By Neil O'Hara
Photographs by Fredrik Broden
With even legendary hedge fund managers struggling to raise capital, and returns once again taking a beating, it may be hard to remember when there was too much money chasing hedge funds. The crash of 2008 ended all that, as hedge funds lost a third of their capital through a combination of losses and redemptions from investors. The end of the boom shone a harsh light on the era's brightest trends—from investing in hybrids or alternatives like private equity, to the "hedge fund lite" products such as portable alpha or 130/30s.
These days managers like Paul Tudor Jones and Steve Cohen—to mention a couple of the most prominent—are pushing the industry back to basics. "People are focusing on a couple of things: Where do we have an advantage, and how do we articulate that to investors?" says Paul Roth, founding partner of Schulte Roth & Zabel.
The most popular hedge funds now are single-strategy funds, many of which have been launched by former stars. One example is Ospraie Management's Dwight Anderson, whose effort to create a vertical platform—with a hedge fund, private equity and a fund of funds—failed. In 2008, Anderson shut down his $4 billion flagship fund after losing 38.6%, but he later launched two new funds, one in equities and the other in commodities, that have amassed $600 million between them. Meanwhile, institutional investors have eschewed gimmicks like portable alpha and 130/30 funds and instead are investing directly in hedge funds.
Given that memories are notoriously short in the investment world, it's worth asking: What were the worst ideas of the boom, and do they have a future?
PRIVATE EQUITY
When money flooded the hedge fund world, spreads shriveled, so many managers acquired less-liquid assets in order to boost returns. Distressed managers faced particularly hard times during the boom and began to make private equity investments in which they bought outright control. Cerberus Capital Management is probably the biggest and best-known example—its initial success in bridging the gap from distressed investing to private equity led many others to imitate its model.
Cerberus took huge positions in the auto industry, buying Chrysler and GMAC, and its hedge funds—which participated in those deals alongside the private equity funds—lost more than 20% in 2008.
Unlike investors in Cerberus's private equity funds, those putting money in hedge funds could take their money out annually. Or so they thought. Few noticed that Cerberus maintained the right to defer redemptions for one year, a right it exercised at the end of 2008. By mid-2009 redemption requests continued to flow in, comprising up to 50% of capital, which led Cerberus to reorganize the funds into a liquidating special-purpose vehicle and a new fund with a multiyear lockup. Now some of Cerberus's private equity investments are recovering: The gain on Cerberus's proposed sale of Talecris Biotherapeutics will more than make up for its losses on GMAC and Chrysler Financial, and its flagship hedge fund is up 4.26% through July this year.
Cerberus remains so committed to private equity that it's moving more into that direction—and putting longer lockups on its hedge funds. But others say private equity is simply not a good deal. Michael Lewitt, author of "The Death of Capital" and co-founder of Harch Capital Management, regards private equity as a "pernicious form of investing" that deprives companies of the capital they need for research and development to support future growth. He argues that, with a few notable exceptions, the returns private equity sponsors earn derive mainly from the fees they charge rather than profits on their investments.
A newly published study by London's Centre for the Study of Financial Innovation confirms that, concluding that the private equity industry takes excessive risks, underperforms stock markets on a risk-adjusted basis and overcharges investors. "Most LBOs done over the past five years are worthless," says Lewitt. "It is a really bad deal for the limited partners."
It's an even worse deal for investors who jumped into private equity through hedge funds. Private equity is a long-term investment that cannot be sold at will, and hedge fund investors typically have a shorter time horizon. When liquidity dried up during the financial crisis, hedge funds with large exposure to private equity were among the first to put up gates and shuffle illiquid assets off into side pockets. Those holding private equity investments have been the last ones able to pay investors back.
