Tuesday, August 19, 2008

Will The Hedge Fund Model Prove to Be Broken

Separating the shills from the bona fide proponents of hedge funds has never been easy. Nor has it been facile to distinguish the secretly-jealous critic from the legitimately, even altruistically concerned. In an interview with Bloomberg's Tom Keene, the articulate David Goldman, former Chief Strategist at Asteri Capital, posits in no unequivocal terms, that the "Hedge Fund Model" of investment will, over the coming-year, prove to be broken beyond repair.

What precisely does he mean? In a nutshell, he means that the majority of Hedge Fund performance will not be able to weather the volatility caused by the continuing de-leveraging and the catastrophic blow-up of so-called crowded trades that this will cause - something that is, and will continue to be exacerbated by the lack actual liquidity in many of the instruments and positions currently favored or stuck like chewing gum to bottoms of their respective portfolios.

The hedge fund model of stewarding money for one or two-and-twenty is, he suggests, predicated upon reasonably low volatility and above average returns. Yet like young unskilled schoolboys playing football (tank you Charles of IBEX Salads for the image), there are obvious trades and simply far-too-many participants chasing the same returns causing the trades to be intensely crowded. These over-exploited trades (in the short-term) are prone to massive bouts of short-covering necessitated by the very hedge fund model itself, for few funds, managers have the confidence (or the investors) that will forgive 20% to 30% monthly drawdowns for riding shorter-term aberrations in exchange for the eventually larger kill in having the right ultimately correct position. Strangely enough, no one's behaviour is illogical. It is just another example of a local optimization problem.

If this sounds to readers like the accident that initially availed itself in the Quant implosion of Aug 2007, then you are correct. And if this sounds like what is happening to unfortunate longs in the energy and commodity complexes, you are also right. Goldman believes that this will manifest itself in an near-unending decimation of funds pursuing the simplest model. He makes exception for the prescient funds, with the actual lock on capital (permanent exchange -traded vehicles or 3 to 5 year locks a-la- the Private Equity model) who also have the conviction, and strength of constitution to make high conviction bets and hold them despite the itinerant volatility of the positions and consequential vicissitudes of mark-to-market. Verbatim, he says:
"...with everyone forced to take the same trade, the volatility, intra-month, is so great, those investors committed to a month-to-month Sharpe-ratio low volatility strategy will be forced to redeem and you will get wild swings, illiquidity, and an inability to liquidate positions.

So I think we are going to have a serial catastrophe of hedge funds, particularly the kind of funds that thought that it was a great idea to buy loans at $0.90 on the dollar and won't be able to sell them at $0.80 later in the year.

Note that he is not bearish on opportunism, nor speculation. He thinks people like TPG did great trades buying assets "cheap" with something resembling matched, non-recourse funding. He simply thinks that doing the same thing (and there is no shortage of managers pursuing such spread returns in part or in whole) without the surety of similar investor commitment horizons on the equity capital side OR committed facilities on the finance side is a recipe for disaster, or at least an unwind cascade of ghoulish proprtions.

To some extent the Fed (like the BoJ before it) can put the brakes on the systemic point-in-time unwind cascades. It can cajole institutions to hold off, it can nationalize banks and make for a more organized liquidation of duff collateral and assets, i.e. whatever it takes to prevent the institutions at the system's core from selling position to make position - something that has little actual utility in fact. But the authorities have little control over hedge funds' investors, and hence the their resulting demands for liquidity.

I personally find such a continued evolution quite plausible. And it won't be undeserved. For other market participants have had ample time to prepare after witnessing the quant-related meltdown. I do wonder whether investors will, as a result, force the Darwinian HF survivors, to accept long-term incentives with clawbacks that manage to incorporate liquidity discounts and incentive payments based upon realizations - a sorely needed interest alignment tool. Maybe I've been a tad unfair to the PE guys by comparison...

12 comments:

Macro Man said...

Cassie,

While you've been in the hedge fund game for longer than I have, it does seem to me that this hand-wringing (and, of course, the concomitant deterioration in performance)is a typical end-of-cycle phenomenon.

Witness the horrible hedge fund performance of 2000, when the business model of "buy the biggest turd of a dot-com that you can and watch that sucker turn into a ten-bagger" was found out to be a house of cards. Clearly, the "enhanced leveraged credit opportunity" category of funds will similarly go the way of the dodo. And good riddance to them.

