The hedge fund industry has come under a lot of fire in the last 12 months. They have been blamed for falling markets, failing banks, rising costs of credit, bad weather, you name it. But while it is easy to target an industry where a hedge fund manager can earn millions in a year, what do we really love them for and what do we really hate them for? We know that they are clearly not responsible for the troubles in the banking industry. The weather is another matter…

While I have defended the performance and relevance of hedge funds, there are areas where hedge funds have been deficient.

Why we hate hedge funds:

Style drift is a major major complaint. Style drift is when your equity long short manager starts trading credit, or fixed income or starts buying unlisted private companies. Style drift is, however, hard to define and hard to police. Is an equity manager with a very fundamental bottom up process guilty of style drift if he chooses to express his view on a company by buying preferred shares? Or the bonds issued by the same company? Blatant style drift is rare and easy to detect if you know what you are doing, but even experienced due diligence people can be eluded or deluded by more subtle types of style drift. Is someone who trades convertible bonds for their volatility characteristics guilty of style drift if they start trading distressed convertibles where the volatility element of the bond is dwarfed by the credit risk of the bond? How about an equity manager who normally takes a long term view but becomes successful at trading in a more volatile market? What if they become successful at their deviation? Would an investor cry foul and redeem?

Not doing what one says they will do is very much related to style drift. Actually, its more related to misrepresentation. The risk arb manager who suddenly decides to operate a long only distressed debt strategy. A public listed equity hedge fund that decides to buy an unlisted resort in Bali. A distressed debt manager who decides to take a punt on some equities (non post reorg equity). These types of style drift are misrepresentation. The regulation of these products falls not under the FSA or the SEC. They fall under the concept of misrepresentation in Contract Law. Offering documents are currently drafted in such a way that a hedge fund manager could do pretty much whatever they liked. This has to change. For contract law to take hold, the level of definition in prospectuses has to be improved. Investors will want to know precisely what hedge fund managers are allowed to do, and not allowed to do, and they will want it in ink.

Hedge fund fees do not reflect proper alignment of interest between managers and investors. Performance fees are a great idea, but what about negative performance? Like any business activity, a workman deserves his wages. Paying performance fees for performance is fine. It is even acceptable that fund managers don’t have negative performance fees (that is pay out when they lose money symmetrically as they charge fees when they make money, lets grant them this latitude). But the current design of performance fees encourages short termism and does not encourage optimal behaviour over multiple periods. A private equity fund style holdback with clawback quickly (though imperfectly) addresses this. Management fees. The raison d’etre for management fees in a hedge fund which already charges performance fees is that it covers costs and overheads. In that case, charge expenses and costs to the fund and do away with management fees. Or cap the management fee in absolute dollar amount so that the fees fall as the fund size increases. Costs and expenses do not rise linearly with assets under management.

Gates. These are the things that hedge fund managers use to keep investors from pulling their capital out. There is a purpose and a use for gates, but the way they were used in 2008 is a negative example. Gates should be used as a last resort. Gates should be structured so that there are clear guidelines to when they can or cannot be invoked. The blanket rights of the fund’s board of directors to impose gates should be re-examined. A fund should be structured properly so that its redemption terms are appropriate to the liquidity of the strategy and market it trades. If done appropriately, the need for gates is greatly diminished. Invoking gates because the manager had more illiquid assets than he was representing and was therefore caught off guard by the volume of redemptions is not a good excuse. Worse still is the tendency to invoke gates since (in 2008), everyone else was doing it and the stigma associated with it seemed to have diminished is downright disingenuous.

Side pockets. These are share classes issued to track illiquid investments and to make sure that investors are equitably treated with respect to their allocation of these illiquid investments. There is a proper use for them, but often they are misused. I can see side pockets used when an investment is illiquid and the valuation is conservative and the true value is likely to be known only upon realization. In any case, side pockets should only be used for new investments and never for legacy ones. Investors don’t like retroactive side pockets. They are more like back pockets.

Terms which are inappropriate for the strategy or market traded. When hedge funds were doing well and the industry was in rapid expansion, hedge fund managers were able to command whatever terms the market would bear. A star manager trading a liquid strategy in liquid markets could demand long lock ups, account level gates, fund level gates, exit fees, high management and performance fees, modified high water mark fees and other features that had no bearing on the strategy. Smaller managers, start ups, less visible or fashionable managers who struggled to raise assets would provide more liquidity than their portfolios could bear, offer discounts so that they would be less viable businesses. Don’t promise more than you can deliver. Don’t ask for more than you need.

