Hard Times Come to the Hedge Funds
A few months ago, one of the hedge fund managers based in Hong Kong sent me an article titled “Hard Times Come to the Hedge Funds” with an interesting passage:
The question is plainly arguable, but it would appear that the key feature of a hedge fund is neither the hedge nor the leverage, but instead the method by which the general partners are compensated.
In most years this litany would also include the complaint that there is almost no way to produce short profits in a generally rising market. Last year that excuse was not available. The market favored the shorts, and yet many hedge funds still lost money – or, at the best, made only a little – on their short positions.
Nevertheless, the hedge funds’ main problem last year was of a more elementary kind: they simply picked the wrong stocks to short. In particular, there were many funds which, figuring that the market would go down, also figured that the drop would be led by some of the high-multiple growth stocks…
The article described some of the key problems the hedge fund industry has experienced over the last few years quite comprehensively. However interestingly, this article was printed in January 1970—almost half a century ago. It was written by Carol J. Loomis, who is known as a “longtime friend of Warren Buffett’s, the pro-bono editor of his annual letter to shareholders, and a shareholder in Berkshire Hathaway,”. This was a time when there were only 150 or so hedge funds managing about $1 billion total in AUM from 3,000 different investors.
The hedge fund industry officially commenced in 1949 when Alfred W. Jones launched his first investment vehicle with hedging and leverage. However, the origin of the hedge fund concept had existed prior to Jones. Benjamin Graham (the author of Security Analysis) and Jerry Newman formed the Graham-Newman Partnership back in 1926 through using their value investing technique (1946 Letter). The macroeconomist John Maynard Keynes also managed several institutional portfolios using hedge fund techniques as early as the 1920s (Keynes, the hedge fund pioneer, by Gavyn Davies).
What is less known is that Warren Buffett, a protégé of Benjamin Graham and the present CEO of Berkshire Hathway, was also a very successful hedge fund manager. In the 1950s and 1960s, Buffett managed closely-held partnership called Buffet Partnership, Ltd which operated essentially as a hedge fund. After Benjamin Graham retired and closed his partnership in 1956, Buffet launched three partnerships. His investment style, concentrated long/short, was very different from the approach he practices today. He bought many “cigar butt” companies. These were low quality, but asset rich companies trading considerably below their intrinsic values. In 1961, he bought the Sanborn Map Company which represented 35% of the partnership’s assets. Owning 44% of outstanding shares, Buffet was able to manage the board to sell the company’s huge non-related assets (stocks and bonds)—generating a substantial profit. At th time, Buffett Partners charged 25% of incentive fees with a hurdle rate of 6% and generated 25.3% annualized return after fees—handsomely beating Dow Jones’ 9.1% annualized return. However, in 1969, a year before Loomis wrote the article, Buffett decided to close down his $100 mm Omaha operation and pursue other interests. At the time, Buffett suggested that his investors may want to retreat to municipal bonds instead. The heyday of the hedge fund was about to end.
The 1970s was the “Dark Age of the hedge fund industry” as Mario Gabelli describes in The History of Hedge Funds – The Millionaire’s Club:
Unfortunately, many of the new hedge fund managers weren't really hedging at all. Shorting even a small percentage of a portfolio restrained performance in the go-go markets of the mid-late 1960's. So most hedge fund managers simply stopped doing it. They were leveraged long-particularly risky business in less accommodating markets. This produced some big hedge fund losses in 1969-70 and major bloodletting in the savage 1973-74 bear market. The more prudent hedge fund operators survived, but many more closed the doors. In 1984, when Sandra Manske formed Tremont Partners and began researching the hedge fund industry, she was only able to identify 68 funds.
The industry did manage to survive the Dark Age and emerged again in late 1980s when a storied new generation emerged including George Soros’ Quantum Fund and Julian Robertson’s Tiger Management. With their exceptional performance, a significant amount of capital was poured into the industry and hedge funds became household names. The industry’s pace of growth surpassed private equity by more than 2% p.a. from 2005 to 2013 and the industry today controls over $3 trillion in AUM.