Cerberus isn't alone; Harbinger Capital Partners placed 37% into a side pocket—mostly comprised of private equity investments. And although it has begun to sell them off, as of June it still had about $2 billion in the side pocket and had not made a promised second distribution to investors. Several other hedge funds maintain a commitment to private equity, including Eric Mindich's Eton Park Capital Management, launched in 2004 with a hybrid approach and a 30% side pocket dedicated to private investments. The fund was up 5.56% in its offshore fund in 2009, lagging other multistrategy funds, but this year it is up 3.23% through June—a better showing than most.
Despite some managers' continued support of private equity, the ire of investors in 2008 has led many hedge funds to rethink the once-heralded move. "Hedge fund managers are questioning whether they can transport private equity into their funds without adapting redemption policies. Having gone through 2008, they know the pain and credibility issues that arise when investors can't redeem," explains Roth.
Although some investors do want better liquidity, others have snapped up new funds devoted to distressed mortgages and bank debt, which typically use a legal structure that combines elements of both hedge funds and private equity funds. "We have seen some very sizable launches, $1 billion or more," says Christopher Kundro, co-chief executive officer of LaCrosse Global Fund Services, a fund administrator owned by Cargill. One example comes from Oaktree Capital Management, which raised $1 billion in mid-2009 for its OCM Opportunities Fund VIII, a vehicle that has a ten-year lockup, and an affiliated entity with a three-year lockup in which investors have an early redemption option.
MULTISTRATEGY FUNDS
It would be too harsh to say that the multistrategy fund phenomenon has been a mistake. Some of the largest, most successful and stable funds, such as Och-Ziff Capital Management and D. E. Shaw, are multistrategy funds.
But multistrats have certainly been taken down a notch. Citadel's Kensington Global Strategies Fund lost 54.5% in 2008, and although it came back in 2009 with a 62.5% return, the fund still has not met its high-water mark and is only slightly positive so far in 2010. Meanwhile, SAC Capital Advisors has largely abandoned its multistrategy fund after the offshore fund lost more than 20% in 2008; the firm has returned to its long/short trading expertise. Tudor Investment Corp. has taken a similar path, turning its flagship Tudor BVI Global into a macro fund instead of a multistrategy one. (See "Tudor returns to its roots.")
Multistrats' subpar performance of 2008 debunked the myth that they could move capital quickly from one uncorrelated strategy to another to take advantage of market opportunities. When every asset except U.S. Treasuries became correlated after Lehman Brothers failed, the multistrategy funds had nowhere to hide—and they often used more leverage than single-strategy funds too.
The California Public Employees Retirement System nixed all its investments in multistrategy funds except for Och-Ziff in a 2009 review of its hedge fund holdings that resulted in it abandoning names like Farallon Capital Management and Platinum Grove Asset Management.
The real problem is that some managers created multistrategy funds as a way to deploy capital that was pouring in, especially when opportunities dried up in their core strategies. There are few better examples of this folly than Amaranth Advisors, a $9 billion multistrategy fund that blew $6 billion on bad bets in the natural gas market and closed down in 2006. Like many multistrat funds, Amaranth started out as a convertibles shop and branched out into areas beyond founder Nick Maounis's expertise when convertibles went through a rough patch in 2005.
In 2008 prominent multistrategy hedge funds like Citadel, D. E. Shaw and Tudor also put up gates, a move that infuriated investors denied access to their money. Firms that did not put up gates—Och-Ziff, for example—have benefited, as investors prefer to direct their money to funds that treated them well. "The funds that did not implement gates are having less trouble in raising capital," says LaCrosse's Kundro.
The big multistrategy firms aren't going away, of course, and many continue to attract new assets—albeit in a different way. Kundro says funds that used to allow participation only in the multistrategy pool have started to offer investors direct access to the underlying strategies. "We are seeing less investment in overall multistrategy umbrella funds and more into the individual strategies," says Kundro, citing Cargill's hedge fund complex, Black River Asset Management, which now allows single-strategy access.
Some big multistrategy funds—TPG-Axon Capital is one prominent example—still do not offer direct access to individual strategies. And multistrategy funds do have advantages. "If you are going to allocate to 20 managers, you probably need to meet 50 or 100 managers," says Ric Thomas, head of alternative investments and absolute return strategies at State Street Global Advisors. "It's hard to do that if you have only one or two people." For middle-tier and smaller hedge fund investors, multistrategy managers or funds of hedge funds remain the only viable option.
