Have Hedge Funds Grown Too Large?

Leo Kolivakis's picture

Via Pension Pulse.

The Vancouver Sun published an article from Laurence Fletcher of Reuters, Have hedge funds grown too large?:

The
hedge fund industry's strong rebound from the credit crisis has
prompted investors to ask whether some funds have grown too large and
inflexible to keep delivering bumper returns for which the sector is
famous.

 

The growth of big funds -- helped by strong returns during
the credit crisis and some clients' belief that risks are lower than in
start-ups -- helped push industry assets to $1.92 trillion at
end-December, close to the all-time high in 2008, according to Hedge
Fund Research.

 

However, with the growth
of big funds has come the old question of whether they could be stuck
if another crisis hits, whether liquidity forces them into less
profitable markets and whether their prized trade ideas will be
discovered by rivals.

 

"By definition a supertanker can't be as
nimble as a speedboat," said Ken Kinsey-Quick, fund of hedge fund
manager at Thames River, part of F&C, who prefers to invest in
funds below $1 billion in size.

 

"They won't be able to respond to
market conditions, especially as markets become illiquid. They can't
get access to smaller opportunities, for example a new hot IPO coming
out of an investment bank -- if everyone wants it then you'll only get a
few million dollars (worth)."

 

Funds betting on bonds and currencies, and CTAS -- which play futures markets -- in particular have grown strongly.

 

Brevan
Howard's Master fund, which is shut to new clients, has grown to $25
billion after gaining around 20 percent in 2008 and 2009, while Man
Group's computer-driven AHL fund is now $23.6 billion, helped by a 33
percent return in 2008.

 

Meanwhile, Bluecrest's Bluetrend fund,
which has temporarily shut to new investors in the past, has nearly
tripled in size since the end of 2007 to $8.9 billion after a 43
percent gain in 2008. And Louis Bacon's global macro firm Moore Capital
has grown to $15 billion after a good credit crisis.

 

LIQUIDITY

 

While
capacity varies between strategies, some clients worry about the time
it can take a big fund to sell a security in a crisis. Even in today's
markets a small fund can sell a position with one phone call while it
may take a big fund a morning.

 

"It's
even more difficult than before the crisis to turn around your
portfolio. Liquidity in the market is not back to where it was. A fund
of $20 billion in 2007 was easier to manage than it is now," said
Philippe Gougenheim, head of hedge funds at Unigestion.

 

"Because
of poorer liquidity you're paying a higher price to get in and out of
positions. Given the current political and macroeconomic environment
it's important to be able to turn around your portfolio very quickly."

 

Big funds may find it hard to keep trades secret long enough to implement them, especially when buying or shorting stocks.

 

One
hedge fund executive told Reuters his firm's flagship fund, once
several billion dollars in size, used to break up trades between a
number of brokers or initially sell a small amount of the stock -- which
could give the market the impression it planned to sell more -- before
buying heavily.

 

Meanwhile, Unigestion's Gougenheim said fixing a
meeting with managers of big funds can be hard -- if a manager runs
most of the money they can be hard to pin down, while if they run a
small part it can be hard to find out who runs the rest.

 

"NOT AN ISSUE"

 

However, fund executives say markets are liquid enough.

 

"Size
is not an issue whatsoever," Nagi Kawkabani, founding partner at
Brevan Howard, told Reuters, adding that the fund's gross exposure --
the sum of bets on rising and falling prices -- was lower than at the
start of 2008.

 

"Markets are much
bigger and deeper than they were five or 10 years ago." Brevan would
return money to clients if funds became too big, although there are no
plans at present, he said.

 

Thames River's Kinsey-Quick said big
CTAs could find it hard to trade smaller markets, although they may
take small bets in these markets to show clients they can play them.

 

An
AHL spokesman said size was "a major advantage... It gives us great
purchasing power with brokers which translates into tighter spreads
whilst paying pay lower commissions."

Hedge funds are one of my favorite topics. One of the best jobs I ever
had in the pension industry was working with Mario Therrien's group at
the Caisse de dépôt et placement du Québec,
allocating to external hedge funds. I was the senior analyst
responsible for analyzing and covering directional hedge funds:
Long/Short equity, short sellers, global macro and commodity trading
advisors (CTA) funds. It was a fun job because I got to meet a lot of
managers from different backgrounds and talk markets with them. I also
learned about their strategies and the differences between directional
and market neutral alpha strategies.

No matter who was sitting across the table from me, I never shied away
from asking tough questions on their organization, operations,
investment process and risk management. Allocating money to hedge funds
isn't a job for the shy and timid; you got to be able to grill them when
you need to. But I also listened carefully to their responses, paying
close attention to how they addressed difficult periods. The best hedge
fund managers aren't uncomfortable talking about periods where they lost
money and how they coped. Anyone can talk up a great game when they're
making money but very few managers have the self assurance to talk about
the difficult periods. For me, those discussions were crucial and told
me a lot about the manager, and more importantly on the organization's
culture and depth. The toughest part of that job was the constant
traveling which takes its toll.

