Morgan Stanley's chief US equity strategist, Adam Parker, has not had a good year so far and as we reported last week has one big fear: being "the counter-indicating idiot."
Today, we give Parker credit for tackling head on the very sensitive issue of persistent asset management underperformance, and unlike his hedge fund peers who ascribe just an 8% causality to "stock selection" as the driver behind poor returns (with more than a majority blaming their peers or "crowding") Parker is at least honest: "the truth is that 100%, at some level, should have said “poor stock selection”, and what these data reveal is that 92% of respondents are blaming something other than their stock selection methodology for the current underperformance. Our portfolio has outperformed for five straight years, and is lagging this year. It is 100% stock selection."
With that out of the way, Parker then proceeds to list the 10 specific excuses given by hedge funds to justify their poor performance for the 7th year in a row.
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From Morgan Stanley's Sunday Start, by Adam Parker:
The Ten Excuses for Bad Performance
At two recent Morgan Stanley investor conferences, the question of poor hedge fund performance surfaced repeatedly. We surveyed a group of long/short fundamental equity hedge fund managers at one of the conferences, asking them for the primary reason for poor performance of their industry.
The answers were: 54% said “crowding”, 23% said “factor exposures”, 8% blamed “macro headwinds” and 8% said “poor liquidity”. The remaining group (also 8%) said “poor stock selection”.
In other words, when performance is bad, it is beta, when performance is good, it is alpha. The truth is that 100%, at some level, should have said “poor stock selection”, and what these data reveal is that 92% of respondents are blaming something other than their stock selection methodology for the current underperformance. Our portfolio has outperformed for five straight years, and is lagging this year. It is 100% stock selection.
The alpha from the HFRI long-short index was close to 14% per annum in the early 1990s, and has been slightly below zero for the past few years.
Why is this? We don’t claim to have some systematic rank ordering of reasons for the decay in performance, but here are ten thoughts.
- First, there has been massive growth in the total number of hedge funds, with HFR estimating that there are 3,400 equity-focused hedge funds today (about as many as stocks under global coverage by the Morgan Stanley research department).
- Second, low interest rates have removed the rebate that hedge funds received, a non-trivial driver of historical returns when rates were materially higher.
- Third, hedge fund CIOs are increasingly cautious. Since 2003, FAS123R has made it illegal for hedge funds (and everyone) to know anything material and non-public in the US, at least, and the high-profile and frequent investigations of hedge funds have curtailed information-seeking at some level.
- Fourth, the more rapid availability of information has materially shortened the time arbitrage that existed previously. The days when you ran to a pay phone to call a large portfolio manager in Boston when you learned something you thought mattered have been over for years. You have to publish something first that passes the smell test from nine different editors, compliance officers, control groups and stock selection committees.
- Fifth, there increasingly appears to be a “group think”, as going to Omaha to hear what Warren Buffett says has transitioned to systematically tracking billionaire holdings and riding out the last bit of momentum from their ideas. Everyone attends or hears about the pitches made by successful hedge fund owners at industry conferences, dinners, charity events and presentations, making questions about “crowding”, well, crowded, to quote a friend.
- Sixth, the quants have stolen some of the alpha. Everyone knows the quants are onto something, so they are hiring junior quants to analyze their “factor exposures”, even though they don’t know what to do with the information once they get it. The HFRI equity market neutral index has beaten the HFRI long-short by about 3% per year for the last ten years, so the “quant thing” isn’t new. In addition, liquidity quant trading, baskets and ETFs have potentially been “sucking” alpha out of the traditional long-short industry.
- Seventh, the LPs don’t invest in hedge funds for as long as they used to, as their manager selection gets analyzed and evaluated, creating more fear of redemption today vs. yesteryear, and exacerbating short-termism among the hedge funds. We don’t remember anyone saying in 1995 that they were bullish on the market because hedge fund performance has been so bad that there may be redemptions and a ‘you might as well go for it’ melt-up. We hear that regularly now.
- Eighth, macro explains a higher percentage of total returns today than in the past, and most hedge funds are set up for bottom-up security selection. This may have been prudent in a 1995 world where 80% of the average stock’s performance was idiosyncratic, but with macro now explaining well over half of the average stock’s returns, many classic hedge funds may be sub-optimally staffed for the current opportunity set. Macro explaining a higher percentage of returns has, in turn, impacted dispersion (which became low) and correlation (which became high), and the dollar, rates and oil exposures, among others, are material on many books.
- Ninth, while all active management has suffered, long-only firms began to realize they could replicate some of the more successful hedge fund approaches, shifting some of the alpha away from the hedge fund industry over time.
- Tenth, the capital markets have been less supportive, meaning, the ‘free money’ associated with IPOs in the 1990s has clearly slowed. Very few high-profile deals have been monster stocks this cycle.
While this surely isn’t a comprehensive or rank-ordered list of reasons for weak alpha generation, it hopefully touches on some of the issues. When will excess performance be likely again? Our suspicion is that much wider dispersion is required, and this isn’t likely until long-dated rates back up meaningfully or economic volatility grows materially. That said, dispersion is clearly wider than it was a year ago, and active management has yet to enjoy an improvement in performance. Here’s hoping that later this year we won’t need any excuses, due to good stock selection.