While you are hopefully correct that the wheat is indeed separated from the chaff, it's not immediately obvious what the alternatives are. Perhaps (he says hopefully) assets will gravitate to more liquid, transparent strategies and funds, where the risk of quarter-end tomfoolery and "married to a turd" illiquidity is minimized.

But somewhere between the 3 year PE lock-ups (and what's the end game there? What do those chaps do with no ability to borrow and few attractive targets?) and the zillions of real money "I beat benchmark by 5% so you've only lost 15% this year, not 20%" managers, I suspect our friend the hedge fund manager will continue to carve out a nice existence for himself, even if some of the more egregious strategies become a thing of the past

"Cassandra" said...

Esteemed MacroOne, I understand your objections, but beg to differ, at the risk of arguing someone else's point. You see his prognostication intersects with a pet-peeve observation of mine that market structure has not-so-subtlely changed insofar as the ratio of feedback trading and shorter-term trading has increased at the expense of contrarian, counter-trend, longer-term positioning. It has been fed by seemingly sensible Darwnian allocation strategies and newly-minted PhDs and CFAs pursuing data-mined adaptaive quantitative strategies that themselves reinforce momentum-like paradigms whether at the asset or asset-class level. The effect is to increase instability and volatility, and elongate trends and departures from something like an intermeiate-term equilibrium. While I would like to remain agnostic as to whether it is for the better or worse, I do believe it is for the worse since allocative efficiency is unlikely to be enhanced, or changed dramatically (e.g. from long to short) at the drop of hat. And since the history of trend-followng looks something like 75% noise and 25% secular run, the newly evolved dominance in recent years would have the obvious effect of wrongly signalling and building trends that historically were how shall we say, "unworthy".

ADIA is the future in their realization that they are paying far-too-much on beta and shouldering the asymmetrical downside. IF you're real capital, better just be long and stomach the vvolatiility or be long and pay for insurance and let someone else micromanage it for the vol, but not 1&20.

Goldmans point was more about the HF Models mismatch in horizons than anything else. PE investors at least pay on whats drawn down, and if I am not mistaken only get incentive fees on realizations, not mark-to-markets. Someone please correct me if I am wrong. The further rub of the HF model as they delve into PE is that the HFs DO get paid on mark-to-market and the agent-principal dilemmas thus loom large, i.e. things looked great in Dec (incentive fee time) and oooops we're bust in January. Service providers here provide coldd comfort, as they too are ypically conflicted and chummier with the manager (their ultimate client) than investors.

Macro Man said...

As a denizen of a market that has been dominated not only by quants and trend-followers, but also by liquidity-arbitrageurs, API parasites, seek-and-destroy bots, and of course Voldemort for the past five or six years, all I can say is "welcome to my world" to the equity types who are accustomed to a more, ahem, genteel market environment that trades around equilibrium.

What I can say from my experience in foreign exchange is that those who do not adapt their modus operandi do in fact die (or at least badly underperform), but those who do can carve out good returns. It does, however, require a fair amount of work.

Funny that you mention ADIA, as they are among the culprits who have made foreign exchange markets so noisy. I have heard that at one point they contemplated a program wherein they would aggregate the positions of their external currency managers, and then take (large) opposite positions in any consensus trades. Investment paragons indeed.

Point taken on HF doing private equity, however. If you want PE, buy PE.

David Pearson said...

I've often thought that the end of de-levering cannot be reached with HF's managing $1.8tr. Somewhere between evolutionary points "A" and "B", their numbers will plummet.

But what is the "selection pressure" in this evolutionary path? You imply its the inability to adapt to volatility. I would put this in terms of their investors. Just a dozen years ago, most HNW investors made money in their businesses and preserved it in private banks. Then the private banks sold they "asymmetric alpha" through HF's -- high return, low vol. The promise made by private banks has been broken, and HNW investors will bleed back into low return/low risk assets.

Another source of the $1.8tr is pension funds. Their move into the alternative space was a product of their refusal to accept lower return targets. Hedge Funds exist, in part,to keep up the illusion that an 8% pension fund return is achievable without taking unacceptable risks. What will happen, eventually, is that these pension funds will take the targets to 5% and leave the alternative space.

Which, of course, leaves the SWF's.

BTW, I started a HF to capitalize on the coming credit crisis in 2005. I closed it to outside clients when I realized I couldn't achieve my return target with their vol expectations. I'm glad I did.

