A New Era of Hedge Fund Transparency?
Submitted by Leo Kolivakis, publisher of Pension Pulse.
Bloomberg reports that the world’s 300 largest pension funds shed $1.5 trillion last year as the financial crisis reduced the value of their holdings, a study by consultant Watson Wyatt Ltd. and Pensions & Investments journal showed:
The decline amounts to 13 percent and left the holdings of the funds at $10.4 trillion at the end of 2008, according to the report released today.
The MSCI World Index of stocks reached a 14-year low on March 9, reflecting the fallout from the global credit crisis and an unprecedented series of bank bailouts following the bankruptcy of Lehman Brothers Holdings Inc. last September. The MSCI index has since recovered, gaining by more than half from its low.
“The world’s largest pension funds were not exempt from the economic crisis and have been set back a number of years,” Carl Hess, global head of investment consulting at Watson Wyatt, said in the report.
“They will now be focusing even more on risk management and reassessing their governance arrangements.” [SIGH!]
Citing the same study, another article from Reuters states that the world's largest pension funds saw total assets fall back to 2006 levels last year:
The assets of the largest 300 schemes fell by 13 percent in 2008 to $10.4 trillion (6.3 trillion pounds), although the compound annual growth rate CAGR.L was at around 10 percent over five years.
"The world's largest pension funds were not exempt from the economic crisis and have been set back a number of years," said Carl Hess, global head of investment consulting at Watson Wyatt.
"While, over a five-year period, they still show impressive growth, results in aggregate during the last decade have been more volatile," he said.
The study, conducted with U.S. publication Pensions & Investments, showed the Asia-Pacific region's share of global pension assets -- about $3 trillion -- has surpassed that of Europe for the first time. The United States is still home to more than 40 percent of global pension assets, at $4.2 trillion.
CAGR figures, however, show that North American pension assets are struggling to keep pace. Asia-Pacific CAGR is at 19 percent over five years, while Europe's is at 12 percent and North America is at 4 percent.
Japan has the second-largest individual market share by country at 19 percent, dominated by the $1.3 trillion Government Pension Investment Fund, which tops the overall ranking for the sixth year in a row.
The research showed that assets held by Taiwanese funds grew at the fastest rate during the five years to the end of 2008, by 14 percent in dollar terms.
It will be interesting to see where we end up this year, but so far, the trend in stocks is up and from my readings of the markets, I see this liquidity-driven rally going on for a lot longer than most pessimists think.
Late this afternoon, I got to chat with a senior pension fund manager who I respect. This guy manages billions and he gets it. He understands what is going on in the markets and in the hedge fund industry. He invests looking forward, not backwards.
He agreed with me on a lot of things. First, growth will surprise to the upside as productivity gains show up in GDP figures. Second, there is abundant liquidity out there to spur the markets much higher. Third, the hedge fund industry has lost its luster after the Madoff scam and the power has now shifted over to LPs.
His exact words: "The days of giving some hedge fund 2 & 20 to manage money without asking any questions are over. Investors will be looking at managed accounts more closely and they will want more transparency. And they're not going to pay 2 & 20 for beta".
If you didn't read my last comment on hedge-fund heave-ho, then go back and read it carefully. As I predicted last December, fund of hedge funds are facing extinction, and 2008 spelled the death of highly leveraged illiquid strategies.And mark my words, the brutal shakeout in the hedge fund industry is not over.
On these last few points, Pension & Investments reports that the secretive Renaissance Technologies Corp., hit by performance problems and huge redemptions in its largest open hedge fund, may concede greater transparency in the strategy for large institutional investors [HT to twinkie]:
Renaissance Institutional Equities Fund's -12.6% return in the first half of the year sharply lagged the Standard & Poor's 500 index's 3.19% for the same period. The second quarter was especially bad: The long-short equity fund returned -4.73% vs. the S&P 500's 15.93%, according to performance data from eVestment Alliance LLC, Marietta, Ga.
The RIEF strategy is designed to outperform the S&P 500 index, gross of fees, by 400 to 600 basis points over a rolling three-year period with lower volatility (10.5 vs. the S&P 500's historical volatility of 15 to 16).
That short-term underperformance is “disappointing” to James H. Simons, RenTech's iconic CEO, chairman and founder. Renaissance Technologies is based in New York and East Setauket, N.Y.