Investor management is poor. Apart from willful misconstruction of the fund vehicles, the investor side of the equation, the capital base, was often left as an afterthought, delegated as a part time job to one of the portfolio managers, the CFO, a junior marketer and was generally not well managed. Banks have an army of personnel to manage the deposit base so as to build stability. Banks with an over-reliance on wholesale funding have found themselves in deep trouble lately. A hedge fund which gave little thought to its investor base and had too much concentration from particular types of investors, notably wholesale intermediaries like funds of funds, were precisely analogous to wholesale funded banks.

Transparency is often poor. Many hedge funds do not provide sufficient transparency because they underrate the value of transparency to investors, don’t care if its important to investors or are simply very secretive. Reference the point above about poor investor management. Transparency is part of investor management and investor retention. Investors want to know what the hedge fund manager is up to. Transparency is also required by investors to monitor potential style drift. Transparency, however, takes different forms. Position level reports are useful to an extent but they are more relevant to some strategies than others. The trading behaviour of a manager can create risk exposures that a snapshot picture in time cannot reveal. Risk reports are often more useful, aggregating exposures to specific relevant risk factors. Receiving these reports from the independent administrator is of course far more useful than if it is sent by the manager themselves. Transparency can also take the form of communications with the manager. Of course the traders and portfolio managers time is best served trading and managing money. Well informed investor relations personnel with relevant experience can be a very powerful investor management resource. Alas, some managers think of these resources as costs rather than as investments.

Not reasons we hate hedge funds:

Strategies are too complex. Hedge fund strategies can run from the simple to the complex. Behind every simple strategy, is a complex thought process. A simple strategy with a simple thought process and a simple execution will not obtain much alpha. Investors do not shy away from complexity, they price it. The more complex a strategy is, the safer it must be for a given return, or, the higher must be the return for a given level of risk.

Fees are too high. Its not how high the fees are, it’s the design of the fees. See my previous article about fees: Hedge Fund Fees. Its not the magnitude but the design.

Hedge funds have long lock ups. We don’t have a blanket aversion to long lock ups. We have an acute aversion to liquidity mismatches. See my article dated Feb 2007 about the Asset Liability Management of a Hedge Fund. 

Hedge funds are all beta and leverage and little else. It is true that the large majority of hedge funds are not of the highest quality. Barriers to entry into this lightly regulated industry has allowed fund managers who have no business running a hedge fund to run a hedge fund. At the aggregate level it is certainly true that leverage and beta have been the main drivers of returns. The solution to the problem is to be selective. The definition of beta alone is a subject of a long discussion and we won’t get into it here. The appropriate level of leverage similarly is a complicated issue. Being selective is not a complicated issue. It is a difficult problem to crack, but the concept is simple. 

Why we like hedge funds:

They actually work. Mutual funds and long only funds lost 40% to 50% in 2008. Hedge funds lost only half that. And many of those losses were due to the collapse of the infrastructure surrounding them and the misguided policies of regulators in response to the crisis. The shorting ban of 2008 for example was a major impediment to hedge fund strategies. In spite of these constraints, hedge funds lost on average 20% in 2008, roughly a quarter of them made money in 2008, and roughly a third of them underperformed long only funds (bear in mind that the performances are not uniform with respect to strategy or size.)

Hedge funds are less volatile. On average over the last 8 years, hedge funds had a volatility of 12% while long only funds had a volatility of 25%. The risk reward properties of hedge funds is also attractive. In the last 8 years, equities have lost 5% while hedge funds have made 5%. A comparison of Sharpe Ratios quickly recommends hedge fund over passive long only strategies.

Market efficiency: As a group, hedge funds represent unconstrained investing. I say as a group because you do not want to be investing with a single manager who is totally unconstrained. Do you? But as an unconstrained investor, the hedge fund industry brings price efficiency to the market, allocating capital efficiently to businesses, sectors, countries and asset classes.

Hedge funds offer diversification benefits. And more. This is an interesting area. Depending on how you measure correlation, that is over what length of time and with what frequency, hedge fund correlation to the MSCI World Equity Index can range from 60% to 95%. What is interesting, however, is that in recent years, investors had complained that correlation between hedge funds and equity markets had risen, and they were right. Throughout 2006 and 2007, correlations ran at over 90%. But correlations have fallen since the middle of 2007 from 90% to 70% in Feb 2009. Just when you needed the decoupling, you got it. In the middle of the bull market, correlations ran high. In the throes of a bear market, correlations fell. Not an entirely undesirable quality.