PORTABLE ALPHA
Probably few trends got a worse rap during the crash than portable alpha, a concept heavily promoted by investment consultants a few years ago as a way for pension funds to generate hedge fund-like returns by leveraging core large-cap equity and fixed-income strategies.
The idea was to replicate the desired market exposure with index futures or a swap and use cash that would otherwise be invested in benchmark securities to invest in hedge funds, which proponents argued would deliver positive returns whether the benchmark index went up or down.
Absolute returns were always a myth, however. Hedge funds do outperform benchmark equity indices in bear markets and often underperform in bull markets, but that does not mean they will never lose money, as portable alpha proponents discovered to their dismay in 2008. Portable alpha is a leveraged strategy, and leverage cuts both ways: If the alpha source earns less than the cost of the borrowing, investors will be worse off than if they had kept their money in the underlying asset class.
"Investors in portable alpha forgot about portable beta and portable sigma," says Andrew Lo, professor at the Massachusetts Institute of Technology and director of the MIT Laboratory for Financial Engineering, referring to market risk and volatility. "When you port strategies from one space to another, you bring along with them the risks." Even if the strategy is market neutral, volatility can still create losses. Lo says one of the most popular hedge fund strategies used in portable alpha programs was fixed-income arbitrage, which exploits perceived mispricings along the yield curve or between different bond issuers. Practitioners are usually short U.S. Treasuries to hedge their interest rate exposure and long bonds issued by government agencies or other less creditworthy entities. That was precisely the wrong bet in 2008. Following the Lehman bankruptcy, Treasuries rose and every other credit instrument tanked. Instead of offering superior returns, portable alpha lost a bundle.
Investors fled portable alpha in droves after 2008, but reports of its death may be premature. Lo expects interest to revive, albeit in a muted form using less leverage and better risk controls, as pension funds desperate to close funding gaps will pursue any avenue to eke out a few extra basis points of return.
The revival may have already begun. Judy Posnikoff, a managing director of Pacific Alternative Asset Management Company, a $10 billion fund of funds, says that two of the firm's clients have set up new portable alpha programs this year. The investors conducted a thorough review of the swap documentation to make sure they understood how much cash they would have to put up and when if the market moved against them, but they are also using separately managed accounts for the strategy. "They are not going into a commingled hedge fund," says Posnikoff. "A managed account gives them more control over the assets in case they need to raise cash."
Portable alpha isn't likely to regain the traction it had before the financial crisis, however. Neil Morris, a member of hedge fund consultancy Kinetic Partners, notes that if investors want to hedge against any associated market or volatility risk, they need to know precisely how the strategy works and what securities it invests in, an extraordinary level of transparency. "It was the idea du jour," he says.
REPLICATORS
The hedge fund boom also spawned efforts to mimic funds' performance using liquid marketable instruments such as stock index and bond futures. Goldman Sachs, Merrill Lynch and others launched hedge fund replication products based on factor models that use regression techniques to find the best fit between the returns on the HFRI Fund of Funds Composite Index and the selected instruments. The returns cover a rolling predetermined number of months, skewed in some cases toward the most recent periods. The factor weightings are adjusted every month when updated performance data becomes available.
However well replication products work in theory, they have delivered mixed performance in practice. They outperformed in 2008, losing much less than the average hedge fund that year, but lagged in 2009, when so many hedge funds bounced back.
State Street's Thomas attributes the tracking error to the fact that the instruments used in replication programs are liquid, but it was the distressed assets that drove hedge fund returns in 2009. "Hedge fund beta programs are designed as liquid beta," he says. "You don't have private equity or distressed. That is what drove the market in 2008 and 2009."
