Macaskill on markets: Coupon clipping with the two percenters

By:
Jon Macaskill
Published on:

The hedge fund industry is coming off another year of substantial underperformance to market benchmarks in bizarrely rude health. Total assets in the industry rose to $2.01 trillion in December to set a new record total above the previous peak of $1.95 trillion in June 2008, according to data firm Eurekahedge. Other monitors put the current total as high as $2.41 trillion.

Hedge funds delivered a deeply unimpressive 8% aggregate gain in 2013 – a year when the S&P was up 30% – but there seems to be no stopping the steady drift of assets into a sector that has combined anaemic returns with high fees to no visible ill-effect since the financial crisis in 2008 caused a temporary setback to growth.

Fee-cutting from the traditional 2% of assets and 20% of gains plus an air of contained panic about improving returns might be expected from the leading lights in the sector, but if anything hedge fund managers seem to be relishing the advent of a new era of coupon-clipping, where fees on an expanding asset base provide enough of a buffer to make outperformance of benchmarks a secondary consideration.

Perhaps this is the effect of so many bank-trading veterans moving to the hedge fund sector in the years since it became clear that the Volcker Rule would spell an end to standalone proprietary dealing desks at investment banks.

Many dealers thought that the glory days of compensation levels at banks that were effectively anchored at surprisingly high minimum levels by nothing more than time-hallowed expectations about bonus totals were over. Instead they are now finding that the newly dominant institutional investors in hedge funds are no harder taskmasters than old-school investment bank heads.

The bonanza of easy money on offer from coupon-clipping was tacitly, if perhaps unintentionally, acknowledged by John Havens, the former president of Citigroup, when he emerged from forced retirement in January to take up a position as chairman of hedge fund Napier Park Global Capital.

Havens remarked that the large institutions that drive hedge fund investments are increasingly patient while waiting for performance. This is as good as labelling institutional investors in hedge funds as suckers, and might not have been quite what the managing partners at Napier Park – credit market veterans Jim O’Brien and Jon Dorfman – had in mind when they appointed Havens as part-time chairman of their fund, which was spun out of Citi last year. But it is difficult to argue with the implicit conclusion reached by Havens that institutional investors in hedge funds are easy marks.

Hedge funds delivered a deeply unimpressive 8% aggregate gain in 2013 – a year when the S&P was up 30% – but there seems to be no stopping the steady drift of assets into a sector that has combined anaemic returns with high fees to no visible ill-effect since the financial crisis in 2008 caused a temporary setback to growth.
Hedge funds in bizarrely rude health
The broad underperformance of the hedge fund industry over the past five years comes with issues for a number of investment styles that once seemed to offer either superior returns – alpha – or a sustainable reduction in correlation to core asset classes.

The long/short equity investing style on which the entire industry was founded has been hit by increasing evidence that some of the historical outperformance of high-profile firms was based on insider trading. The dogged pursuit of SAC founder Steve Cohen by the US authorities over suspicions of insider trading might or might not result in an eventual conviction for the noted art collector and in-mansion basketball court enthusiast.

But the Feds have already secured multiple convictions on insider trading counts of dealers with a link to SAC, and the fund has been forced to pay a $1.2 billion fine and convert from a $16 billion operation levying fees as high as 3% on outside investments to a family office reliant on trading gains to increase the roughly $9 billion of personal wealth of Cohen and his trading partners.

Hedge funds can be found that bucked the overall trend of long/short equity underperformance of benchmark stock indices last year, but many of them are small funds that project an air of hairy-palmed day trading, with gains based on punts that just happened to come off.

Even mid-sized funds that outperformed last year, such as Glenview Capital Management, often applied trading strategies that were bold enough to make a traditional institutional investor uneasy. Glenview founder Larry Robbins placed a bet that the implementation of Obamacare in the US would boost hospital stocks that worked out very well. Glenview’s main fund was up by over 40% last year and a capital opportunity sub-fund rose more than 90%. But at points in the year Glenview had close to 50% of its exposure in a few hospital stocks and leverage applied to the portfolio magnified the risk of a position with a strong political component.

This gutsy but risky approach to trading is clearly not calculated to give much comfort to the new breed of supposedly patient institutional investors in hedge funds, so how are more systematic approaches to markets working out? Not very well, at least for key parts of the hedge fund sector.

Quantitative investing based on algorithmic computer models has been having a tough few years. Cantab Capital’s flagship quant fund fell by close to 30% in 2013 and chronic underperformance by quant pioneer AHL continued to wreak havoc on the share price of its listed parent company, Man Group.

Specialist hedge funds concentrating on areas designed to combine steady returns with low correlation to traditional stock exposure have also disappointed. Commodity funds inevitably suffered, given the reversal of the long cyclical boom in the asset class. Foreign exchange funds that did not milk the short yen trade that has been the biggest theme of the past two years were hampered by a lack of movement in other currencies.

And credit hedge funds have struggled to provide value, as low volatility has hampered sophisticated strategies such as debt/equity arbitrage and basis trading of default swaps against corporate bonds. Some credit funds have suffered from being either over-sophisticated in their approach or taking the ‘hedge’ element in their titles too seriously and trying to stand in the way of a rally in high-yield debt that shows no sign of letting up in the early part of 2014.

Volatility across asset classes is a crucial driver of profitability for many funds and is also showing little sign of a meaningful upward move so far this year. But funds can at least take some hope from a fall in correlation within equities in the early weeks of 2014. That should in theory give a boost to returns in well-managed long/short equity hedge funds by increasing relative-value trading opportunities.

And while coupon-clipping, or fee-harvesting, may be an increasing feature of the hedge fund industry, there are still some practitioners with a refreshing sense of adventure. Dean Barr, former CEO of alternative investments at Citi and current managing partner in hedge fund stake investor Foundation Capital, recently made headlines with a lawsuit over an investment he made in a venture to recover emeralds from the sea floor off Florida, based on a treasure map that had been bought in a Key West bar. Sadly the treasure map and the emeralds both turned out to be fakes, but Barr should be applauded for his willingness to test the boundaries of modern investing.

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