Hedge funds turn to relative values
As alternative managers struggle to make absolute returns in difficult markets, they’re trying to get their investors to judge them on relative performance measures. It’s a fundamental change for the industry, but can it halt an expected flood of redemptions?
Hedge funds have been accused of lots of things over the years. Being too open and honest is rarely, if ever, among them. But with investment returns proving hard to come by, many hedge funds are being forced to placate nervous investors by giving them more information than ever before about exactly how they go about making money.
In conversations with leading figures, a picture emerges of a business populated with a depressed group of former high-flyers who are as uncertain about the future as everybody else.
The stereotype of the brash, hard-charging hedge fund manager, investing with flair and verve, has seldom seemed as flawed.
Dwindling performance as a result of geopolitical and market volatility means that absolute returns, for so long the holy grail for hedge funds – not to mention their promise to investors – are rare.
Instead, managers and their investors have had to settle for relative returns. The question then is how long before investors conclude that a hedge fund posting anything other than absolute returns – those uncorrelated with the wider market – is no longer worth the outsized fees they charge compared with more traditional investors.
Even in relative terms, hedge fund performance has been anything but stellar in recent times. Over the course of last year, the mean average performance for hedge funds globally was minus 4.44%, according to Hedge Fund Intelligence, lagging broad equity market indices such as the S&P500.
Granted, market conditions since late 2008 have been among the most difficult to navigate in living memory. For many hedge fund strategies, the combination of volatility, greater correlation between asset classes, political and economic uncertainty, a fractured financial sector and investor nervousness have created a backdrop against which posting the outsized returns on which the business earned its stripes is nigh-on impossible.
There are of course occasional flashes of hope provided by managers who have, at various points during the crisis, posted huge returns. John Paulson’s bet against the US housing market springs to mind. It is those flashes that seem to be keeping the mood in the hedge fund market and among its investors somewhere well above despair but certainly no higher than cautiously optimistic.
|Emma Sugarman, BNP Paribas|
Emma Sugarman, global head of capital introductions at BNP Paribas in New York, says prevailing market headwinds are causing a good deal of frustration: “Many managers think emotion is ruling the market and people are basing their actions not on any deep research but on sentiment.” Todd Steinberg, former global head of equity derivatives and delta one at Macquarie Securities and currently a private investor, says that given that hedge fund performance is most frequently compared with that of broad equity market indices such as the S&P500, there is an acceptance among the investor base that hedge funds have largely underperformed equity indices. “But the shocking thing is that in many cases, hedge funds have underperformed cash and treasuries,” he says.
Steinberg adds that anecdotal evidence suggests that interest in putting new money into hedge funds is dwindling. “Some managers are scrambling around for money while struggling internally too,” he says. “What seems clear is that generally there is not a huge amount of conviction in many trades and, as a result, the investor base doesn’t have the sense that hedge funds have a clear road map for the year ahead.”
Towards the end of last year, predictions abounded that large-scale redemptions by investors would send many funds out of business. In reality the redemptions were relatively minor and the predicted massacre never materialized. One possible explanation for this is that battle-weary investors who understand the difficulty of investing in such volatile markets no longer expect anything approaching bumper returns, particularly if their hedge fund managers offer a high level of transparency and disclosure about their activities.
|Alex Ehrlich, Morgan Stanley|
Alex Ehrlich, global head of prime finance at Morgan Stanley, says: “There has been a lot of focus on performance. But the reality is that redemptions towards the end of last year were modest. One reason is that many investors are taking a longer view on hedge fund performance in this uncertain market environment.” In its Institutional Investor outlook for hedge funds for 2012, Preqin, a data provider serving the alternative investment community, noted that the toxic blend of sovereign debt crisis and slow economic growth had adversely affected some of the biggest and best-known hedge funds in 2011.
But it also pointed out that institutional investors remained committed to investing in hedge funds, with the size of the industry now approaching its pre-crisis level of $2.6 trillion in assets under management. The report said: “The industry has embarked on a renaissance of sorts since the market crisis, including managers offering increased liquidity and transparency, which continues to be at the forefront of investors’ minds.”