This growth has yielded large amounts of fees. Using a typical fee structure of 2/20 (2% management fee and 20% incentive fee), fees alone have generated $60 billion in revenue. Today, there are 94 billionaires in the asset management industry, or 5.2% of the total count of billionaires from all industries (Forbes, 2016). Despite the relatively shorter history of hedge funds compared to mutual funds or private equity funds, hedge fund wealth contributed unevently to over 63% of some $349.1 billion in cumulative net worth of billionaires in the more general asset management industry. The attractive compensation structure of hedge funds also lured many MBA graduates to pursue careers in the space over opportunities in investment banking, management consulting or in private equity. Everybody involved in the hedge fund industry got richer… except perhaps the investors.
Despite its spectacular growth, the hedge fund industry’s performance over the last 10 years has been quite poor. Between July 2006 and Jun 2015, Absolute Return strategy (hedge fund’s umbrella term) generated only a 4.2% return—ranking 7 out of 8 strategies classified by the Yale Investment Office. In fact, the hedge fund strategy yielded only half of the returns generated by the long-only equity strategies like Foreign Equity (9.0%) and Domestic Equity (8.2%). Even though the hedge fund strategy bears lower risks and thus lower expected returns compared to long only strategies, hedge fund performance created nothing but disappointment for most investors.
One of the multibillion dollar event-driven managers we recently met complained and even blamed the market’s high volatility and crowdedness of so-called hedge fund names for his recent mediocre returns. Hedge fund managers enjoy two advantages over other long-only strategy managers: shorting and non-benchmarking. These are additions, not subtractions, to the traditional investment strategies adapted by mutual funds. By shorting expensive or speculative stocks, hedge fund managers can protect their long positions with cheap valuations. Volatility should be a friend of hedge funds, not an enemy. Hedge funds are not benchmarked to any index like most mutual funds are—so they can choose the best investment ideas without almost any constraint.
Furthermore, many hedge fund managers forget one important thing; although they are called “hedge” funds, they do not necessarily have to hedge. This is not to say that hedge fund managers should not hedge or short companies, but instead that hedge fund managers indeed have the freedom to go long and short depending on market conditions and present opportunity sets. While investors grant extraordinary autonomy to manage their portfolios, the hedge fund managers often become hostages of their own names and seemingly forget another, probably more important thing—making money.
Farewell, My Hedge Fund
A smile ushers in the spring. A tear does darken all the world. How truly does this befit you. To you… only you are possessed of such charm.
Master Yuan, Farewell My Concubine
Farewell My Concubine is a cinematic masterpiece directed by Chen Kaige. This is a story of two acclaimed Beijing Opera stars, Dieyi (Leslie Cheung) and Xiaolou (Zhang Feng-yi) set in mid-20th century Beijing. During this time, Chinese society was undergoing one of its most traumatic periods spanning Imperial Japan’s invasion in the 1930s and 1940s, the civil war up until 1949, and the Cultural Revolution taking place in the 1960s and 1970s. The film’s title is taken from a famous Chinese opera repertory about a loyal concubine, Consort Yu, who chooses to remain with her defeated king, Xiang Yu, even if it forces her to cut her own throat as the victorious rival army approaches. In the movie, Dieyi, a pretty, gentle boy and also a son of a prostitute, is trained to play dan (female) roles. Thanks to his charm and beauty, he was also able to cunningly secure fame and patronage from both the Japanese and later the Communist Party, while reclusive Xiaolou fell out of grace. Dieyi secretly loved Xiaolou despite the latter’s marriage to a woman. Dieyi’s unrequited love eventually morphed into hatred and anger and Dieyi began to struggle with a prolific addiction to sex, opiates and alcohol despite his successful professional career. It was only a matter of time until Dieyi’s professional life would catch up with him as the Cultural Revolution commenced. The tides turned and his duplicitous position collapsed as he was villainized as an “anti-revolutionary” and even a male prostitute. Surrounded by the supporters of the Cultural Revolution movement, Dieyi was forced to confess his sins in public and avow that he has come “step by step toward this fate.”