Macro said...

The real low-hanging fruit in the extinction sweepstake is, of course, the fund of funds.

I don't believe that a lot of pension funds can get away with 5% return targets, as that would leave them with a bad funding gap. What they can do, of course, is their own due diligence, and not pay yet another layer of fees for someone to pick their investments for them.

zanon said...

I concur, the hedge-fund boom has been driven by conservative institutional investors (pensions) now having a % allocation in them.

They will discover, in time, that they have found a very expensive way to hold equities.

etc said...

"I concur, the hedge-fund boom has been driven by conservative institutional investors (pensions) now having a % allocation in them.

They will discover, in time, that they have found a very expensive way to hold equities."

In time, pension funds will also discover that a lot of assets are currently priced for returns in the mid-single digits.

RichL said...

Hedge funds and the other sharp operators can only make money if they can take advantage of the dumb money in the market. Currently well over half the trades are done by quant strategies, prop books and hedge funds. Professionals don't make money trading vs. other professionals. These spastic markets won't entice additional retail or less sharp institutions to play, and relatively high valuation isn't helpful either.

If these premises are true, performance fees will create low returns for the ultimate owners of the funds. And the way these taffy pulls usually end is with an extended boring slow period, but when that occurs I haven't a clue.

PeeDee said...

I'm not sure it makes any sense to speak of "hedge funds" as a group, unless by that you simply mean unregulated investment products - the technical definition in the US investment market. I don't see unregulated investment products declining, particularly in a SWF and super-HNW world.

As for strategies, whether pursued by prop desks, insto's, hedge funds or individuals, they must come and go. This is, for me, part of what makes investing so interesting.

While beta is and should be cheap, there will always be money to be made (and earned) taking positions against the crowd. This will never be a crowded trade, by definition.

I am still seeing good (post fee) long and short-term returns and low volatility from a market-neutral long/short fundamental stock picking strategy, and overlay that on cheap beta and cash. But stock picking is a strategy that cannot be automated, and doesn't scale, so it will never satisfy the flood of money looking for a free lunch.

Anonymous said...

peedee - I agree with David Goldman that hedge funds effectively share a model based upon 1)uncertainty of capital commitment 2) uncertainty of leverage commitment 3) uncertain liquidity if and when #1&2 force one to liquidate position. Now one rightly reader pointed out that there is no shortage of contrarian positions to take (anticipating the inevitable lognormal expression of fat-tailed exiting crowded trades) and no shortage of liquidity when entering those. However, I'd argue that here too the cost has gone up. I used to risk 3 or 4% to make ten over an interval with a 65 to 70% win ratio, though with increasing trend-strength, deleveraging, illiquidity and feedback strategies driving (as Goldman pointed out) divergences and massive short-covering bursts, my return may be the same, as is my win ratio, but my neg tails are now huge. So I might now risk 15 to make 10%, even though the certainty of (ultimately) making 10 is unchanged. Now, I am OK with that though my nerves are more frayed, but investors are NOT OK with it even if they say they are -
and THAT is what is broken.

So what do I do? Macro-Man says adapt or die, i.e. trade shorter-horizons, run long momo strategies, cover and re-establish, stomach the higher TA costs and more frenetic activity to satisfy investors, but that eats alpha too. I could leverage less, and doubledown at extremes. Yes that's possible, but Martingale threat is always present.

Yet if you don't do something, investors will not like the volatility and redeem, as they will if you do the wrong thing.

On the other side of the coin, investors are happy to ride the trend with seemingly adept investors, but what will they say to the -30% month or when the adaptive paradigm reasserts itself to increase the noise -to-signal ration and incessantly stop them out until an unteneable drawdown is reached. Even they and their investors have vol thresholds.

There is an HF-model catch-22 driving everyone to the same trades, and similarly driving them out just as quick. It is a feedback system gone awry, and while I can;t recommend a replacement, I can tell you this one is broke...

"Cassandra"

Sally said...

"the extinction sweepstake" ... where can one get the Racing Form?

etc said...

"So what do I do? Macro-Man says adapt or die, i.e. trade shorter-horizons, run long momo strategies, cover and re-establish, stomach the higher TA costs and more frenetic activity to satisfy investors, but that eats alpha too. I could leverage less, and doubledown at extremes."

Buy or open a closed-end mutual fund: cass for the mass.