This indicates that performance is no longer the be all and end all, and points to a growing sophistication and realism among hedge fund investors.
Morgan Stanley’s Ehrlich accepts that for managers that continue to underperform, the pressure might ramp up quickly, although those that had a decent 2011 have some immunity to this, adding that most of their investors are sophisticated and understand the headwinds.
Gravelle Pierre, president of Iron Harbor Capital Management, says ‘performance’ can be a slightly vague term adding that nominal performance was, in all likelihood, disappointing for most managers and, hence, investors.
“If funds published risk-adjusted numbers,” he says, “investors might be surprised...meaning some funds that underperformed on a nominal basis look relatively OK when compared with the negative real yields of short-term/low-duration fixed-income products.”
He adds: “In recent discussions we have had, it appears that some investors are becoming a little more sophisticated in evaluating performance and may be drilling down deeper into risk-adjusted performance and looking at multiple measures of risk. We see that as a major theme in the coming year or two.”
The importance of an institutional framework and the organization and transparency such a framework provides is growing across the global hedge fund landscape. Gone are the days when an annual letter from a hedge fund manager to investors was enough information. Now managers and their staff have to spend a good deal of time telling clients what it is they are doing with their money and providing reasons for good and bad performance.
Pierre at Iron Harbor says: “In tandem with the increased scrutiny on risk profile, we expect increased value will be placed on effective communication with investors in terms of frequency and depth. A lot of talented hedge fund managers struggle with this aspect. Major hedge fund investors are biasing towards taking a more active role in their partnership with hedge funds. In truth, an investor should not be surprised by a manager’s performance over a given period if the communication has been effective.”
One of the main reasons why effective and regular communication is crucial is the phenomenon of style drift – where a hedge fund diverts from its main area of expertise and deviates from what investors expected from it at the outset of their relationship. This also has an impact on the risk profile of the hedge fund. “At a minimum, there needs to be a high degree of communication between the manager and their funding source to deal with this issue,” says Pierre.
As Christy York, head of capital introduction at Citigroup, puts it: “Aside from setting up a proper institutional infrastructure, it has never not helped being able to explain clearly to investors how you make money.”
Among the reasons hedge funds possess such allure is their payment structure. But while so many funds remain below their high-water marks – the point at which they can charge performance fees – levels of compensation are not what they were.
A recent report on hedge fund compensation suggests average reported cash compensation for hedge funds last year was $311,000 and that in most cases larger salaries had made up for smaller year-end bonuses. David Kochanek, publisher of HedgeFundCompensation.com, said in a statement that even against the backdrop of a difficult environment, 44% of those surveyed said they were happy with their pay. “We’ve seen this before. When the investment market tightens, professionals report more satisfaction with their pay. Their focus shifts from greener pastures and moves to becoming content with where they are,” he said.
In past times of market strife on this scale, some hedge fund managers and their staff might have elected to return to the proprietary trading desks of investment banks where many cut their teeth. But with prop trading essentially a business of the past because of new regulatory measures such as the Volcker rule, many hedge fund managers have no viable alternative to sticking it out.
As Steinberg puts it: “Hedge funds are not paying either.” Virtually no banks, he says, are interested in building prop trading businesses now and so the options for hedge fund employees are much more limited. “Many are demoralized as a result. Lots are hanging on in quiet desperation,” he says.
Towards the end of last year most were taking a wait-and-see attitude. They were hoping politicians would do them a favour and provide at least some indication as to what the immediate future might hold with respect to a number of factors including the possibility of a global recovery spurred primarily by a plan to end the European sovereign debt crisis.
The global picture has some encouraging signs of progress, particularly in the form of recent jobs numbers in the US, money is being selectively redeployed in the market although, as Sugarman says: “There is still rightly a great deal of discussion about macroeconomic developments, particularly with respect to Europe. Nobody wants to catch a falling knife.”
She adds that the care with which managers are investing is no surprise, likening the combination of looming US elections, the European crisis and uncertainty over Asian growth to a perfect global storm.
