Rich managers, poor clients: A devastating analysis of hedge-fund returns

HEDGE-fund managers are the smartest investors around. With keen eyes and sharp brains, they spot and exploit inefficiencies in the markets. Or at least that is what the industry tells its clients.

There is no doubt that hedge-fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book* by Simon Lack, who spent many years studying hedge funds at JPMorgan, points out, it is hard to think of any clients that have become rich by investing in hedge funds (whereas Warren Buffett has made millionaires of many of his original investors). Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old Treasury bills.

How can that be, when traditional performance measures for the industry show average returns of 7% or so? The problem is a familiar one in fund management and is the equivalent of the “winner’s curse” that occurs with auctions (the successful bidder is doomed to overpay). Take a whole bunch of fund managers and give them an equal amount of money to invest. The managers that perform best initially will tend to attract more investors, and so will gradually become bigger than the moderate or poor performers (who will eventually go out of business).

But the manager will not perform well indefinitely. By the time a bad year occurs, the manager will be running a much larger fund. In cash terms, the loss on the expanded fund may easily outweigh the gains made when the fund was smaller. The return of the average investor will be lower than the average return of the fund.

What is true for individual funds also turns out to be true for the industry as a whole. Between 1998 and 2003 the average hedge fund earned positive returns every year, ranging from 5% in 2002 to 27% in 1999. Back then, however, the industry was quite small: overall assets only passed $200 billion in 2000.

That strong performance attracted the attention of pension funds, charities and university endowments at a time when their portfolios had been clobbered by the bursting of the dotcom bubble. They duly piled into “alternative assets” like hedge funds and private equity. By early 2008 the hedge-fund industry had around $2 trillion under management.

But that year turned out to be the annus horribilis for the hedge-fund sector. The average performance was a loss of 23%. In cash terms the loss for that single year was more than double the industry’s total assets under management in 2000, when it was still doing well. Mr Lack reckons that the industry may have lost enough money in 2008 to cancel out all the profits it made in the previous ten years.

At this point, hedge-fund managers might cry foul. The losses suffered in 2008 make a huge impact on the way Mr Lack calculates his figures. If you use the same methodology on stockmarkets, hedge funds outperformed the S&P 500 between 2001 and the end of 2010.

But private-equity managers are judged on a similar basis (the internal rate of return) to Mr Lack’s calculations. And his numbers probably flatter the hedge-fund industry. Indices of hedge-fund returns overstate the numbers because of factors such as “survivor bias” (poor performers stop reporting their numbers) and “backfill bias” (only successful newcomers start to report). These effects could add 3-5 percentage points a year to average returns. Many investors invest in the sector through funds of funds, which charge an additional layer of fees.

Even if you allow for the rebound in markets (and hedge-fund returns) in 2009 and 2010, investors have still got the short end of the stick. They have yet to recover the losses suffered in 2008. But hedge-fund managers took home almost $100 billion in fees between 2008 and 2010 (and an aggregate haul of $379 billion between 1998 and 2010).

Mr Lack’s book suggests the blind faith displayed by many institutional investors in hedge funds needs to be reconsidered. Individual managers may be brilliant but it is hard to spot them in advance. John Paulson was not particularly well-regarded before he made a fortune betting against subprime bonds—and his performance has slumped since. Investing in hedge funds will enable some lucky managers to enjoy an early retirement on their yachts. It will not enable pension funds to eliminate their deficits.

Source: http://www.economist.com/node/21542452

Waves from slowing China to break our shores

On November 18, the great and good of the New York financial community flocked to the drawing room of the NY Palace Hotel to attend a lunch given by Chinese brokerage CICC in honour of the former vice-prime minister, Zeng Peiyan, and a senior delegation of Chinese leaders such as Lou Jiwei, chairman of China Investment Corp.

