Triumph of hope over experience
The worldwide demand for hedge funds and other absolute return funds will grow at an annual rate of 20% over the period 2005-8, according to the 2005 CREATE-KPMG report*. Since millions of people lost billions in the last equity bear market, this aspiration is understandable.
It is also easy to understand why two-thirds of investment professionals in the UK have changed jobs in the past three years. If anything, this jobs merry-go-round is spinning even faster in the US. Two plausible reasons are offered: the hedge funds are vacuum cleaning the scarce talent; and mainstream fund managers are responding by launching high alpha strategies to retain their talent.
So far, however, the deliverables have fallen well short of intentions. For example, only 4% of out-performance is attributed to skills of the managers, according to Edhec Risk and Asset Management Research Centre in France. Even if the figure is higher, it is hard to see how a vast drove of intrepid job hoppers can conjure up anything other than a perfect mirage. After all, for most investment strategies, alpha is a zero-sum game even before charges are taken into account: for every winner there is a loser, as in a game of poker.
Not surprisingly, some 76% of the trading volume in the US stock markets relied on passive investing in 2000-04, according to Utpal Bhattacharya and Neal Galpan of the University of Indiana’s Kelley School of Business. The comparable 1995-99 figure was 64%. Both figures are well above the ‘pure’ passive funds bought by investors. The implication is that actively managed funds are less active than they claim: many may be closet trackers, departing from the index only at the edges of their portfolio in order to distinguish from the herd.
Such tendencies also prevail in Europe but with some variability. Belgium, Italy and Sweden have figures as high as the US, but the figures for the UK is 50% and for Germany 31%.
Does it mean clients are being short-changed?
The answer is ‘yes’ in the sense that they do not necessarily get what it says on the tin and ‘no’ when one realises how hard it is to generate absolute returns year after year. Or, as chairman of a large US pension fund put it to us “when you’ve seen a successful alpha manager, you have seen one; they are a rare breed inside and outside the hedge funds space.”
Since the last bear market, clients have required their fund managers to deliver absolute return products by revamping their investment philosophy and processes. Regulators have added a whole raft of controls and systems to ensure that clients are treated fairly. All these changes are implemented with the best of intentions in order to encourage creativity in producing predictable outcomes for clients in line with the underlying value proposition.
But, in the process, they have failed to take into account one vital fact: throughout human history, creativity has usually produced unpredictable, not predictable, outcomes. By definition, creativity is about producing something new and different.
On this argument, to expect portfolio managers to be highly creative within a prescribed set of processes to be carried out in a constrained environment is akin to deliberately setting them up to fail. As the famous American humorist Groucho Marx once observed: “The secret of success lies in honesty and integrity. If you can fake them, you would be very happy”. For these managers, closet tracking is not their first or last choice; often, it’s the only choice.
No wonder, talent has flown into hedge funds. But even there, two factors have constrained the ability to generate absolute returns, mirroring the situation in the long only space. The first covers capacity. Our research shows that on the most generous definition, less than 15% of hedge fund managers have been able to generate absolute returns in the past three years. The rest are either untested or subject to a brutal burn and churn that characterises the hedge fund universe.
Second, this limited size of prime capacity would not be a problem if only it was scalable. But it is not. There are three approximate scale points, expressed in FUM:
q Single strategy managers need a critical mass of $100m (€78m) to break even;
q They prefer to go multi-product or multi-strategy in the $1-4bn range to avoid style drift;
q Most fund of hedge funds can be scaled up to $15bn.
These are orders of magnitude and clearly vary between strategies. But they serve to emphasise an important point: namely, growing the businesses in response to rising demand involves transitions that the majority of boutique hedge fund managers are unwilling to accept, because of the resulting dilution of their craft.
Furthermore, they see theirs as lifestyle businesses where profit matters more than growth, scope more than scale, performance more than size, autonomy more than ownership. Like rock stars, hedge fund managers can only work in small bands.
Migrating to a more complex business model has its own downsides. Most of the current generation of pure manufacturers is very cautious about going multi-strategy because it changes the ownership structure and invites bureaucracy. They accept that multi-managers are essential for dynamic switching but are unhappy about the side effects. Indeed, many large fund of hedge funds have found it exceedingly difficult to retain their pioneering spirit within a more complex business model.
In any event, they all have to grapple with three other paradoxes. Start-ups require a critical mass to attract money but without money they can’t build that mass. A sustainable business requires scale but scale is the enemy of alpha. Pension funds require governance discipline but discipline stifles creativity.
Each choice carries unpalatable risks. The same applies to long-only managers, who are pursuing hedge fund-type strategies within an unconstrained regime.
When choosing a product or an asset class, the most repeated ‘health’ warning for a would-be investor is that past performance is no guide to future outcomes. Yet, that is what fuelled the last bull market and it is undoubtedly at work in the current one. The record inflows into mutual, emerging market and property funds over the past 12 months by US, European and Japanese investors alike is largely driven by rocketing indices in the global markets. The ‘irrational exuberance’ of the 1990s is back.
Once again, investors are relying on a simple rule of thumb: growth in the recent past will continue into the foreseeable future. Much the same criterion is used when selecting a fund manager. Yet history teaches us that momentum-driven investment is what creates booms and busts. It also tells us that only a tiniest minority of portfolio managers generate absolute returns consistently for more than three years. Putting more and more money into a given fund soon exhausts its opportunity set: success begets failure before long.
In the 1990s, the first significant wave of money into absolute-return strategies was driven by high-net-worth clients. Many of them earned exceptional returns. The current wave is driven by pension funds in the mistaken belief that the past is a fair guide to the future.
Their underlying aim is laudable: to diversify into uncorrelated asset classes. After all, as markets in financial, physical and intangible assets evolve the scope for exploiting price inefficiencies is always present.
However, they need talented portfolio managers who can devise new strategies and commercialise them at ever faster rate, akin to a treadmill; in other words, people who have strong instinct for spotting opportunities and trading them profitably before competitors arrive on the scene.
These are people who need to work in an environment where they have the autonomy and space to generate and implement high conviction ideas. This ‘gut’ factor separates the stars from journeymen.
Not only are such people few and far between, most of them prefer to work in independent boutiques or pure play fund managers, not too encumbered by the bureaucracy and the quarterly-targets culture of the parent bancassurance groups.
Like their hedge funds counterparts, they prefer to work in small boutiques or teams, with their own restrictive scale points. The rhetoric of absolute returns sits uncomfortably alongside this underlying reality.
As a result, many absolute returns funds will increasingly be at the mercy of market movements. If they hit their targets, it will be more by luck than judgement. The industry’s ability to deliver skills-based returns is far more limited than the weight of current money implies.
Amin Rajan is the CEO of research consultancy CREATE email@example.com
*’Hedge Funds: a catalyst reshaping global investment’ is available from www.create-research.co.uk