Friday, December 5, 2008

Time for hedge funds to return to their roots

With the news getting worse and worse for the hedgies (e.g. Fortress, Thomas Lee, D. E. Shaw), it’s time for a rethink on hedge funds.

For hedge fund investors: You probably went into them believing that they were uncorrelated absolute return vehicles, or pure alpha. Isn’t it funny how correlations all go to 1 in times of crisis? Maybe it’s time to return to your roots and understand the role of alternative investments in your portfolio.

For hedge fund managers: The really successful ones began fifteen or twenty years ago as small, nimble, guerilla investors. Somewhere along the way the guerillas came down from the hills, got big and became the government. Maybe it’s time to return to the hills again.

Investors thought hedge funds were the panacea when the hedgies showed positive returns in the post-Tech bubble crash. Ultimi Barbarorum writes:

Last time we had a bear market, hedge fund fortunes were made. Andor Capital, William von Meuffling, Crispin Odey, Chris Hohn, even Jim Cramer when he was trading, all made out like bandits producing 20-50% returns on the short side in 2000-2002, many after having doubled their money by being long in 1999. This made them look, if not like gods, then at least jolly clever and deserving of an investment. Hedge fund managers were smart, nimble, slightly less eminent versions of George Soros, milking the patsies in the long only community for vast profits. Hugh Hendry would come on CNBC Europe and wow us with his acumen and hibboleth-smashing iconoclasm; everyone was wrong! Only he could see the truth, it seemed. Chris Hohn would rarely have a down month, let alone a quarter, and at the end of the year give half his profits away to charity, that was how much he thought of the armani-wearing, white-toothed, fake-tanned, long only growth managers whose pockets he was picking. The successful hedgies ran maybe $1bn, most ran less, and Andor, the biggest long-short manager, ran about $6-7bn.
Ultimi Barbarorum made the further point that hedge funds got too big and became the market. Size for a hedge fund is not necessarily the answer.

The guerilla returns to the hills?
Not all is lost. Hedge funds do have a role in a portfolio. Don’t forget what they are and what they aren’t:
  • Small
  • Opportunistic guerilla investors who are able to change their stripes
  • Not an asset class
Once the industry started to get institutionalized (not small) with hedge fund indices of various flavors, consultants and HFoFs started pigeonholing everybody (once you were a convertible arb fund you had to stay a convertible arb fund, even if the opportunities went away), the guerilla got pinned down (not opportunistic) and that was the beginning of the end.

What a lot of people don’t understand is that hedge funds were never an asset class, unlike other alternatives like real estate. One of the key characteristics of an asset class is the ability for an investor to construct a low-cost passive index portfolio, with known component holdings and known weights. Hedge funds were originally marketed as pure alpha, or portable alpha vehicles with low correlations to the major asset classes. These are characteristics that you can’t pin down with an index.

Hedge funds have been here before
This is not the end for the hedge fund industry. AllAboutAlpha reports that hedge funds went through a similar crisis in the late 1960s. The same problems that exist today existed then. Horrible returns, fund blowups – these aren’t new inventions. Hedge fund investors found out what they had wasn’t a contract with a hedge fund manager, but a call option on a management contract. When the incentive fees dried up, the manager packed up and went away.

After the blowup, the hedge fund industry went through a period of contraction and reinvented itself. No doubt we are in for some version of that same story going forward.

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