Investors hold nerve as hedge fund returns plunge
HFR aggregate index down 5%; Paulson’s luck runs out
News that one of John Paulson’s funds is down 47% this year highlights the difficulty hedge fund managers are having in the uncertain financial environment. Paulson, known for his early call on sub-prime that produced triple-figure returns for investors during the crisis, had been counting on a revival of the US economy.
Hedge fund returns year to date have disappointed, with third-quarter results the fourth worst quarter to be reported. The HFR aggregate index was down more than 5% towards the end of this month, with equity hedge strategies averaging losses of 8%.
Investors, however, are continuing to allocate to the asset class. John Godden, founder of hedge fund consulting firm IGS Group, says that despite some strategies’ poor performance this year, investors are looking to continue or increase their allocation to hedge funds.
"Investors realize that high target returns are off the table, but they are still aware of the compounding value that hedge funds add to an overall portfolio," he says. "There have been some disaster stories, but most people’s experience of holding hedge funds over the last three years is that they went down only half as much as everything else."
Hedge fund assets have grown during the crisis, and are now over $1.97 trillion, and net inflows are continuing, although less so in equity strategies.
Godden says certain strategies are coming back to the fore as the cycle shifts. "As we all suspected, the equity long/shorts have been found to have had too much equity market beta exposure," he explains. "In 1997, 75% of hedge fund assets were in CTAs and macro. Equity long/short counted for around 10%. By 2008, that had shifted to where equity strategies were 50% and the carry trade held that. That will now rebalance."
CTAs, macro funds and arbitrage strategies on the other hand average returns just above or below zero for the year. Ken Heinz, president of HFR, says investors are looking for actively managed funds that are long and short, rather than feeling exposed to the uncertainty of the equity markets. "People have become sensitive to the fact that in the equity markets there is the possibility at any moment of having a weekly drawdown that is more than they can tolerate," he says.
"It is harder to make money and this may be a long cycle but the nature of hedge fund managers is not to give up. In debt and credit strategies, many managers are looking to opportunities outside the US"
The challenging environment is causing managers to look at how best to deploy their assets. Henry Bregstein is the global chair of the financial services practice and co-managing partner of the New York office at law firm Katten Muchin Rosenman. He says: "It is harder to make money and this may be a long cycle but the nature of hedge fund managers is not to give up. People tend to exit the industry based on having made enough money or being under pressure from regulation. They are looking elsewhere. So in debt and credit strategies, many managers are looking to opportunities outside the US."
Godden says he sees funds looking to "quasi-banking strategies" such as corporate debt and asset-based lending. Fixed-income and alternatives house BlueBay Asset Management, for example, has made a foray into corporate lending. He adds that the industry is polarizing, with assets going to large managers or start-ups.
Bregstein says there is a strong preference for larger names, as they offer the comfort of financial stability and can afford the costs that higher due diligence from investors brings. "Five years ago, hedge funds were thinking about taking those roles in-house to save money," he explains. "It was viewed as a low-expertise function, but after the crisis, with some high-profile blow-ups, that reversed and now hedge funds are working much more with third parties. That cost can be too much for a smaller firm."
The number of start-up hedge funds has slowed – around 100 new funds have emerged this year so far. But both Godden and Bregstein say interest has started increasing, in spite of the more challenging investment environment.
"Some of the highest returns have come from smaller managers," says Godden, and several large European funds of funds or family offices are seeding smaller players, as they think that is where the growth will be. "A lot of people are looking to get started and if you look at the list of top-50 hedge funds in 10 years’ time, I would wager that 40% of them started around now."
It had been thought that the closure of bank proprietary trading desks would spur a raft of start-ups, but industry participants say those start-ups have struggled to attract investors. "They are great traders, but lack the sensitivity required to deal with investors in times when returns drop, so as a sector of the industry they have become quite unpopular," says Godden.
He sees more start-ups originating from large asset management groups. "With banks buying banks, many ended up with multiple asset management firms which were consolidated, freeing up interesting teams of people," he says.
As for Paulson’s fund, Godden says the future is a little uncertain. "Paulson’s early call on the sub-prime market and returns in the crisis saved a lot of funds of funds – counting for as much as 75% of their positive performance. It has been difficult this year to predict timing for strategies such as his, let alone get the direction right.
"He needs to get his returns back on track soon, though, or else investors will start to pull out money, which will bring down assets, and then more will pull out. He’s far from over but he has lost a lot of money now, which is concerning."
However, in a letter to investors on November 1, Paulson revealed that gross year-end redemptions will be less than 8%.