MIT's Lo, who is also chairman and chief investment strategist of AlphaSimplex, an investment adviser that manages (among other things) hedge fund replication programs, argues that these products have done reasonably well in delivering what they claim. Nevertheless, he accepts that they do not appeal to investors who are looking for hedge fund returns. "The performance has been consistent for investors looking for the broad strokes of the hedge fund industry," he says, "but these products are not capable of taking on illiquidity exposures that will goose the returns by an additional 300 to 400 basis points."
Despite extensive fanfare in 2006, when replication products first came to market, the idea has never caught on with institutional investors. Skeptics like PAAMCO's Posnikoff, who admits to a bias against a product whose success could pose a threat to the fund-of-funds business, argue that replication vehicles can't capture the active manager's skill, which is the main reason for investing in hedge funds in the first place.
130/30
One skill hedge fund managers have that long-only managers typically lack is the ability to handle short positions, a process that requires enhanced risk management to cope with limited upside and unlimited downside—the opposite of the potential returns on a long position. It's also essential to 130/30 funds and other short extension products, which attempt to leverage investment managers' research by allowing them to make bigger bets against securities they believe are expensive and buy more securities they consider cheap.
Although sometimes pitched as "hedge fund lite" products, the real story behind 130/30 programs is a marketing ruse by asset gatherers. These portfolios are always 100% net long, which means investment committees often have the authority to invest in the strategy without seeking an allocation to alternative investments. The marketers have their eyes on the enormous dollars tied up in long-only large-cap stocks rather than the much smaller quota allocated to hedge funds and other alternative investments.
Like portable alpha, 130/30 funds rode a wave of popularity into the financial crisis—and then wiped out. Not only did they lose money when the market went down—no surprise there for a product with 100% market exposure—but in many cases they also delivered performance inferior to the equivalent long-only portfolio, a direct contradiction of the theory on which they rest.
Morningstar, the Chicago mutual fund tracker, shows that on average the 12 mutual funds that follow 130/30 or equivalent strategies rank well below the median performance of their category (almost all long-only funds) for the second quarter (68th percentile), year to date (60th), one year (69th)—and over three years the three funds that have track records that long all rank below the 90th percentile (94th on average). These 12 funds did outperform the HFI Global Composite index for the 12 months through June 30 (+13.2% versus +7.00%), but they have lagged so far this year (-7.37% versus +0.51%).
To Kundro at LaCrosse, the silence from potential clients for 130/30 administration is deafening. "A couple of years ago, we were bombarded with requests," he says. "Many of the funds that contacted us never launched. Now I don't hear anything."
State Street's Thomas points out that the lion's share of assets in 130/30 programs was allocated to quantitative managers, who have struggled during the wild market swings from 2007 through 2009.
Hedge funds have not been big players in the 130/30 game, but those who did jump in were quant shops—including AQR Capital Management and D. E. Shaw, which has $3.6 billion in its long-only and 130/30 programs.
Quants excel in trending markets, but they tend to come unglued at turning points or in volatile markets when the models cease to work until a new trend is established. State Street launched its 130/30 programs in 2005 and outperformed for the first two years—then gave back the edge and a little more by the end of 2009. "Since inception in our four key 130/30 strategies, we are down a bit in three, but it's not that significant," says Thomas.
He points out that some investors have abandoned quantitative managers due to their poor performance, leaving the field far less crowded and perhaps ripe for a rebound. While 130/30 doesn't enjoy the buzz it had a few years ago, he thinks it will come back into fashion when quantitative managers regain their footing. "The theoretical basis for doing 130/30 is still there," Thomas insists.
Hedge fund managers didn't rush into 130/30s because the strategy boils down to a market-neutral fund combined with a long-only portfolio—and hedge funds already offer the market-neutral piece. As Thomas explains, an investor wanting to tap a hedge fund manager's expertise could simply invest in the fund and buy a S&P 500 index. And in a world of uncertainty, a simple hedge fund may offer the best option. "Institutional investors are worried about tail risk and looking for ways to hedge that," says Thomas. "The natural place to go is a hedge fund."