course with current holdings within one’s portfolio) is very important. Luckily, in this day and age, the low cost of computing power allows many market participants to conduct the necessary quantitative due diligence that is required.
Lessons From Amaranth
The problem is that it’s the qualitative due diligence that is so much more important and more difficult to conduct. This leads to Amaranth.
Here’s a recently posted “Top 10 Lessons” list from William Hutchings at Financial News Online on the Amaranth affair.
Some of my thoughts from each of the ten points:
Risk managers: In a way, the risk manager at a hedge fund has to be like a “mother-in-law from hell” who monitors the situation. However, just like no one wants someone watching them as they cook saying “too much salt”, managers don’t like constraints. Hedge funds are like mutual funds with less constraints. So for the risk manager, there has to be some balance and therefore their job is difficult in that it involves some politics. Brian Hunter had the hot hand. If the risk manager was based in Calgary, or even if he/she flew west every week, do you think things would have turned out differently? I’m assuming they had all the correct data. How is this different from Barings and the Nick Leeson situation? The official story in that case study is that England did not know what was happening in Singapore. If that’s true then they were incompetent. If that’s false, yikes. Yikes as in LTCM and Amaranth. The risk managers had sliderules that adequately gauged the risks so risk measurement was not the issue. Human nature is quite simple: It’s hard to walk away from the table when everyone sees you as the one with the hot hand. Concentrated positions: I’ll talk a bit more on diversification versus concentration in a following point. But with regard to concentration, I spoke with various participants in the Canadian energy markets in late September and was informed that Amaranth was not the only one with massive exposures to natural gas. No surprise, as everyone from hedge funds to utility companies has an interest in the commodity. I do not know if Amaranth had the largest exposure to natural gas and if others were simply successful in winding down positions in a more effective manner but it seemed to me at that time that what occurred seemed to be a non-event to so many. The only detail suggested to me that was different in this case was the fact that the losses were skewed so heavily to one participant. Manager pressure: I’ve written about this many times in the past. Low barriers to entry allow for a greater number of participants and the idea of less “alpha per capita”. I don’t know if there’s more or less alpha than in the past or if the amount is even relevant. However, the idea that there are more funds searching for alpha leads me to believe that there will be greater use of leverage to squeeze out as much juice as possible. LTCM, Barings, Amaranth. Obviously, leverage works both ways. Position transparency: This is what institutional investors are asking for more and more. Let’s say they get it. Full position transparency. I guess they become the mother-in-law of the mother-in-law. Just think about it. Large versus emerging funds: Another trend in the institutional space is interest in emerging fund managers. The logic is that these hedge funds focus on new areas that have relatively less competition and thus greater “alpha per capita”. The problem is that the hedge fund manager will be less likely to provide any amount of secret sauce and that obviously includes position transparency. Hopefully, process transparency will suffice. I personally think that this logic makes sense. The problem is sustainability. Will a hedge fund company be more sustainable if it is acquired (Morgan Stanley?) but allowed to manage the investment business with yet another mother-in-law in the kitchen? There’s just that added dimension of risk in putting money with a relative start-up that makes this an interesting dilemma for institutional investors. I can only guess that they can take an equity position with the hedge fund company and help them eventually gain some business from other similar institutional investors. Financial system: Not much for me to comment on this. I only hope there is some rigorous yet coordinated effort amongst regulators and central banks. Industry aggregated position transparency: On the one hand, my comments on the point above apply here as well. However, let’s say that there is a global watchdog that communicates with AIMA or some other representative of the hedge fund industry of an extreme concentration and over-investment. Then what? So, let’s say for example, that gold flies by $1000 and money continues to be dumped into gold ETFs, gold futures and gold everything. What about if it’s in a far smaller scale (yet still significant) but applied to a stock? I believe the market already provides the necessary existing mechanisms to handle this. Market participants will be quick to implement the necessary positions when things get out of hand in such a manner. Diversification: Although portfolio theory is about adding non-correlated investments to lower overall volatility, I believe that true active management in its most extreme form (the hedge fund) means allowing for concentrated positions. Clearly, the issue is to what degree of concentration. Too much diversification and you become “index like”. Too much concentration and you rely on the poor risk manager mentioned above to make sure that the risk measures are agreed upon and the procedures related to risk management are firmly adhered to. Fund of funds risk taking: I hate to use the term again because I have a wonderful mother-in-law, but the FoF is another example of an overseer to the hedge fund manager. I know of a FoF that had its largest exposure to Amaranth. Certainly, the event hurt their performance in a very significant manner but hopefully they learned something from it. If it helps better define their risk measurement and management process, then that’s all that can be asked after the fact. In this case, the FoF was down less than 9% for the month. According to the Hutchings article, “Investors expected falls of 10% or so in any given month. What they did not anticipate was a loss of 70%.” I would agree with this and, in fact, seeing a manager go through an “Amaranth” is healthy as part of the ongoing due diligence of a manager especially in the area of hedge funds. Liquidity: Hedge fund investors should hopefully know before they get anywhere near actually investing that illiquidity is part of the game. However, they should also know that in many cases, fund-of-funds may also be limited in their ability to redeem when they wish. Knowing the full extent of the situation and what one can and cannot do is something I wonder if investors take the time to adequately study.
I’ve slowed down a bit in terms of writing as the holidays bring so many nice distractions. This will definitely be my last piece for the year and it’s been a real joy writing for Seeking Alpha over the past seven months. To those who have sent comments (kudos or otherwise) over this time, many thanks. Best for the new year!