Facing the Chinese were senior executives from the buy-out world including Henry Kravis of KKR and Blackstone’s Jonathan Gray while the hedge fund contingent included Maverick’s Lee Ainslie, Eric Mindich of Eton Park, John Paulson, and Dinakar Singh of TPG-Axon. Wall Street was represented by Ken Wilson, the former Treasury official who is now at BlackRock and Lazard’s Gary Parr. There were a few chief executives as well, such as Klaus Kleinfeld of Alcoa.

The Chinese message was stark according to multiple guests: if your Congress passes a bill labelling us as currency manipulators, we will crush you. And because we find your government rather difficult to deal with, please convey that message on our behalf.

As economic growth slows both in Europe and Asia, the search for an edge becomes ever more critical and one of the more obvious ways to grow is to export, which depends at least partly on a relatively cheap currency.

The Chinese take great exception to the suggestion that they are the only ones trying to keep their currency cheap when, in their eyes, most of the world is playing that game. Many Chinese believe that any “quantitative easing” from the Federal Reserve is merely an indirect way of putting downward pressure on the dollar. They believe the euro was designed as a way to keep German industry competitive because if there was no euro, the D-Mark would have appreciated and Greeks and Italians (and Chinese) would no longer have been able to afford to drive sleek Mercedes and BMW cars.

The Chinese sense of resentment is also fuelled by a growing sense of confidence in the government’s own macro-management skills. The rest of the world frets that China may face a hard landing as its manufacturing index drops into negative territory. China’s export machine has been slowing, as labour costs rise, forcing many makers of cheap goods to shut down. The residential property market is plummeting.

That sense of concern is not evident in Beijing. China has seen the emerging markets of Asia seize up in the late nineties, with little impact on its own well-being. Japan has been losing ground for two decades. The global financial crisis of 2008 suggested that the US model was deeply flawed, its growth dependent on debt that came largely from Beijing itself. Now, with Europe in recession, many Chinese feel that their system has proved far superior to those of any of its competitors.

In the past, slower growth in China would have been a problem. In the last ten years, China needed growth of 8 per cent to generate jobs for about 115m people joining its labour force. But the demographic change as its population ages as a result of the one child policy means that in the coming decade less than 20m people will join the labour force. That means a slower rate of growth will not be calamitous for China.

China is beginning to reverse its tight monetary policy by cutting the reserves banks have to post with the central bank for the first time in three years. Now, because of the combination of those demographics and a slowing in Europe, China’s biggest export market, China needs to continue to shift to a more domestic demand led economy.

In recent weeks, data show a bipolar world in which the strongest bloc is the US, rather than emerging markets or (obviously) Europe. JPMorgan, for example, cut its forecast for Chinese growth and expects GDP to expand 7.4 per cent on an annualised basis this quarter and by 7.2 per cent next quarter. It forecasts emerging markets to grow this quarter and next by a mere 4 per cent, the lowest in the past decade outside the Great Recession, according to its economists.

One reason the US has been doing better than Europe and Asia is because exports have been stronger than expected. It has benefited from the fact the euro remains relatively high, a reflection of the fact that monetary, fiscal and regulatory policies have all been tighter than they should be, despite the expectation that at some point European governments will reverse those policies and the euro will ultimately go to parity with the dollar.

Still, the world should not take too much pleasure from a slowing China. A slowing China means less export orders for the rest of the world and (as officials later suggested in private meetings around that lunch) fewer buy orders for the rest of the world’s debt. If China slows, it may well be more of a problem for the rest of the world than for China itself.

Source: http://www.ft.com/intl/cms/s/0/d07ac0ce-20ea-11e1-816d-00144feabdc0.html#axzz1iUVbDoKd

Gold: Haven turns riskier but retains its appeal

Bewitched, bothered and bewildered – that is how many gold bulls have felt in recent months. As the eurozone crisis has ratcheted up to fever pitch, their beloved precious metal – supposedly a haven against precisely this sort of financial market turmoil – has barely budged in price.

Since mid-October, gold has traded in an uninspiring range of roughly $1,650-$1,750 a troy ounce.

More worryingly for its supporters, the metal appears to be moving more closely in line with risky assets such as equities and emerging-market currencies than other havens such as US Treasuries.

