Investing: Hedges on the edge

The Church of England, the Cern particle physics laboratory in Geneva and the Fire and Police Pension Association of Colorado may at first glance have little in common. But there is one thing: they all have hundreds of millions invested in hedge funds.

All three cautious investors are among a wave of institutions – from endowment funds to retirement schemes – that have begun piling into a once freewheeling industry seen by many inside and outside the financial world as emblematic of boomtime excess.

But there is a question mark hanging over the hedge fund rush.

Since the beginning of 2010, the industry has registered net inflows of nearly $150bn from investors. Yet in the same period the average hedge fund has returned just 7.5 per cent – compared with 9.3 per cent for global equities and nearly 15 per cent for global bonds.

The contradiction between popularity and recent performance points to a profound reshaping of hedge funds and their place in the financial ecosystem. Hedge fund managers can no longer claim to be masters of the financial universe with financial instruments at their fingertips and thankful clients at their beck and call. Rather, they are facing a future where they differ little from the rest of the more staid, client-oriented asset management world.

The big question though, is whether the taming of the industry – seen by many as no bad thing – is also putting its investment magic in jeopardy.

Either way, the shift hints at a crisis of identity. In recent months some of the industry’s biggest names, from George Soros to Carl Icahn, have thrown in the towel.

Big hedge funds such as New York’s Moore Capital have handed back money to investors for fear of falling into the industry trap of growing too big to succeed. Markets continue to punish anyone displaying the kind of gumption that, before 2008, made a generation of money managers into multibillionaires. As a case in point, John Paulson, who made more money than anyone else in the industry with his 2007 bet against subprime mortgages, has since 2010 lost more than anyone else with his bet on a US recovery.

Most hedge fund managers knew the party ended in 2008, but few expected the hangover to last quite so long. “The thinking that you could hunker down for a couple of years [in 2010 and 2011] and then it would all normalise again – that is going away. And it’s coming as a shock,” says Luke Ellis, the head of London-listed Man Group’s FRM fund of funds unit, which with $19.5bn under management is one of the biggest investors in hedge funds.

“People in the industry are waking up to the fact that 2006 was the abnormality, not today,” Mr Ellis adds. “If you ran money in the go-go years up until 2007, you’re going to be asking: ‘Why am I bothering to try and make money now?’ ”

It is not hard to see why institutional investors are so attracted to hedge funds in spite of their recent performance difficulties.

Even though 2008 was the industry’s worst year for performance, it did more than any other to underscore their value. While hedge funds lost, on average, 19 per cent of their clients’ money that year, other asset classes performed far worse. A pension fund with a high allocation to hedge funds did better than one solely allocated to equities.

To the casual observer, the profound economic ructions currently roiling global markets – from sky-high European sovereign bond yields to whipsawing US equities – might seem like ideal conditions for wily and opportunistic hedge fund managers to make a killing.

Yet, these are not easy markets at all for most hedgies. Their investment ideas might work in the medium term, but short-term volatility, usually triggered by unpredictable political events, is proving too much for their own risk appetites. With trading volumes in normally liquid markets like equities down as much as 60 per cent, the problem is compounded.

Institutional investors, the hedge funds’ biggest clients, have little, if any, tolerance for losses. As such, fund managers are constrained by the need to tightly control their bets and ensure they can return money quickly if asked. “Investors are vividly recalling what happened in 2008,” says Toby Young, head of investor relations at hedge fund Caxton Associates.

As a result, hedge fund managers are sitting on portfolios with high levels in cash, hoping that safer opportunities will materialise when markets calm.

One example is in distressed debt, where hedge funds sense that there is a killing to be made in high yielding European corporate bonds as the continent’s banks are poised to offload huge portfolios of debt at knock-down prices. But with politicians intervening to stop the banks from having to do so any possible gains that could be made from that situation will have to wait.

Caution is not necessarily a bad thing. Some believe it heralds a “back to the future” step for the industry, with hedge funds returning to their original objectives to hedge and protect – aiming for small but consistent and low risk returns – rather than big directional wagers.

But others worry it is stripping away the real edge that hedge fund managers have as investors.

And in an environment of lower returns, big questions are also being asked about the sector’s notoriously high fees. For fund’s returning just 8 per cent annually, the typical fixed 2 per cent annual management fee looks steeper than ever.

Funds are now under pressure to cut the fee to 1.5 or even 1 per cent. As always, however, they expect something in return – such as a bigger slice of the profits, when they make them.

Since 2008, says former congressman Richard Baker, who now heads the Managed Funds Association, the US hedge fund industry’s representative body, “pensions and endowments place a higher priority on preserving assets than reaching for extraordinary returns and taking extraordinary risks to do so”. He adds: “There is greater reliance on our industry to be a tool to minimise risk and deliver returns.”

Indeed, the returns such investors expect are very different from those that made the industry famous. “We are experiencing that positive uncorrelated returns are more important for institutional investors than large returns,” says Tommaso Mancuso of London’s Hermes BPK, which manages $2.3bn in hedge fund investments for the BT pension fund and those of other institutions. Rather than 15-20 per cent a year, institutional investors are comfortable with 6-10 per cent, a sample of more than a dozen top-flight hedge fund managers told the Financial Times this month.

