Grating Expectations

By Cliff Stanton and Jeremy Frank

May 2016

“Hedge Fund Fees Destroy Value for Asset Owners” says a recent headline we came across, quoting a study by CEM Benchmarking that analyzed the performance of 150 institutional portfolios. To which our highbrow response is “Duh”. Is it at all surprising to learn that after fees any group of strategies fails to add value? Of course not. Active management is unquestionably a zero sum game before fees, and thus after fees there can be no alpha for investors as a whole. This isn’t news.

But more importantly, we are puzzled by our industry’s insistence on making broad based statements about the performance of hedge funds and liquid alternatives, as if these are homogeneous groups of strategies with similar goals and risk profiles. We’ve harped about this before, so we won’t belabor the point, but while there are undoubtedly skilled investors who can add value with consistency, top down studies: A.) cannot properly assess added value, as it requires labor intensive, fund by fund analysis that takes into account the specific risk exposures driving returns, and B.) will always conclude that alpha is lacking, because that is the only conclusion that can be arrived at; alpha simply can’t exist in the aggregate.

Another item that caught our eye recently was yet another sign of the short termism that is affecting (or afflicting?) investors. In a recent study conducted by State Street Global, 40% of the institutional investors polled indicated that they would seek to replace a manager if the manager underperformed over a 1-year period. 49% said they’d replace an underperforming manager at the 2-year mark, and 11% replied that 3-years was the limit to their patience. Unless we did the math wrong, that implies that none of the surveyed entities would stand for a manager who underperformed for more than 3-years. As we stated a few months back, “There is only one strategy we can think of that met performance expectations over every one-year period, and Mr. Madoff isn’t taking new money at present.” Even using a three year measurement period, based on calendar year returns from Berkshire Hathaway’s 2015 investor letter, this “astute” group of investors would have fired Warren Buffett 13 times over the past 49 years. Likely not a good move.

But the mindset of these investors can be framed further by looking at their return expectations. This group indicated that their overall portfolio return assumption over the long term, defined as 5+ years, was 10.9%. Now to be fair, “5+ years” is an ill-defined time period, and so it’s not exactly clear how to interpret that number. But with that being said, with 30-year Treasuries yielding 2.67%, the equity portion of a simple 60/40 portfolio would need to annualize at about 16% over the next 30 years to meet that 10.9% total return expectation, which is far in excess of the historic long term return to equities. We suppose it will be their superior skills in hiring and firing managers every 18 months or so that will make up the differential. (Pardon our cynicism; we haven’t slept well this week.)

The Data

Long/short equity was essentially flat during the month of April, as equities rose at a somewhat slower pace than they did in March. Long/short credit was the only positive performing category during the month, bringing year-to-date performance into the black. The worst performing category was managed futures, and it is now down slightly for the year, having lost more than 4.5% over the last 12 months. All categories are down over the last 12 months, except for equity market neutral, which posted a slight gain. Overall, the last 12 months have been quite difficult for active managers as a whole, both traditional and alternative. See our education section for more discussion of longer term performance.

Equity market neutral continued to see inflows in April, adding almost $300 million in assets. As is usually the case, the majority of the flows went to two of the top performing funds over the last 12 months. However, even in the face of losses, the managed futures category has continued to see positive flows, bringing in almost half a billion dollars in April and over $5 billion year-to-date. Long/short equity outflows continued to slow, with net redemptions totaling about $328 million during the month.

Alternatives in the News

Just What the World Needs – Another Blog

We felt we needed more outlets to express ourselves in a world obsessed with self-expression, and so, we give you the 361 Capital Blog.

Nightmare or Opportunity

With all the broken deals so far this year it seems that the merger arbitrage space may resemble a nightmare more than an opportunity. The nearly $400 billion in failed mergers will be a record even if there are no more broken deals over the remainder of the year. However, some hedge fund managers see the landscape as ripe for gains. Many managers are raising new merger arbitrage funds or increasing allocations to the strategy, saying return expectations are higher than they have been for years. It maybe that with increased risk, comes increased opportunity.

Valeant Effort

One of the leaders of the crowded hedge fund trade in Valeant Pharmaceuticals is moving on.

Ready the Financial Aid

Hedge funds suffered their largest industry outflow of capital since 2009 in the first quarter, according to Hedge Fund Research.

Hibernating Bear Making Jim Cranky?

Hedge fund managers are charging too much for not enough, according to short-selling legend and 30-year hedge fund veteran Jim Chanos of Kynikos Associates.


Education

Looking at the long-term performance of the alternative categories in “The Data” section above, one could be forgiven for concluding that none of the main alternative categories have offered much in the way of value over the last 3 years. Of course, as we pointed out in the intro, the value add for an entire category must be low because alpha is indeed scarce. Even still, if the underlying managers had exhibited the same value add during the 1990s or even the 2000s, the total return of these categories would look starkly different, and much more competitive with equities. As we’ve written about before, this is especially true of categories such as managed futures, equity market neutral and long/short equity, as they tend to have large cash balances, and thus are greatly affected by the level of short term interest rates. In fact, one of our brokers did a study that showed that between 1990 and 2012 the return on cash collateral accounted for about half of CTA returns.

Point being, directly comparing strategy returns from diverse timeframes that include different interest rate structures becomes a bit more complicated, because you have to adjust for risk-free rates, and few actually do so when reviewing total returns. However, 0% rates have made it easier to spot true value add, versus cash-inflated returns that could have been had via a money market fund much more cheaply. Specifically, managed futures and market neutral funds have produced excess returns (alpha) of just above 0% over this 3-year period, which is made clear with short-term rates at about zero. However, a truly market neutral strategy that has returned 3-5% a year over the last 5 years has actually provided 3-5% alpha over that timeframe. Most investors would proverbially (or perhaps literally) kill for that kind of alpha from a long-only active manager. The same can be said of managed futures funds that tend to be uncorrelated with broader markets. While low single digit returns aren’t exciting, investors may need to be more realistic with their return assumptions and be glad to accrue alpha wherever it can be had. As a bonus, if rates ever do go up, you know where to look to benefit directly from such increases.

And Lastly

If only it were funny. As the WSJ recently reported “Five years after Venezuela nationalized much of its mining industry, President Nicolás Maduro is inviting multinational firms back in to try to revive the country’s dying economy.” Time to work on the prospectus for the “Fool Me Twice Double Short Venezuelan Miners ETF”.

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