For an update on the sad state of the hedge fund industry, we go to the FT which confirms what we had been reporting every week in 2011 courtesy of the periodic HSBC hedge fund industry report, namely that less than one third of all hedge funds in 2011 paid material bonuses to their employees (or if they did, they better have done it without the knowledge of their LPs), because "more than two-thirds of hedge funds are below their high water mark., the point at which they are able to charge investors performance fees." And since performance fees, or the 20 in the "2 and 20 part", is where the discretionary component of analyst, trader and PM compensation comes from, it is safe to say that the bulk of hedgies did not have a good year in 2011. And, in fact, for many the anger goes far back: "It can be a long way back. Credit Suisse calculates that 13 per cent of hedge funds have not earned any incentive fees since at least 2007. Most of these are small funds with assets of less than $100m, which struggle to retain staff without the income available from performance fees." One such fund was of course Citadel which after its abysmal performance in 2008 only managed to climb above its high water mark in the past week for the first time since 2007. And while this is not really news, what is far more curious is that according to Credit Suisse hedge funds have resumed levering once again.
The bank’s hedge fund clients currently have leverage of 2.5 times, meaning that the average fund has $150 of debt added to each $100 of capital, off the post-crisis low of 2.4 times, but well below the 2.8 times high.
Cash balances have also fallen from 25 per cent of assets in the summer to 22 per cent now as confidence has improved.
Since there is just under $2 trillion in hedge fund "equity" or capital, leveraging this 2.5 times means that there is net purchasing power of roughly $5 trillion in the market, and the 0.1 turn of incremental leverage explains why the ongoing redemptions from equity mutual funds are being more than offset by a slowly levitating market.
Yet a far more important question is how many of these funds will fizzle out in the near-term and have to bring their leverage to zero by implication?
For many funds significant trading gains or a sustained change in stock market momentum is needed. Just over a third of event funds, which seek to trade around corporate activity such as mergers, or long-short equity funds that pick stocks, are at least 10 per cent below their high-water marks.
Such managers dealing with losses must also fight to retain assets. While the industry attracted $70bn in new capital in the first three quarters of the year, according to Hedge Fund Research, it saw very slight outflows in the final quarter as investors redistributed capital.
For instance, clients pulled $8.6bn from event and equity-driven funds in the fourth quarter, in pursuit of better performance. Macro funds, which seek to profit from broad economic trends, attracted $7.9bn, while relative value arbitrage – a strategy of seeking price differences between related securities that was one of the few not to lose investors money last year, according to HFR – took in $5.9bn.
Unfortunately, with hedge funds, or the once upon a time smart money, now trapped chasing the vagaries of momentum investing, where positions change on a daily basis courtesy of the far more dominant HFT, sometimes several times during the day, it is easy to see why the market is now far more irrational than ever, as fundamentals will not be a factor for a third year in a row, and the only two factors in investing will be "frontrunning the central bank" and "chasing the intraday stock heatmap." That neither are viable long-term strategies is obvious, but at this point that is a given.