Alternative Strategies Have Failed – Part I. Hedge Funds
by the Curmudgeon and Victor Sperandeo
In this first of a two part series, we examine the recent poor performance of hedge funds, which are sold as private placement limited partnerships. As usual, background information is provided with references, followed by Victor's incisive and on target comments.
The second article in the series will examine liquid alternative (open end/'40 act) mutual funds with emphasis on multi-alternative and long-short equity funds. With very few exceptions, those funds have failed to live up to their “all weather” claims and have been even more of a disappointment than private hedge funds! Stay tuned for part II!
Many hedge funds are marketed as helping to smooth out volatility while delivering superior risk-adjusted returns in any market environment. That certainly was not the case in August, when some of the biggest and well known hedge funds suffered steep declines amidst plunging global stock markets, stupendous volatility, and a continuing crash in China's market along with a surprise devaluation of the Yuan.
Hedge Fund Performance Lags Badly:
According to a September 4, 2015 article in the print NY Times hedge funds on average lost ~3.5% in the last year through August. That compared with a decline of about 1.6% in the S&P 500 and a gain of roughly 1% in the 60/40 benchmark index. Longer term, hedge funds have underperformed benchmarks over five- and 10-year periods.
“August was a fair test, and many hedge funds had a tough time,” said Simon Lack, founder of the financial consultancy SL Advisors and author of “The Hedge Fund Mirage” and the forthcoming “Wall Street Potholes.” Hedge funds “have failed to beat a 60/40 mix every single year since 2002, and they’re on track to repeat this year.”
The New York Times and Financial Times recently reported (see references below) that activist investor William Ackman’s Pershing Square Capital Management dropped about 9% in August while there were significant losses in funds run by such prominent hedge fund managers as Leon Cooperman (Omega down 8% to 11% YTD)), Ray Dalio (Bridgewater's “All Weather Risk Parity fund” down 4.02% in August) and David Einhorn (Greenlight Capital down 14% YTD).
Risk parity is the strategy that has aroused the most attention recently as Leon Cooperman of Omega has accused it of exacerbating the global stock market sell off and his own funds' precipitous decline in August. Risk parity hedge funds currently have as much as $600bn of assets under management, excluding leverage which multiplies its influence on the markets. Those funds seek to create a blended but dynamically adjusted portfolio of stocks, bonds and commodities balanced by the respective volatility of the asset classes, rather than traditional capital allocations. The strategy was pioneered by Bridgewater, the largest global hedge fund. Its superlative and steady performance has helped it attract pension funds and insurers across the world and spurred risk parity strategies at other alternative asset managers (notably AQR).
Victor and I believe that the main culprit for exaggerated stock market moves is not Risk Parity, but rather High Frequency Trading (HFT), which we have previously referred to as “legal front running.” We encourage you to (re) read Victor's take on HFT: Assessment and Perspective of High Frequency Trading (HFT) as well as the Curmudgeon's examination of HFT dynamics: High Frequency Trading Firms Push Speed Limits in Risky New Arms Race
Actual Hedge Fund Returns to Investors are Much Lower than Reported:
There are two dirty little secrets about hedge funds that makes their after tax return much, much less than reported:
1. Survivor-ship bias: Many poorly performing hedge funds go out of business due to large losses which prevent them from earning 20% or higher incentive fees (on profits ABOVE last high water mark). Their negative returns are NOT counted in the HFRI Indices or by other Hedge Fund tracking/reporting firms. Also, other poorly performing hedge funds don't report their returns to the rating agencies.
2. K1 tax reporting (US). The IRS requires that limited partners (LPs) in single manager “investor” hedge, multi-manager hedge/futures, and feeder hedge funds all report their K1 expenses, management and incentive fees as 1040 Schedule A under Miscellaneous Investment Expenses. Such expenses are subject to a 2% AGI threshold, but more importantly are DISALLOWED if the limited partner is subject to the Alternative Minimum Tax (which almost all LPs are)! As a result, the overwhelming majority of LPs in such hedge funds must pay income taxes, at their highest marginal rate, on income/gains never received. Again, that's because investment expenses reported on Schedule A are disallowed under AMT (rather than being netted out against the gains/income). Only single manager “trader” hedge funds or single CTA managed futures funds (NOT fund of funds or feeder funds) can deduct expenses, management and incentive fees on 1040 Schedule E, which effectively subtracts them from reported capital gains (Schedule D) and dividend/interest income (Schedule B).