February was another difficult month for hedge funds. If anyone thought 2009 would be an easier year for hedge funds, think again. Hedge funds lost 0.51% in February, compounding January’s 0.09% loss for a year to date loss of 0.60%, according to the HFRI Index. Fund of funds managed a smaller loss of 0.31% which together with January’s gain of 0.67% resulted in a +0.36% return for the year.

Broad indices, however, hide interesting detail.  

Equity hedge funds lost 1.38% in February for a YTD loss of 2.22%, market neutral funds lost 0.77% for a YTD loss of 0.60%, EM Asia lost 1.46% for a YTD loss of 2.89%, this compared with the MSCI World which lost 8.6% in January and 10.17% in February.

Fixed income arbitrage, however, continued January’s profits with a 1.35% return in February for a YTD return of 3.60%. Dislocations in sovereign fixed income markets has opened up some interesting opportunities for that strategy.

Merger arbitrage has continued to outperform. The strategy lost 5% last year, the second best performing strategy behind global macro in 2008. This year, it has made 0.31% in January and 0.63% in February for a YTD gain of 0.94%. Consolidation in distress, high dispersion of valuations, Emerging Market strategic acquirers, all continue to make the strategy highly interesting, even with the LBO market in stasis.

Global macro lost 0.08% in January, then made 0.05% in February for a YTD return of -0.03%. Global macro is dominated by a few outstanding managers, and a whole lot of mediocre ones generating fairly random results.

Event driven and Distressed strategies made moderate returns in January (+0.36% and +1.00% respectively,) followed by moderate losses in February -0.92% and -0.87% respectively, for YTD returns of -0.56% and +0.12% respectively. While investors have as expected begun to look at distressed debt, default rates in corporate credit have yet to accelerate. Managers wandering into high yield have been fully exposed to spread volatility.

Convertible arbitrage has been the best performer this year, +4.87% in January and +3.26% in February for a YTD of 8.39%. Convertibles of course performed particularly horribly in 2008 (down 33.65% for the year) and there has been a relief rally in the asset class. In addition to this, valuation issues contributed to an exaggerated drawdown in 2008 where wide bid offers led to exaggerated cheapness in 2008, from which the market is now rebounding. Nevertheless, convertibles remain extremely cheap and the strategy may see further tailwinds.

While there are no benchmarks for capital structure and credit strategies the same dynamic is driving performance this year. These strategies were highly distressed last year from market dislocation as well as from poor liquidity driving valuations artificially low. These strategies are repricing and are recovering to a great extent from a return to normal liquidity and bid offers.

Hedge funds are still dealing with, 1) a difficult market environment of high volatility and falling equity markets, 2) continued selling pressure from deleveraging hedge fund peers and bank prop desks, 3) redemptions by investors trying to cash out, 4) possible industry intervention by regulators seeking to regulate hedge funds, possible market intervention by regulators in bailing out areas of the economy. As the nature, if not the extent, of the volatility begins to return to normalcy, hedge funds will find it easier to cope with the falling markets. As long as the volatility is irregular and very high in the short term, hedge funds will continue to struggle. Intra day volatility explained by fear and deleveraging rather than by rational pricing continues to plague the markets, albeit in much calmer fashion than was seen in 4Q 2008. Regulation remains a high risk. Arbitrary, unilateral intervention in markets will continue to overhang hedge fund strategies.

Hedge funds have had all sorts of bad press. In the past week, just speaking to members of the general public, investors, even hedge fund managers, I was shocked at the level of resentment directed at the industry and in the case of hedge fund managers, even some degree of penitence. How strange.

In 2008, up until the middle of the year, hedge funds hadn’t lost much money. The HFRI Index was down 1.36%, the HFRI Fund of Funds Index was down 2.43%, equity long short was down 3.78%, equity market neutral was up 2.49%, fixed income arbitrageurs were down 2.40%, macro had a good first half up 6.53%, event driven managers were down 2.65% and distressed debt was down 2.81%; even convertible arbitrageurs were down a paltry 6.46%. Emerging market managers were down more heavily, in Asia down 14.50%. Maybe it was the difficulty in shorting in those markets.