Over the past two years, RIEF's assets have plummeted 81% to $5 billion as of June 30, down from a peak of $27 billion. The outflows stem largely from high-net-worth “hot money” that came into the fund via bank distribution channels, hedge funds of funds and institutional investors taking advantage of the fund's easy redemption terms to make up for tight liquidity conditions.
RIEF offers monthly redemption which has never been restricted, something Mr. Simons insisted on when the fund was established.
“I never liked lockups when I was on the other side of one and didn't want them for these funds. Investors have been withdrawing from the funds because they can, especially with RIEF not doing so well this year,” Mr. Simons said in an interview.
Given RIEF's performance problems and declining assets of its institutional arm, RenTech officials could offer large institutional investors a new investment vehicle with more transparency — a huge concession from the tight-lipped hedge fund manager.
The driver behind this move is Matthew H. Scanlan, formerly managing director and head of the Americas institutional business at Barclays Global Investors. He became president and CEO of Renaissance Institutional Management LLC, the RenTech subsidiary that manages quantitative long-biased funds, in February and has begun to imprint his institutional perspective on the firm's management.
Mr. Simons agreed: “Matt has begun to make important changes to how we present our strategies to institutional investors, and he has been urging us to offer some degree of transparency as we plan to do in the new (RIEF) structure.”
Renaissance — best known for its fabulously successful $10 billion hedge fund, the Medallion Fund, which reportedly returned 80% in 2008 and has been closed to external investors for years — simply did not have to offer investors transparency. Sources said many investors in slow-trading RIEF and its sister fund, Renaissance Institutional Futures Fund — a global futures and forwards fund — assumed or hoped they would be getting a little of Medallion's nanosecond trading success, and didn't insist on transparency when they handed over their money.
But “in the wake of (Bernard) Madoff, everyone wants more information about their investment strategies,” Mr. Simons said.
“Historically, we did not provide investors with a lot of details about the strategies because we're a target for reverse engineering and we have a lot of trade secrets around here to protect. But it is possible to be a bit more open,” said Mr. Simons.
“We are looking at a new (RIEF) structure for large institutional investors that would offer some disclosure. We don't have the exact details ready yet, we're still tinkering with the model, but it will offer more information for large institutions that agree to appropriate confidentiality arrangements,” Mr. Simons added.
The move to give institutional investors even a little peek into one of the firm's “black box” quantitative strategies is a big concession for RenTech. Institutional investment consultants have decried RenTech's lack of transparency since RIEF's introduction in 2005.
One consultant who insisted on anonymity said Renaissance's prospects for institutional success are low unless its offers some degree of transparency. “We've tried to get to know them, without much success,” the consultant said. “They will not give away any transparency, and we just don't know what's under the hood. RenTech just ends up being so much more work that we're better off looking at other managers for our clients.”
Slump must end
Transparency notwithstanding, Mr. Simons said the “real issue is that the fund (RIEF) has to pull out of its slump. We came into 2009 looking very good, well ahead of the S&P (500 index) and during the first couple of months of this year, we were going like gangbusters, but in March and April we did poorly. The fund has its own mind and doesn't like some of the stocks that the rest of the world likes. People are very skittish right now.”
The fund is 100% net long — going 175% long vs. 75% short — with a beta of 0.4.
RIEF met its performance goal in all but two of the past five quarters on a rolling three-year basis, according to a Pensions & Investments' analysis of data from eVestment Alliance. In the second quarter of 2008 and the second quarter of 2009, the fund still outperformed the S&P 500, but by less than 400 basis points.
RIEF's average outperformance of the S&P 500 over a rolling three-year period was 599 basis points, according to P&I's analysis.
While redemptions and negative performance in RIEF and RIFF have combined to drop firmwide assets 53% to $17 billion as of June 30 from a peak of $36 billion in mid-2007, sources say RenTech executives might not be worried about the fate of the two RIM funds because Medallion remains so successful. About 35% of Renaissance's remaining assets are managed for institutional investors, according to a source with knowledge of the firm who declined to be identified.
Mr. Simons' himself admitted that “the life of the firm does not depend on these funds (RIEF and RIFF), but I like these funds. I have a lot of personal money invested in them, as do other Renaissance employees.”