I have read over the 3,000 books on Wall Street, finance, economics, psychology, and trading, which are now in storage. A book published in 1968 titled “Hedge Funds" was quite important as it taught me the proper method of measuring risk. That same year (1968) I managed a “short side” account for a hedge fund.
The “Hedge Fund” concept was started by Alfred Jones (i.e. A.W. Jones) in 1949. An April 1966 Fortune magazine article by Carol Loomis titled: The Jones Nobody Keeps Up With prompted the beginning of the hedge fund industry. The concept was to use both Long and Short individual stock positions to invest, thereby creating a fund that could profit from stocks moving up AND down, depending on the skill of the manager (i.e. stock picking/selections or “Alpha”) and the weight of the risk exposure.
The difference in the exposure of longs and shorts was the market "risk." If using margin (leverage) with 100% long and 100% short positions, then your (market) risk was zero, assuming equal Beta's of the average long and short positions. If you were long 120% and short 80%, your risk was 40%, as that was your net long exposure. If you were long 150% short 50%, you had 100% risk compared to the market index of choice.
In August 1971, I founded my own options firm called Ragnar Option Corp. I was fortunate to have worked with many great hedge funds at the time by offering (OTC) options as a hedge in lieu of shorting stocks. All successful hedge funds during those years were much disciplined as to the net risk exposure and balance between the longs and shorts.
It's important to note that the GOAL of "Hedge Funds" at that time was never to "outperform" the Dow (or later the benchmark S&P 500), but rather to achieve positive ABSOLUTE RETURNS during a complete bull/bear market cycle. And there were indeed down years, severe corrections, and bear markets!
From 1966 (when I started working on Wall Street) to the end of 1974, there were five down years with only four up years in the Dow, which was the benchmark index at that time, The S&P 500 became the institutional benchmark in the early 1980's when Vanguard started an S&P 500 index fund.
Investors viewed their hedge fund investments as a safe, robust, “floating return” concept that made some money (more or less) in all markets with returns greater than the risk-free rate of return, e.g. 30 day, 90 day, and 1 year T-Bills. Profits over and above the T-Bill “hurdle rate” received a 20% incentive fee. In addition, there was (and still is) a management fee of 1-to-2%.
Fast forward to today: what has occurred over the last 30 years is that investors began to believe the 2/20% fees are the reason hedge funds should "outperform" the S&P 500, which has subverted the original goal of absolute returns in any stock market environment.
The cause of such bullish and misguided investor expectations was (and is) greatly due to the central planning of the Fed to keep a stock market decline from occurring. That's seemed to negate the historical three years up and one year down business and stock market cycles. The new psychology or thinking was that down cycles are not to be worried about because of the "Fed Put," started by Fed Chairman Alan Greenspan in 1996.
Curmudgeon's Corroboration: Francis Gannon, co-chief investment officer at Royce Mutual Funds, recently was quoted in the NY Times:
“This particular cycle has been affected by the actions of the Fed and the many unintended consequences of what the Fed has done…..The laws of finance have been suspended for quite some time. Now this is starting to crack. I think we are on a road to normalization.”
The conclusion was that most equity oriented hedge funds became long biased "leverage" funds to outperform stock indexes. That kept investors satisfied, while the managers collected their 2/20% fees. The (mistaken) perception of investors was that "out performance” was the goal," rather than consistency of returns over both positive AND negative markets. This is the PRIMARY reason why hedge funds (sometimes called “Alt Funds") have not been robust. They are over exposed to the long side when the markets fall!
The logic of the original concept of hedge funds was best summarized by this quote:
“Don't go for knockout in one punch, if your desire is to stay longer in the fight and thrive; go for outlasting them. Take the higher road.” by Assegid Habtewold, The 9 Cardinal Building Blocks: For Continued Success in Leadership.
That mentality is out the window now, in order to satisfy investors’ bullish expectations and thereby increase Assets Under Management (AUM). As a result, the term "Hedge Fund" has become an oxymoron in most cases today.
Victor's End Note:
Managed Futures are not to be confused with Hedge Funds, because they are a separate asset class. Highly correlated to GDP, interest rates, and the CPI, Managed Futures returns have been very low since 2009. The very weak economic recovery or "expansion (?)" is due to President Obama's failed fiscal policy and politics, as I've explained in many previous Curmudgeon posts.
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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