An independent professional's take on the latest news and trends in global financial markets

A Struggle For Hedge Funds

This item from the Financial Times caught my eye today:

Paulson & Co, the world’s third-largest hedge fund manager, has seen another painful month thanks to growing fears over the health of the US economy. The firm’s $9bn Advantage Plus fund, which aims to profit from trading corporate events, lost 4.26 per cent in August, according to an investor, wiping out gains made in July. The fund, Paulson & Co’s largest, is down 11 per cent so far this year.

Paulson & Co is far from alone in having had a difficult year. Very few hedge fund managers have reported strong performance in the past eight months.  The average hedge fund manager made just 0.17 per cent in August, according to Hedge Fund Research, and has returned just 1.29 per cent so far this year. Pressure is now on for many managers to deliver stronger returns in the next four months.

My long-held sceptical views about hedge funds as a group have not, shall we say, been tested by this latest news. The very best hedge fund managers are terrific, but they are a small minority, so you have to pick them with care (if that is, they allow you to invest with them in the first place). There is sufficient academic evidence to show beyond reasonable doubt that many hedge funds are charging very high fees for performance that they don’t really earn, while the risk-reward structure is heavily weighted in favour of the manager at the expense of the client.

About half the returns hedge fund make are not alpha (stockpicking skill) but leveraged beta (returns from particular markets or sectors that could be obtained much more cost-effectively through other instruments, and without the risk involved in using leverage). That said, I myself know and work with a couple of hedge fund managers. There is no doubt that the best funds, the one in which the managers own a large chunk of the equity, and have every incentive not to take excessive risk, do get the cream of the talent.

It is no accident however that the explosive growth in hedge fund assets since the turn of the century has had a lot to do with the cheap money policy that brought many countries in the West to the brink of bankruptcy. A combination of two bear markets in equities and a decade of artificially low funding costs made marketing hedge funds a no brainer for several years. It also brought in far too much money, eliminating some of the  investment anomalies that smaller, nimble hedge funds had been able to exploit before.

Now the industry is firmly on the back foot. Poor performance by many funds during the financial crisis badly dented the general notion that hedge funds can  do well in all types of market conditions. The Madoff scandal was an eye-opener for many gullible investors who clearly had no idea what they were investing in (it certainly wasn’t a hedge fund, although the returns he appeared to be offering looked like it should be).

While funding costs remain at rock bottom levels, the days of easy credit have meanwhile dried up. Regulators have also been trying to bring the industry under tighter control, even though the one thing that can be positively said in defence of hedge funds is that it was not they, but the banks, which caused the global financial crisis. No hedge fund failure threatened to bring the rest of the financial system down, as the grossly imprudent lending and trading practices of the big universal banks did do.

This year’s disappointing hedge fund results will no doubt make the saleability of hedge funds as a class even harder than it has already become. The fact that  John Paulson, who made an eye-popping amount of money and was lionised after his big bets against the US housing market were vindicated in the sub-prime fiasco, has not been immune is a reminder of how fragile superstar status in investment can be. His main fund is down 11% year to date, according to reports.

It is true that Mr Paulson has done very well with the gold fund that he launched last year; according to the FT, the fund was up 9% in August. It was a smart move to create gold-denominated share classes in all his funds. Before getting too carried away, it may be  worth contrasting the gold hedge fund’s performance with the amount you could have made by simply buying one of the physical gold ETFs that have attracted such a large retail following in recent years. The ETF I own (PHAU) is up 29% in the last 12 months.

The good news for the survivors in the business may well turn out to be that returns will improve in due course as those without the talent or investor support to survive in today’s choppy market environment leave the industry. There has always been a marked tendency for investor money to move disproportionately, and often very quickly, towards a very small number of the largest firms with the best recent track records. John Paulson himself has become a text book example of the phenomenon.

But success can be transitory. There is no doubt that there will be rich pickings for the smartest hedge fund managers in the next few years. The challenge for those setting out to make their way (and their fortunes) in the business today is not finding ways to make money. The hard part will be raising the money to get started and then doing well enough to keep the high  fees that have been the norm in the past. In the hedge fund world, as everywhere else, investors make their choices with more than one eye on the rear view mirror. Experience shows it is always hardest to get the money when the returns are set to be there; and easiest to do so just as the opportunities are diminishing. Better times for a select  few may therefore lie ahead.

Written by Jonathan Davis

September 9, 2010 at 9:10 PM