One option that many hedge funds are said to be exploring as performance continues to prove elusive is forming alliances with or even merging with other funds.
Equity long/short is still by far the most popular hedge fund strategy and some managers are concluding that in order to navigate markets being driven by sentiment and macroeconomic developments, they must bring macroeconomic and macro-hedging expertise in-house.
Paul Hamill, global head of prime finance at HSBC in London, says: “Equity long/short has been a difficult strategy because even if you had the most talented of managers, they could still end the year in negative territory or get it wrong due to the macroeconomic backdrop. One of the fundamental questions becomes: if you don’t have macro hedging capability, how do you perform?”
One potential solution, he suggests, is to merge with another company.
“Hedge fund mergers or takeovers of smaller funds firms by private equity companies and traditional asset managers will become more common in the coming months,” he says.
But obstacles can appear even if the rationale behind a merger or potential alliance is sound.
The problem, as Hamill puts it, is how to convince one hedge fund manager to work with another? “That is a question of culture, of personality and of fit, and there is no guarantee that it will work. But scale and product diversification do give you a better chance of attracting talented individuals and of raising capital,” he says.
From a valuation point of view, the case for merging is quite strong. For a single-manager fund a valuation of three to four times earnings is not uncommon. But add another one or two managers and the accompanying assets under management and the value can be more like five to six times earnings. Firms with good product diversification, branding and scale can therefore attract higher multiples compared with a single-strategy manager lacking the scale to attract institutional allocations.
“As long as you have a good management company structure, a good CFO, COO and IT infrastructure, there is no reason that a good hedge fund manager should be distracted by having other hedge fund managers around them. In fact you could say that a single-strategy principal lacking scale is more distracted because they have to deal with so many things related to the management of the company and not necessarily of the fund.”
Recent examples of deals in the hedge fund industry include Royal Bank of Canada buying BlueBay Asset Management in a deal that valued BlueBay, which had about $40 billion in assets under management, at almost £1 billion ($1.6 billion). Other deals include Foreign and Colonial’s purchase of Thames River Capital and the deal between TPG Axiom and Montrica, Credit Suisse and York Capital. In fact more than 20 deals have been signed globally in the past 18 months.
The lack of pure hedge fund to hedge fund deals probably boils down to culture – the question of how to get two strong managers together and make it work in a fair and equitable way? Most hedge fund managers are not prepared to give up control and that is when the rationale for deals can fall down.
For all the industry’s problems surrounding the retention of talented staff and the provision of returns worthy of their fees, some hedge funds have undoubtedly continued to prosper. The business remains home to some of the world’s most talented investment professionals and any reports of the death of the hedge fund industry should be ignored.
York at Citi highlights the progress made in recent years as a cause for optimism. “The industry is an amazing animal in that it evolves depending on the investors it seeks. Just a few years ago, for example, it would have been almost unthinkable for a European pension fund to be taking the decision to invest in single-manager hedge funds,” he says.
Indeed direct investment by pension funds in hedge funds, as they seek ways to plug in some cases huge funding deficits, looks set to increase as investors become more comfortable with hedge funds and as hedge funds, in turn, become more open and less mysterious.
Philip Masterson, head of business development for Europe at SEI’s investment manager services division, said in a recent statement: “Investors are clearly looking for better returns, but they are also demanding a higher degree of overall risk management. To stand out and attract investors, managers will have to be more forthcoming not just in how they are enhancing their investors’ returns, but also demonstrate how they manage the portfolio’s risk exposure.”
Pierre at Iron Harbor adds that in addition to better communication, risk analysis and a deeper partnership between managers and funding sources, there is likely to be a more aggressive effort to identify and scale up smaller managers.
He says: “The reason for this is that some of the very biggest funds have been at the top of performance lists for a long time, and investors are going to be increasingly concerned about the share of their assets committed to those few managers. In addition, the funding sources are going to start to be concerned that a manager with a private jet and a house in St Barts might be less willing than a smaller manager to put in the 16-hour days that this job often requires.”