The story of Dieyi and Xiaolou can be paralleled in some sense with the story of hedge funds. Since the mid-2000s, the hedge fund industry saw a shift in investor base as institutional investors, such as pensions, insurance companies and sovereign wealth funds, took the helm as the largest capital provider for the industry. This has led to great change in the industry over the last 10 years—both positive and negative. In general, the hedge fund business has become more standardized and more protected by regulators. As institutional investors are in many cases, guardians of ordinary people’s money, they are not supposed to take too much risk. Resultantly, this has greatly reduced the risk-taking culture amongst managers. In the end, the more “sophisticated” and “mature” the hedge fund industry became, the larger allocations became into this “safer and uncorrelated” asset class. Management fees have resultantly increased in importance relative to incentive fees due to the sheer size of funds provided by institutional investors. Thus undoubtedly, the hedge fund industry has prospered without necessarily generating satisfactory returns.
This suspect performance has now led to an investor exodus. Several U.S. pension and mutual funds, such as the California Public Employee’s Retirement System (CalPERS), the New York City Employee’s Retirement Systems, MetLife and AIG, have decided to liquidate their hedge fund positions over the past few years. The president of one of largest allocators of funds for hedge funds, Tony James from Blackstone, predicts that the hedge fund industry may lose about a quarter of its assets in the next year. 2015 was the first year since the height of the 2008 global financial crisis that the number of hedge fund closures outstripped the number of funds that opened.
Like the story of Dieyi, the hedge fund industry sought patronage from two distinct groups. And also like Dieyi, the industry suffered from a sense of confusion as two different investor groups demanded very different things. For hedge funds, the entrance of large institutional investors gradually forced the industry to relinquish its formerly-prized risk-taking culture in an obsession towards risk management and higher Sharpe ratio at the expense of pursuing making money. Mediocre returns have followed and the industry is facing a day of reckoning.
Wise investors like the Yale Investment Office have taken drastic actions over the last 10 years. Yale started investing in Absolute Return strategies as early as 1990. In fact, it was one of the first institutional investors that provided capital to the hedge fund space. At the time, Yale decided to allocate 15% of capital to Absolute Return—making it the third largest allocation for the endowment. By 1997, Yale made it the largest at 23%. From 1999 to 2000, the private market (private equity & venture capital) temporarily became the largest allocation thanks to strong venture capital performance, but Absolute Return soon regained its status as the largest allocation until 2006 when Real Estate retook the crown. Since then, Yale has kept reducing exposure to Absolute Return strategies. This makes it quite extraordinary that institutional investors have since accelerated their allocation to the hedge fund while Yale has cut back. The university has been quite taciturn in this regard, mentioning in its annual report that:
An important attribute of Yale’s investment strategy concerns the alignment of interests between investors and investment managers. To that end, absolute return accounts are structured with performance-related incentive fees, hurdle rates, and clawback provisions. In addition, managers invest significant sums alongside Yale, enabling the University to avoid many of the pitfalls of the principal-agent relationship. (Annual Report 2011)
Yale never refers to the alignment of interest issue for other strategies. Therefore, our interpretation is that, on average, the alignment of interests between investor and manager is problematic amongst hedge funds. Yale has had to become cautious and observant.
Interestingly, the endowment started increasing its allocation to Absolute Return strategies since 2012. While still below its historical average, hedge fund allocation has been increasing in the portfolio despite relative underperformance. This begs the question; why exactly has Yale increased its allocation? The key to this is proper manager selection. In part, this is because there is tremendous diversity in the space. Yale’s Absolute Return program has performed handsomely in the past 30 years despite the asset class’ poor performance as a whole.