“There has been a lot of disappointment with gold in the fourth quarter, especially from those who were banking on the metal’s safe haven properties, given the escalating situation in Europe,” says Edel Tully, precious metals strategist at UBS, the Swiss bank, in London.

The problems began in September. After hitting a record of $1,920 early in the month, gold collapsed 20 per cent in a matter of days. It was the metal’s sharpest weekly fall since 1983.

The plunge came amid a broader market sell-off, surprising some investors who had assumed that holding gold could act as a form of insurance against bullish positions in other commodities or equities.

The reason for the sharp fall was simple: as investors were rapidly losing money on other positions, they sold their gold to raise cash.

However, it caused investors to question gold’s claim to be a “safe-haven” asset. The metal’s case has not been helped in the months since, when gold has tended to rise as risk appetite rises, and fall when risk appetite wanes.

The dominant theme has been a “dash for cash”.

Most prominent among the investors forced to sell was John Paulson, the hedge fund manager who shot to prominence with an enormously profitable bet against the subprime mortgage market during the financial crisis.

Over the third quarter, Mr Paulson’s fund sold more than a third of its holdings of the SPDR Gold Shares exchange traded fund, equivalent to about 34 tonnes.

Elsewhere, European banks have been using their gold holdings to raise cash amid a widespread shortage of dollars in the region.

Dealers say that banks – primarily in continental Europe – have been actively lending gold in the market in exchange for dollars. The move has pushed gold lease rates – the implied interest rate for lending gold in the market in exchange for dollars – to record lows.

The one-month gold lease rate in December hit -0.57 per cent, suggesting that a bank lending gold for one month would have to pay to do so, at an annualised rate of 0.57 per cent.

“Gold is a function of liquidity,” says Walter de Wet, head of commodities research at Standard Bank. “Certainly there has been a lack of liquidity, particularly in the interbank market in Europe. That is putting a drag on gold.”

But while investors are feeling bruised, few are ready to call time on bullion’s decade-long rally.

“Commodity hedge funds are still involved in trading gold. It is still a popular trade,” says Fabio Cortes, manager of a commodities fund of funds for Oakley Capital, the private equity firm in London. Of the metal’s safe haven appeal, he adds: “It hasn’t lost it – it has been reduced to some extent.”

Indeed, the fundamental drivers of the surge remain in place. Central banks are buying record quantities of the metal. The so-called “official sector” bought 364 tonnes of gold in the first three quarters of this year, according to data from Thomson Reuters GFMS, the precious metals consultancy, compared with sales of more than 400 tonnes a year in the decade to 2009.

Moreover, Chinese demand is increasing rapidly as Beijing deregulates the country’s gold market.

Chinese imports of gold from Hong Kong have hit record levels in recent months, and the country is on track to more than double imports from last year.

Matthew Turner, precious metals strategist at Mitsubishi, the Japanese trading house, argues that the crucial determinant of whether gold lives up to its safe-haven billing is whether investors fear inflation.

“At different times investors seek different safe havens. During equity market crashes, investors tend to seek safety in the dollar, or bonds, and only sometimes gold,” he says. “Other financial panics might involve investors selling government bonds or fleeing the dollar due to rising fears of inflation. In these scenarios, gold can outperform.”

This suggests the trigger for gold’s next move is likely to be the actions of central banks – particularly the European Central Bank, which many investors believe will be forced to provide a backstop to the eurozone by more aggressively intervening in the sovereign bond markets.

In the second quarter of 2010 and the third quarter of this year – the two moments when the ECB moved to expand its bond-buying activities – gold demand jumped.

For next year, the ECB is likely to be the key to gold’s performance.

As Ms Tully predicts, if the ECB were to embark on a policy of quantitative easing, it would have “explosive implications for gold”.

Source: http://www.ft.com/intl/cms/s/0/6e68b5e2-24d9-11e1-8bf9-00144feabdc0.html#axzz1i2iwpKa6