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EXPOSED: How Once-Bold Hedge Funds Have Devolved Into Risk-Averse Scaredy-Cats
June 27, 2012 01:31 PM
SIGN OF THE TIMES
It's time to call the hedge fund industry what it has become -- a bunch of scaredy cats trying to hold onto "2 and 20" paying assets. Let me explain.
It wasn't that long ago when hedge funds were at the top of the Wall Street pyramid, with nine- and even 10-figure pay packages bestowed on the titans of the industry, the ultimate goal for so many big bank analysts and MBA graduates. Some succeeded, some failed, but for those able to charge “2 and 20” – a 2% management fee based on assets under management and a 20% performance fee – the stakes were well-understood: produce a lot of return relative to the amount of risk taken.
But, after being battered by three forces -- the collapse in 2008, the V-shaped recovery for risk assets in 2009, and the game of macro ping pong between central banks and European policymakers in 2010 and 2011 -- too many hedge funds appear to have only retained the latter part of that mandate – risk management.
Since the end of 2009, hedge funds, in the aggregate, have managed risk well. Unfortunately for their clients, however, they haven't really made any money, as this chart of hedge fund performance shows.
It's not just hedge fund investors losing out, but the broader financial market as well. As hedge funds have become the marginal buyer and seller of risk, market dynamics have become distorted.
Back in the days when individual investors cared about stocks, in the late 1990s and still to some extent in the middle of the last decade, individuals were the marginal buyers and sellers of risk. Markets would become overbought and oversold but never stay there for too long, as there was a fairly healthy ecosystem of risk takers with differing views and time horizons.
My first job out of college was doing some basic trading systems testing, some of which was published in
, so I became intimately familiar with the statistics behind short-term overbought and oversold conditions.
Today, individual investors are nowhere to be found. Wiith domestic equity outflows averaging $1-2 billion per week. Mom and Pop are putting their money into bonds and gold. There is always a marginal buyer or seller of risk, and in this environment it's hedge funds.
What makes hedge funds different from individuals is their obsession with monthly returns. With time horizons so compressed, especially from the marginal investors in hedge funds (fund of funds), a couple bad months can lead to redemptions. And it's redemptions, not losses, that hedge funds really fear.
The key to avoiding redemptions? Don't take large drawdowns, and don't massively underperform if markets have a big up month.
Avoiding large drawdowns in this environment is easy – just don't have much exposure. Avoiding underperformance in big up markets is trickier.
Here's how it works. Essentially, hedge funds begin every month short an equity index call option a few percent out of the money. If markets don't move a lot directionally they presumably have enough skill to grind out a little performance. If markets rally significantly, however, they have to chase the upturn so that they don't fall too far behind their benchmarks.
Right now, a hedge fund manager's best friend is a 5% selloff during the first week of the month. Why? All of a sudden it's easy to look good. Any performance number for the month suddenly looks reasonable; even better, if we get one of those fluke 2-3% rally days there's no pressure to chase it because the market will still be down a couple percent on the month. This peaceful state of mind lasts until the end of the month, at which point it's time to stress about a big rally in the following month.
How has this mindset shown up in equity performance? Looking at just the final week of the month's performance since the start of 2011, we find that the market has significantly outperformed when it comes into that week down on the month versus up on the month. After all, if you're a hedge fund looking to buy stocks or cover shorts, there's no need to do so during a down month until the month is almost over and you have to worry about the next one.
For instance, at the end of April 23 of this year, the
) was down 2.9% on the month. Over the next week it rallied 2.3%.
We have completed 16 months since the start of 2011. In 9 of those the S&P 500 entered the final week up on the month, and in that final week the average return was -0.23%, with only four of those nine weeks being positive. In the other seven months where the S&P 500 entered the final week down on the month, the average return in that final week was +2.36%, with six of those seven weeks being positive, and all for at least 1%. May fits the same pattern, so we'll see how that goes.
The way a hedge fund wins in this environment, whether they realize it or not, is when markets either fall or go nowhere, allowing them to look reasonable relative to equities. They hopefully make a little money on non-directional plays, manage risk, and say they beat the performance of bonds with decent risk-adjusted returns.
A cynic might say the extreme caution preached by fund managers like John Hussman, Jeffrey Gundlach, and Bill Gross is simply self-interest, keeping clients scared, since they have business risk if the market takes off without them on board.
One day, however, a large rally will come, whether it's in 2012, 2013, 2014, or 2015. And when that day comes, we're likely to see the biggest turnover of assets and asset managers that this industry has ever seen.
No positions in stocks mentioned.
2 AND 20
V SHAPED RECOVERYRECOVERY
HEDGE FUND INDICES
RISK ADJUSTED RETURNS
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