As mentioned earlier, Yale recognized the principal-agency problem in the hedge fund industry as early as 2002 when it started citing the issue within its Annual Reports. While the hedge fund industry flourished with significant amounts of easy money, many hedge fund managers became lazy and far too comfortable with their business. Many young hedge fund managers raised $200-300 mm on the first day while putting their own “entire personal net wealth” of $1-2 million at risk. By collecting a 2% management fee, they could double or triple their money in the next few years without any performance (or even with negative performance). Frankly put, this is a highly attractive but unsustainable business model.
For us as investors, we do not want to take our lives with the hedge fund managers like King Xiang Yu. Instead, investors shall bid farewell to those hedge fund managers who are incentivised to enrich only themselves. However, we do not think the industry is a lost cause, and we have still been able to find managers who have set up proper incentive mechanisms aligning factitious stakeholder interests.
In sum, we hope to:
Ensure the alignment of interests between managers and investors by implementing performance-related incentive fees, hurdle rates and clawback provision as much as we possibly can,
Ensure the managers’ own capital represent a significant portion (5-10%) of assets they manage so that they do not rely on management fees to enrich themselves,
Avoid managers receiving capital from risk-averse institutional investors (unless you are among them and happy with the mediocre, but stable returns),
Avoid empire builders who tend to have multiple funds with multiple portfolio managers,
Avoid managers who never made a mistake or who claim they have never made a mistake—they will eventually lose a lot when things go against them, and investors who chased good performance will redeem quickly and managers will further underperform.
In addition, we strongly believe in the fundamental-driven, long-term, concentrated, and active investment approach for both private and public strategies. This includes our buyout, venture capital, public long-only equity and absolute return strategies. As pointed out very well by Loomis 46 years ago (we think she is a genius), a hedge fund is a scheme to reward a manager based on his performance with few restrictions. In order to maximize benefits, we need to ensure there is an alignment of interests between the manager and investors. We like this performance-driven structure very much and actively seek managers with a shared philosophy.
But we do have a few more, perhaps controversial, comments to add:
Avoid hedge fund and public equity managers who have too many analysts. Most investors think that it is better for a portfolio manager to have support from many high quality analysts. In our view, this is not true and becomes problematic when a portfolio manager has too many good senior analysts. Based on our experience, the number of positions the fund takes tends to increase as the number of analysts do to a level beyond the benefit of diversification. In order to motivate senior analysts, the portfolio manager has to listen to the analysts’ recommendations and add those positions to the portfolio. Maybe up to 20-30 positions, this relationship could be beneficial. However, beyond that level, we think there will be negative attributes. We expect a portfolio manager to understand in-and-out of companies they invest in. This becomes quite challenging if a manager has more than 50 positions. Think this way—a manager with 50 names in the portfolio can theoretically spend 5 business days or 40 working hours per position on average. Can he be an expert of each position he owns? We doubt it—the math does not add up. All the idea generation, primary research, and financial modelling are done by someone else—and the portfolio manager’s job is relegated to meeting management and making top-down judgments. Unlike private equity, a hedge fund business should be very simple and efficient. The same calculation can be applied to the number of analysts. If a portfolio manager hires 10 analysts, how many hours can he spend with each analyst? If he spends 2 hours per week to speak with each analyst or to review each analyst’ recommendations, that’s 20 hours a week or half of business working hours. It simply seems implausible.
Avoid smart managers who think they are smart. In many cases, they think they are smarter than they actually are. They know how to behave and how to treat investors. Their arguments can be convincing too. However, there are too many uncertainties in this world and even the most skilled manager is bound to make mistakes. Smart managers who think they are smart take more risk than they can handle as they often overestimate their abilities.
“Every great money manager I’ve ever met, all they want to talk about is their mistakes. There’s a great humility there but and then obviously integrity because passion without integrity leads to jail. So, if you want someone who’s absolutely obsessed with the business and obsessed with winning, they’re not in it for the money, they’re in it for winning, you better have somebody with integrity.”
