Both global and regional hedge funds have generated close to zero returns for the last 18 months. Some of the returns posted by public databases look even worse, due to distortions from smaller high-beta managers and limited coverage of larger managers.  The main culprit would seem to be long-short equity strategies which have really struggled with both market exposures and stock selection. This raises questions about whether the long-short business model is broken, whether the cost structure is wrong or is it just cyclically out of favour.

We have taken a closer look at the Asian long-short strategy over the last 10 years and looked into the attributions of the average gross monthly returns. In undertaking this exercise we took the following approach:

•    Population - The population was made up of the Asian long-short funds on Albourne’s platform which will be the main funds in which our clients have underlying investments. This will not be representative of all Asian long-short funds as there should be a quality, institutional and size bias. Not all funds on our platform can be included due to requirements of non disclosure agreements.

•    Aggregation - For practical reasons we aggregated the returns into one broad index.

•    Fees - We created a hypothetical gross return based on a typical fee structure. This may create some understatement in fees in periods when managers both made and lost money. This fee includes both a management fee and a performance fee.

•    Beta - We calculated a single beta over the 10 year period using the slope of the best fit regression line using gross fund returns and market returns including dividends.

•    Interest - If we assume the beta component is invested in equity, 1-beta can enjoy a risk free interest rate. This is a rather simplistic few of the cash management of a hedge fund using a prime broker.

•    Alpha - Alpha is the excess fund return left after deducting fees, the market return on the beta component and the risk free rate on 1-beta. Arguable alpha should be pre-fees but we have used the term to means alpha available to the investor, though we also refer to a pre-fee alpha which adds back these fees.

Over this period our population returned an average monthly gross return of 1.29% and a net monthly return to investors of 0.92%. Over this period the beta was 0.35 and this created a beta component in the return of 0.41% per month. The pre-fee alpha averages 0.78% per month which is then split 0.38% in fees to the manager and 0.4% alpha left for the investor. This equates to the managers almost sharing the pre-fee alpha 50/50. This ends up significantly higher than 20% performance fees as the manager enjoys fixed management fees, and performance fees on beta and interest.

Certainly the manager’s share of pre-fee alpha does seem high. However, part of the argument for paying a premium fees is to finance a higher quality research product, yet have capacity constraints on AUM. Market forces ultimately decide if an investor will keep paying this fee share. We have seem this happen over the last few years with an aversion against higher net hedge funds where more fees are getting paid on beta, yet lower net hedge funds and boutique long only managers have thrived.

 We tried to quantify the extent of our quality, institutional and size bias by looking at broad market EurekaHedge data for Asia ex. Japan long short managers. The average estimated monthly gross return was similar at 1.32%. However, the beta was much higher at 0.52 and the alpha was lower. In this case the manager enjoyed around 5/8th of the pre-free alpha in fees. This supports our view that the larger more institutional managers generally have a higher quality of return.

Currency is also a factor to consider as a hedge fund will typically hedge in to the fund currency to protect the absolute value, whereas long only managers typically doesn’t and is benchmarked against an index expressed in the funds currency. Therefore, local currency indices should be a better benchmark for hedge funds than a composite USD index. We found the attribution was still very similar but the beta was higher at 0.45. However, the higher beta on a lower return gave a similar attribution.

The Japan factor

The Japan factor is significant. In the long only community, a mandate is very clear whether it includes Japan or not. In hedge funds it is much less certain. Some clearly state they don’t do Japan. Some can but don’t. Some use it as a source of shorts. Even if we try to split the Asian long short universe into Asia ex-Japan and Asia including Japan, the return streams aren’t that different. However, the benchmark including Japan is significantly weaker, so alpha appears higher. Using a USD composite index including Japan adds 0.12% to average monthly alpha. Using a local currency composite including Japan adds a further 0.11% per month.

Over the last 10 years we have looked at attribution by year. The last 12 months have been very difficult and for the first time in 10 years we are seeing aggregate negative alpha. The actual 2008-09 crisis was more of a beta problem than an alpha problem. The immediate rally afterwards had been low alpha but was good for beta. Up until mid 2011 we had seen a good alpha recovery. The period since then has characterised by severe macro driven corrections such as August/September 2011 and May 2012. This has been accompanied by very low volumes, brutal short covering, excessive de-ratings and a strong rotation into defensives. Long alpha have been very difficult and too few managers have been good enough on the short sid

Although this return profile is not great, we don’t see it has a crisis yet, especially for this group of larger more institutional managers. Alpha has not been as easy post-crisis but it is still there most years. Even in a bad year like this year, the negative alpha is still modest. However, it does seem like a shrinking group of managers are navigating these conditions successfully.

We did similar analysis for the broad market EurekaHedge data for Asia ex-Japan long short managers. The current problem is more extreme as the beta is higher, leading to higher losses and alpha has been overall negative post 2008-09 crisis. As smaller managers are more prevalent in these indices, this makes us very cautious on the outlook for these managers.

It is very clear that post 2008-09 crisis the industry has already cut net exposures. Clearly some of this was reacting after the fact as can be seen with beta reaching a low with the market in March 2009 and dipping again after August/September 2011. The longer term trend is still towards a lower net. This is more driven by older high net managers losing assets than changing their style.

Lower net managers have been rewarded with more assets and most of the successful new launches have tended to have low nets as well. Many managers now run strategies with net exposures between 20-45%. We expect the observed beta to be a little lower than the cash net due to a value bias and more cyclical shorts. Therefore, we expect beta to stay around 0.2 to 0.3.

We are a bit cautious on the value attached to short term beta measures and they become more distorted by alpha. Consistent alpha in a trending rising market will exaggerate the beta. We started the analysis by raising a few questions:

Is the long-short business model broken?

The investors have “spoken with their feet” over high net managers which were the historic core of the Asian hedge fund industry. These managers used to run average nets of 70%, and many have now shut or seen large outflows. A much lower net institutional hedge fund model is taking over. When investors want high net exposure and a high alpha manager, they have increasingly gone to boutique long only managers. The business models have had to change with investor demand and they may need to change again if alpha is not sufficient.

Is the cost structure wrong?

The manager’s share of pre- fee alpha probably was too high at close to 50/50, but going forward fewer investors are prepared to pay performance fees on beta, unless the manager’s alpha record is exceptional. In some of the boutique long only space we are seeing hybrid fee structure emerge to address some of these concerns, yet recognize this is still a premium research based product.

Is the strategy cyclically out of favor?

We have been through a challenging periods for many stock pickers. This shows itself in a number of measures; low divergence between different percentile ranges, weak performance of the value factor, high valuation spreads between cyclical and defensives, very low liquidity and the risk on/risk off nature of the market. A lot of this will prove cyclical and will revert in time. The key differentiating factor in managers in the last few years has been short side alpha. Too few have focused enough resource here. Current industry returns aren’t satisfactory but investor pressure has already created change and will continue to do so. A stronger industry will emerge out the other side.