Mr. Simons, 71, also said the firm's success does not depend on his presence, noting that his own retirement “won't be too terribly” far away. He said that over the past few years, he has moved many of the firm's day-to-day operations to Peter Brown and Robert Mercer, co-presidents.
“I could step out without the walls falling down,” Mr. Simons said.
Last Friday, the WSJ reported that according to a Securities and Exchange Commission watchdog report, Renaissance Technologies raised questions about Bernard Madoff at least as early as 2003:
James Simons met Mr. Madoff through Long Island business relationships formed in the 1980s, The Wall Street Journal reported in February. Mr. Simons's positive view of Mr. Madoff subsequently helped Mr. Madoff raise money from others. But as the new SEC report shows, Mr. Simons and others at his firm later grew distrustful of Mr. Madoff.
In April 2004, the SEC in a routine examination of Renaissance unearthed internal 2003 emails among executives of the firm outlining concerns about the Madoff firm's trading and claimed profits, the report said. The SEC followed up with a 2005 exam of the Madoff operations that failed to uncover fraud.
The first Renaissance email, dated Nov. 13, 2003, was written by Nathaniel Simons, son of founder James Simons and manager of the firm's division that selects other hedge funds where Renaissance puts employee and client money.
The younger Mr. Simons noted what he considered several strange characteristics at Mr. Madoff's operation, including unusually low fees and market rumors that Mr. Madoff cherry-picked profitable trades for certain clients. One industry consultant suggested to Renaissance employees that Mr. Madoff would soon run into "a serious problem," Mr. Simons wrote.
The email from Nathaniel Simons, which was sent to senior Renaissance executives including James Simons, suggested that New York's then-attorney general, Eliot Spitzer, who had prosecuted high-profile securities-fraud cases, should be on alert for Madoff.
"It's high season on money managers, and Madoff's head would look pretty good above Elliot [sic] Spitzer's mantle," the younger Simons wrote. He added that unless Renaissance could "get comfortable" with the regulatory risks, the firm should "get out."
Separately, following the November 2003 email from Nathaniel Simons, Henry Laufer, Renaissance's chief scientist, questioned Mr. Madoff's ability to exit the market, selling its investments and holding primarily cash supposedly to avoid losses that hit other investment firms.
The timing of the moves, Mr. Laufer said, was almost statistically impossible. "We would have loved to figure out how he did it so we could do it ourselves," he testified this year to the SEC. "And so that was very suspicious."
Renaissance didn't pull its Madoff investments immediately, according to the report. Nathaniel Simons told regulators the firm believed the SEC had closely examined Mr. Madoff's investments, and regulators should have been able to perform the same analysis of Mr. Madoff's trading strategy that Renaissance had. He told the SEC, "[Y]ou just assume that someone was paying attention to make sure that there was something on the other side of the trade."
"We did feel that despite the fact that we're kind of smart people, we were just looking at matters of public record," he also said in his testimony.
However, Renaissance became increasingly uncomfortable with Mr. Madoff and withdrew money, and James Simons urged other investors he knew to withdraw, people familiar with the matter said.
Renaissance employees expressed dismay in testimony to the SEC this year that regulators hadn't unearthed Mr. Madoff's fraudulent trades. "This is not rocket science," Mr. Laufer told the inspector general's office, according to Friday's report.
In that comment, I raised my concerns about Renaissance Technologies because their returns were outstanding and based on highly sophisticated mathematical models that only a handful of people in the world understand.
Now we see that even the mighty "RenTech" can experience a drawdown and they're wise to change their tune on transparency (even if it is a bit). As I stated above, the days of giving a hedge fund millions of dollars to manage without asking for any transparency are over. Moreover, I suspect in the not too distant future there will be new regulations that will mandate managed accounts for all these investments.
But let me be clear on something: transparency without liquidity and full control and understanding of investments and strategies is useless. You do not want to second guess your hedge fund managers every time they experience a losing month, but you want to be able to pull the plug on them if losses cross a certain threshold or if they violate their investment agreement.
This is why it makes sense to partner up with professionals that understand hedge fund strategies and have experience with managed account platforms (go back to read my comment on hedge fund heave-ho).
The rules of the game have changed. After the disaster of 2008, pension funds will be scrutinizing their investments a lot more carefully, especially their investments in alternatives like hedge funds, private equity, real estate and commodity funds. Those funds who refuse to adapt will find it extremely difficult to raise the money they need to compete.