Stan Druckenmiller, Full Excerption is in Appendix
In closing, we want to share three very interesting and thought-provoking articles:
Speech of Stan Druckenmiller, who is also listed among the Hedge Fund Billionaire. (appendix)
Some Thoughts on Becoming an Independent Fund Manager by Robert Vinall, RV Capital
GFIA Research Insights, October 2014, by Peter Douglas, GFIA (especially from page 7)
Appendix: Excerpt from Stanley Druckenmiller’s Speech
I thought I would spend a moment just reflecting on why I believe my record was what it was, and maybe you can draw something from that. But the first thing I’d say very clearly, I’m no genius. I was not in the top 10 percent of my high school class. My SATs were so mediocre I went to Bowdoin because it was the only good school that didn’t require SATs, and it turned out to be a very fortunate event for me.
But I’d list a number of reasons why I think I had the record I did because maybe you can draw on it in some of your own investing or also maybe in picking a money manager. Number one, I had an incredible passion, and still do, for the business. The thought that every event in the world affects some security price somewhere I just found incredibly intellectually (unfinished) to try and figure out what the next puzzle was and what was going to move what. And the fact that I could bet on that interaction, those who know me, I do like to bet. One of the great things of this business, I get to gamble for a living and channel it through the markets instead of illegal activity. That was just sort of nirvana for me that I could constantly be making these bets, watch the market moving, and get my grades in the newspaper every day.
The second thing I would say is I had two great mentors. One I stumble upon and I sought out. And I see some young people in the audience and probably some grandparents who have some influence on some young people in the audience, and I would just say this. If you’re early on in your career and they give you a choice between a great mentor or higher pay, take the mentor every time. It’s not even close. And don’t even think about leaving that mentor until your learning curve peaks. There’s just nothing to me so invaluable in my business, but in many businesses, as great mentors. And a lot of kinds (sic) are just too short-sighted in terms of going for the short-term money instead of preparing themselves for the longer term.
The third thing I’d say is I develop party through dumb luck – I’ll get into that – a very unique risk management system. The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that re superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere.
And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you. And if you look at what excites you and then you look down the road, your record on those particular transactions is far superior to everything else, but the mistake I’d say 98 percent of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.
…… But before he left, he taught me two things. A, never, ever invest in the present. It doesn’t matter what a company’s earning, what they have earned. He taught me that you have to visualize the situation 18 months from now, and whatever that is, that’s where the price will be, not where it is today. And too many people tend to look at the present, oh this is a great company, they’ve done this or this central bank is doing all the right things. But you have to look to the future. If you invest in the present, you’re going to get run over.
KL: You put money out with other managers. What qualities and characteristics do you look for in those people that you place money with?
SD: Number one, passion. I mentioned earlier I was passionate about the business. The problem with this business if you’re not passionate, it is so invigorating to certain individuals, they’re going to work 24/7, and you’re competing against them. So, every time you buy something, one of them is selling it. So, if you’re with one of the lazy people or one of the people that are just doing it for the money, you’re going to get run over by those people.
The other characteristic I like to look for in a money manager is when I look at their record, I immediately go to the bear markets and see how they did. Particularly given sort of the five-year outlook I’ve given, I want to make sure I’ve got a money manager who knows how to make money and manage money in turbulent times, not just in bull markets.
The other thing I look for, Kenny, is open-mindedness and humility. I have never interviewed a money manager who told you he’d never made a mistake, and a lot of them do, who didn’t stink. Every great money manager I’ve ever met, all they want to talk about is their mistakes. There’s a great humility there but and then obviously integrity because passion without integrity leads to jail. So, if you want someone who’s absolutely obsessed with the business and obsessed with wining, they’re not in it for the money, they’re in it for winning, you better have somebody with integrity.