Such reduced ambitions cannot be explained only by the fall in key global interest rates – the benchmark to which investors link expectations. High correlation between assets, low trading volumes and the threat of unpredictable political market intervention are also denting returns. “I think there is a recognition that the world we are in now is a very different one,” says one senior executive at a top 20 firm.

What matters to institutions is that returns are stable. “They look at the world differently to the way, historically, Swiss private banks, family offices and high net worth individuals did,” says John Forbes, the chief operating officer of Caxton Associates, a leading New York-based hedge fund. “Institutional investors want lower volatility, reliable returns and well-run organisations that have very good compliance and operational controls,” he says. Caxton has lost money in only one of its 30 years in business.

To boot, some firms have grown increasingly transparent about the reduction in their risk-taking. Winton Capital Management, a UK hedge fund manager, has made clear to clients that growth in the assets under management of its flagship fund has been accompanied by reduced use of leverage and trading algorithms with more cautious risk-taking parameters.

It is an approach that appeals to institutions. In 2011, Winton alone took in a 10th of all inflows into the industry. The firm tells its clients to consider their investments panning out over decades, rather than years or even months.

“Sustainability of returns is the holy grail because the average life of a hedge fund is just five years,” says Paul Marshall, founder of London hedge fund Marshall Wace and one of the European industry’s most prominent figures. “What’s the point, if you’re an institution, of doing two years of due diligence only to invest in a business that’s not going to last more than another three?”

The problem, as Mr Marshall notes, is that a large part of the industry promises things it can no longer deliver. “A lot of the [equity hedge fund] industry is exactly the same as it was 10 years ago,” he says. “Too often the model is just one talented guy and a few analysts who last a few years but fail to develop a sustainable edge.”

Even at the top end, managers are falling short. “There are quite a number of funds which are just too big for their strategies,” says Mr Marshall. “You get mission creep from the managers: they move into different markets beyond their competency to boost returns. The single biggest area where there should be more scrutiny is capacity.”

Indeed, although some have handed back money to investors in an effort to improve lacklustre returns – and avoid becoming too cumbersome to trade efficiently in today’s low-volume markets – they are exceptions. Large hedge funds still dominate, with the top 20 hedge funds – of about 8,000 – managing more than a quarter of the industry’s $2tn in assets.

What is more, many worry that institutional investors’ focus on the way returns are generated is having a profound and damaging effect on the levels of those returns.

“Investors have been hoodwinked by the myth that somehow hedge funds can offer no risk and a good return,” says Chris Hohn, founder of the UK’s Children’s Investment Fund and one of the industry’s biggest names, best known for his activist campaigns against big corporations. The reality, he and others say, is that by promising little volatility and no losses, hedge fund managers are giving up whatever market edge they might have, even though they may well continue to charge large fees.

TCI, Mr Hohn’s fund, in contrast to much of the industry, takes large, concentrated positions in overlooked or severely out of favour stocks. While it lost heavily in 2008, its long-term record, even including that year, is still comfortably in the top decile. It is up 22 per cent this year, thanks among other things to bold and big stakes in Japan Tobacco and Rupert Murdoch’s News Corp.

“We’re succeeding in a world where many hedge funds do not know what to do,” says Mr Hohn. “The macro guys are lost. The trading hedge funds are lost. The hedge fund index is basically flat over three years. That’s a big thing.”

Referring to the sharp reversals in sentiment that have dominated markets, he says: “The last three years have been risk on, risk off, and to try and cope with that, everyone has just tried to trade markets. There’s no alpha in that – no value added.”

His remarks point to the contradiction at the heart of the industry’s crisis of confidence: should managers focus on taking calculated risks over long periods or should they focus on managing risk in the short term? In other words, are hedge funds risk takers or are they risk mitigators?

Most in the industry have little doubt about what they would prefer. “How are things? Things are crap,” says the head of one $5bn equity-focused fund, who declines to be named. “Markets are thin, investors are nervous and there’s no appetite for risk.”

His remarks are echoed elsewhere. Mid-level and junior traders who once shared in big payouts when their firms took the customary 20 per cent slice of hefty trading profits are now being paid out of much-diminished bonus pools. Their pining for the pre-2008 glory days is palpable.

However, the evidence is that, with more and more money flowing in, the trend towards smaller profits and less exciting trading is not short-term but secular. Rolling 12-month returns in the past two decades show a clear downward trend matched by a growth in assets.

The pressure from investors to focus on liquidity – or the speed with which they can pull their money out – is, perhaps, the biggest problem. “If you want something akin to daily liquidity in a hedge fund, then you are going to get returns like those you get at a deposit account at a bank,” says Man Group’s Mr Ellis. “Only we don’t give out free toasters in the hedge fund industry.”

Not that hedge funds are going anywhere: “If you’re a fund manager, you can sit there and bemoan how difficult life is, or you can say, ‘this is still the best way to make money’, and have fun doing so. What else are you going to go and do?”