From July 2008 it was all downhill. And it began with the failure not of a hedge fund, but of an investment bank. Lehman was too important to fail, but in a dogmatic salute to the free market, it was allowed to. Now we talk about nationalizing banks, everyone being Keynesians, arbitrary, unilateral bailouts, and other innovative plans that involve the temporary suspension of capitalism. In the ensuing carnage, someone decided to ban shortselling. How did the hedge fund industry do? For the full year, he HFRI Index was down 18%, the HFRI Fund of Funds Index was down 21%, equity long short was down 27%, equity market neutral was down 6%, fixed income arbitrageurs were down 18%, event driven managers were down 21% and distressed debt was down 24%; convertible arbitrageurs managed to lose 31%. Only macro managers made a modest gain of 4.78%.

Part of the carnage was down to Lehman’s demise and the resulting disorderly unwinding of contracts with their counterparties and their counterparties’ counterparties. Part of it was a shorting ban that encouraged an industry which in aggregate ran net long and therefore had to delever both longs and shorts. Part of it was a ‘run on the bank’ situation leading investors to redeem from funds in fear of one another’s tendencies to redeem in fear of one another’s tendencies to… you get the idea.

A direct consequence was a general deleveraging in the banking industry, forced deleveraging from the disappearance of Lehman, a large scale and widely connected counterparty. Now the woes in the housing market, the mortgage market, the mortgaged backed market and the CDO structured credit market had been going for almost a year already. Lehman just tipped it over. The whole banking system. Then the whole peripheral banking system or ‘shadow banking’ system. Hedge funds are serviced by prime brokers who are mostly the large investment banks. Prime brokers provide leverage and collateral management to hedge funds. As the banking system fails, and as the prime brokers threatened to fail or failed in the case of Lehman, credit lines are pulled from hedge funds. The result is that hedge funds are forced to reduce their leverage. When everyone is headed for the door, its not the fire that kills you, it’s the stampede.

One area where regulation has not focused sufficiently on is the dearth of independent investment decision making as characterized most glaringly by the fund of funds industry. In the years leading to 2007 one theme was clear and that was that big funds of funds were getting bigger and smaller ones were falling away. This put more and more money in the hands of fewer and fewer decision makers. Size forced large funds of funds into larger hedge funds so that larger hedge funds got larger and smaller ones got smaller and fell away. In addition, the number of hedge funds that were common to the large fund of funds’ portfolios increased, exacerbating the potential for contagion. A problem in a single hedge fund now had the potential to cause a problem in a fund of funds creating a problem for that fund of fund’s underlying hedge funds and thus other funds of funds with similar holdings. For a fund of fund, there was now a correlation or dependence that came from their underlying hedge funds being exposed to the same investors; the same investors who met for lunch at Relais de L’Entrecote in Geneva, or Nobu in London, or Smith and Wollensky in New York, had the same starter, main course and dessert and talked about the same hedge fund managers over grappa.

Regulators have a lot to think about. But its not what they think, or where they are looking. Please look again.

In today’s news there were several items about shortselling, notably that the ASIC (the Aussie regulator) was considering extending the short selling ban, and that short selling was responsible for market weakness in various markets.

At a time when public opinion and emotions run high against hedge funds, this is dangerous; because banning short selling is misguided, counterproductive and harmful.

Reference an earlier post I made on 25 September: Short Selling and Market Efficiency.

All these were academic studies based on sophisticated reasoning and hypotheses.

But think of things simply for a moment. As an industry, hedge funds have always run net long. This net long exposure is chronic and stable. It tends to range around 30% to 50% net long. By the way that means that on average, an equity long short fund would be, for example, long 100 dollars and short 50 to 70 dollars for every 100 dollars of capital.

A ban on shorting would mean that they would be constrained from shorting and would therefore have to run a short position of say 20 to 30 dollars. In order to maintain their net positions at around 50% say, they would have to reduce their long positions to around 50 to 80 dollars.

The point to take is that a ban on shorting has resulted in hedge funds reducing their long exposure as well as their short exposure. The net impact on the market is unclear. What is clear is that the hedge fund would be buying stocks it considered low quality, thus propping them up, and selling stocks it considered high quality, thus threatening their funding and viability. Loans and bonds can have market size covenants which could get triggered. This is when it can get entertaining and amusing, if it wasn’t so worrying. Imagine a ban on shorting that triggered a wave of short covering driving up the prices of companies which should not exist, and the selling off of companies which are perfectly fine, but for the shrinkage in their market size end up triggering debt covenants resulting in technical default.

To the regulators I say, please guys. Take a deep breath. Put the safety back on. Holster the gun. Before you shoot the market in the foot.