Investment

Increasingly shunned by family offices – are hedge funds finally about to experience their final reckoning?

Hedge funds are unlikely to earn the approval of family offices any time soon. The Bank of International Settlements has gone further by warning their leveraged bets were undermining the US Treasury bond market when coronavirus struck.

Yet, the US Federal Reserve has just decided to throw $2.3 trillion behind positions held by hedge funds and other participants. It is even prepared to buy their junk bonds and ETFs

Fed chairman Jay Powell, a former partner at Carlyle, the private equity firm, says his actions will save an imploding US economy. It has certainly put a floor under the market.

Separating winners from losers from 15,000 active hedge funds feels like playing Whack-a-Mole

And this is not the first time the Fed has taken action to support Wall Street following problems with banks and hedge funds.

In his latest commentary, Howard Marks, co-founder of Oaktree Capital Management, reckons its actions amount to moral hazard, likely to irk the next generation.   

Family offices were already pretty dubious about hedge funds which once delivered double-digit returns but now get criticised for their lack of transparency, high fees and low returns.

A 2019 UBS survey said hedge fund allocations by family offices had fallen to 4.5% of their portfolio, half the level struck in 2015.

One family office told UBS: “I’m not a huge fan. I like a lot more visibility into what’s going on.” 

Another says he went off the sector in 2008, when hedge funds invested his money in private equity situations, contrary to promises.  

An adviser said he recently switched from hedge funds to long-only equities to avoid risk.  A family office said it had never learned much from hedge funds, despite their fees. In contrast: “When you have a direct deal, you are meeting the entrepreneur, learning about the business.”

Over the years, consultants at Willis Towers Watson have broken down returns at hedge funds, and discovered little evidence of skill. A lot of their return now comes from leverage. Advanced technology and fast-action trading can also help, although many systems have become depressingly standardised.

Family office consultant Cambridge Associates says: “Only a very small number of funds offer an appropriate level of risk-adjusted returns.” Higher market volatility could provide a boost to hedge funds, but a new bout of money printing could swamp them.

The share price of Man Group, the UK’s largest hedge fund player, is barely higher than twenty years ago. 

Hedge funds outperformed the equity indices in the crisis month of March with a fall of – 6.2%, according to an HFR composite index. 

Dan Steinbrugge, chief executive of advisory firm Agecroft Partners, believes clients will see them as satisfactory.

But returns have varied widely. Universa Investments, advised by Nassim Nicolas Taleb, author of The Black Swan, rose 3,600% in March. In contrast, Bodenholm Capital of Sweden is among the firms which are liquidating. 

According to HSBC data on larger hedge funds, Saba Capital, was the top performer in the year to March, with a 70% increase. The Tosca Pegasus fund is bottom with a fall of 54%. 

Bridgewater is among the several hedge fund giants to admit being caught out by market disruption with a drop of 20% in the first quarter, after failing to take risk off the table.

Another participant says 40% falls this year are not uncommon. “Central banks are throwing everything they have got at the market. But people are still being whipsawed,” he said.  

Separating winners from losers from 15,000 active hedge funds feels like playing Whack-a-Mole, according to a commentator.

Steinbrugge said: “Approximately 90% of all hedge funds do not justify their fees. Fed up with poor performance, investors are increasingly likely to redeem from underperforming managers.” 

The HFR composite return over five years, annualised at 1.3%, is way below the index. Berkshire Hathway’s Warren Buffett has successfully argued that hedge funds are costly, complicated and incapable of beating them.  

Even so, hedge fund assets rose to a record $3.25 trillion in the middle of last year, due to their leverage and support from institutions.

Due to their frequent mediocrity, and a tendency to mimic each other, hedge funds often employ similar approaches, fuelling crowded trades.

They have also struggled to perform over the last decade due to a lack of volatility in the market facilitated by zero-bound interest rates facilitated by the central banks. Hence, the use of leverage.

Along the way, global market and high-frequency trading has promoted closer linkage between markets and market participants. Dealers have less time to think so they rely more heavily on computer models, where similarities exist.

Andrew Lo, a professor at MIT Sloan, says all this creates a “tight coupling” where markets fall victim to unexpected black swan events, outlined by Taleb. 

Their impact on crowded, leveraged, trades, developed for outdated market conditions has become rapid. Large quant players often rush for the exit at once. Extreme price movements develop, as liquidity is sucked out of the system. 

In 2005, Raghuram Rajan, former head of the Indian central bank, argued we needed to brace ourselves for more big, systemic, shocks. And so it has come to pass. 

In 1998, $125 billion hedge fund LTCM came unstuck when its bet on Russian bonds soured following their default.  The Fed led a rescue as LTCM assets crashed, leverage spiked to a multiple of 250 and the health of the US Treasury bond market foundered.

The black swan behind the crisis of 2008-9 was the fall of an overcooked US housing market, where agents had encouraged impoverished borrowers to take out subprime mortgages, promptly resold and repackaged to banks. 

Risk modelling failed to grasp the inability of borrowers to service debt in a period of rising interest rates, although a tiny minority of hedge funds did manage to short subprime. Again, the Fed staged a rescue.

This time round, global markets have been spooked by the likely impact of the coronavirus on global GDP.  You can’t blame hedge funds for that. But events developed in a period where their trades meant markets were more tightly coupled than normal. 

To be specific, hedge funds have been funding their activities through the repo market, widely used as a source of overnight liquidity. Through this device, they borrow cash from third parties by offering them government bonds as collateral. They use it to fund large positions in treasury bills, while shorting futures contracts to pocket the yield difference. 

According to the BIS, hedge funds can leverage their repo trades a hundred times over. Over time, they took advantage of yield differentials in other asset classes, like equities, whose performance became increasingly correlated with bonds in 2019.

Last September, there was a shortage of cash available to meet demand, prompting the Fed to supply liquidity to the system. It was forced to do so again in December. According to the Wall Street Journal, the Fed has considered ways to fund hedge funds through a clearing house rather than the repo market.

But events overtook the Fed as concern over coronavirus grew in March, as the price of futures rose more quickly than bonds, leading to hefty market-to-market losses. Friction in the bond markets grew apace.

When hedge funds could not meet multiples of margin calls, dealers unwound their trades, triggering a downward spiral in Treasuries, when they should be a safe haven.

Primary dealers were over laden with new Treasury bonds, and could not spread the load. De-risking spread to other systematic strategies, including managed futures and risk parity. Ultimately, the Fed stepped in as a buyer of last resort.

The Fed made clear its determination to do what it took to support the US economy and Wall Street – not necessarily in that order. And market participants backed off. 

Clearly, hedge funds remain a protected species. You can see why in official data, which shows that personal wealth currently is at record levels against personal income. But this has not been achieved by GDP growth. It has resulted from financialisation, where financial assets have grown more quickly than the underlying economy.

The Fed’s support for Wall Street, and financialisation, will prop up our wealth, as well as the world’s hedge funds, for a little longer. But the system is creaking. 

One day, if not now, there will come a time of reckoning.

 

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One response to “Increasingly shunned by family offices – are hedge funds finally about to experience their final reckoning?

  1. All hedge fund investors need a selection process based on experience and technical common sense. The dispersion of returns is part of that, and fund selection myths need debunking. If chosen well, alternative funds can play an important role in a portfolio. The problem is that many allocators neither have the experience, or willingness to pay for it. Worst still, many think (because of wealth or position) they can do it themselves.

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