Getting back to the article
above, there are several things I want to bring to your attention.
First, back in September 2008, I wrote a comment that the shakeout in the hedge fund industry will be brutal. Last March, I wrote on their incredible comeback as institutions were increasingly horny for hedge funds. And institutional funds keep pouring billions into hedge funds. According to a recent survey by Preqin, an independent research firm focusing exclusively on alternative assets, there was a 50% rise in public pension plans investing in hedge funds over the past four years:

Preqin
research shows that the number of public pension systems investing in
hedge funds has increased significantly over the past four years. There
are now 295 public pension plans worldwide known to be allocating to
hedge funds, up from 196 in 2007. The mean allocation to the asset class
has also grown in the same period from 3.6% to 6.6%; it is now one
percentage point higher than the average private equity allocation of
these investors.

Public pension systems and hedge funds:

  • Pension systems generally invest in hedge funds for capital preservation and portfolio diversification purposes.
  • They seek absolute returns of 6.1%, lower than the average expectations of other investor types which stand at 7%.
  • Funds of hedge funds are popular with pension funds – four-fifths
    of public pension systems that made their first hedge fund investments
    in 2010 did so through multi-manager allocations.
  • 70% of all pension funds investing in hedge funds have funds of funds commitments in their portfolios.
  • The top 10 public pension system investors in hedge funds have a collective $836bn in AUM

Public pension systems’ hedge fund portfolio performance:

  • As of Q2 2010, hedge funds showed positive one-year returns.
  • Hedge funds have outperformed listed equities over a three- and five-year period.
  • Hedge
    funds have outperformed public pension funds’ average annualized return
    expectations of 6.15% by producing average returns of 9.8%.
  • Despite
    negative returns over a three-year timeframe, public pension system
    investors have increased their allocations to the asset class; this is
    in stark comparison to the many high-net-worth counterparts that have
    reduced their hedge fund commitments during the period.

You can download the full Preqin report by clicking here.
I'm not shocked to see public pension plans allocate aggressively into
alternatives, which include hedge funds, private equity funds, real
estate funds and infrastructure funds. Why are they doing this? Many
plans are underfunded so to make up for the shortfall, they're reducing
their fixed income allocation and going into hedge funds and other
alternatives. As the big beta boost in the stock market matures, pension
funds are focusing more on alpha strategies that can deliver returns in
turbulent markets. Also, many pension funds have investment policies
that limits the amount of leverage they can take internally, which is
why they allocate to external hedge fund and private equity managers to
increase their leverage.

Not surprisingly, the bulk of the assets
have been going to liquid hedge fund strategies like global macro, CTA
and L/S equity. It was two years ago when I wrote a comment on the death of highly leveraged illiquid strategies.
Nothing has changed; they're still dead. Post 2008, there is a premium
for liquid alpha strategies and most of the smarter institutional
investors are managing their liquidity risk very carefully.

Some public pension funds know what they're doing, scoring big with hedge funds. I cringe, however, when I read that Preqin finding that four-fifths
of public pension systems made their first hedge fund investments in
2010 did so through multi-manager allocations and that
70% of
all pension funds investing in hedge funds have funds of funds
commitments in their portfolios. I'm not a big fan of fund of funds
which add another layer of fees. If by "multi-managers" Preqin meant
mutli-strategy hedge funds, then that's fine (standard 2 and 20 fee
structure). Keep in mind, fund of hedge funds were facing extinction in December 2008. It's amazing how fast things have turned around.

It's true, the top hedge fund managers know about making money,
generating huge brokerage commissions that gives them access to some of
the best investment ideas Wall Street generates. But even the best
hedge fund managers can experience a serious hiccup (witness Philippe
Jabre's recent $300 million Japan mistake). And I get really nervous when I read that GAM just launched another retail fund of funds. Just tells me things are getting frothy again in hedge fund land, but it also confirms my suspicion that we're heading towards another 1999, as all this liquidity finds its way into stocks, bonds, currencies and commodities.

Have hedge funds grown too large? Maybe, we'll see during the next
crisis, but I still favor liquid over illiquid alternatives. I would
however look at allocating more to market neutral funds in this
environment but be careful with the leverage they're taking. Moreover,
institutional investors, especially those with little or no experience
with hedge funds, should strongly consider the merits of a managed account platform that allows them to control operational and liquidity risk. The last thing you need is to invest in some fake hedge fund that defrauds you.

***UPDATE***

An industry expert shared these comments with me, which I share with my readers:

I
agree with you, favoring liquid strategies vs illiquid ones. The
biggest problem with illiquidity is that investors were not getting paid
for providing liquidity to others. At the very least, if you take the risk of doing it, get compensated for it!!!

 

In
terms of who can use managed account platforms (MAP), I believe it
applies to all kinds of investors, not only to those with little or no
experience. What we’re seeing this year
is the very large and very experienced going to MAP in order to better
control their risks. The “cash on steroids” approach.

 

Finally, the size debate is a hot topic, with arguments going both ways. My take is the following: returns will necessarily diminish with the size of the HF. You can have a Bridgewater one year, but that’s just one exception rather than the norm. On the other hand, I do not agree that they are getting too big for the financial system.
Goldman is the largest HF, they have permanent capital (or I should say
they act like if they have permanent capital…) and their size dwarfs
any hedge fund. I would be much more worried about Goldman, vs the others who manage their liquidity risk much more carefully now.

I thank him for sharing his insights with me and letting me post them here. he also sent me this Infovest21 article,
which discusses how large US pension funds are increasing direct
allocations to hedge funds and some are using fund of funds as
subadvisors
to facilitate
knowledge transfer so the pension may eventually take on the
internal management of the hedge fund program.