Talking about hedge funds collectively is like talking about living things in aggregate. To use a biological metaphor equivelant to the Linnaean system: Asset classes are equivalent to Kingdoms in the Taxonomic world.
One hedge fund is like an "animal" to a degree, unfortunately most commentators on "hedge funds" neglect to see or understand the subtle distinctions between say, a great whale and the common garden slug. As a reader of this blog you of course appreciate such hard to notice subtleties and appreciate that Convertible arbitrage, high frequency forex algo and private equity investments may have subtle distinctions and nuances not quite appreciated by the general media when they utter the term, hedge fund.
With those caveats in mind, let us consider the scope of the Kingdom Hedge fund contemporenae as reported in in the 2009 Alternative asset report courtesy of the Teutonically cheerful Deutsche Bank.
Firstly we notice the purchasers of hedge funds are looking for diversification before absolute returns. As an anthropologist, I would suggest considering, not only the responses in this survey but also the context and time in which they were asked.
Few managers receive a bonus based on a correlation co-efficient, thus stated intention and actual motivations or actions may differ when viewing these survey results. The survey was conducted with over 1,000 professional hedge fund investors, family offices, Fund of funds, pension offices and other sordid types charged with protecting nest eggs, outperforming benchmarks and capturing the bonus brass ring at the end of the year.
Should you be running a hedge fund or considering it, the size requirements are growing. The allocators like to see $100m or more $100m these days, which is probably a function of wishing to get a feeling of fund operational and platform stability. A surprising number of funds close due to back-office and operational errors, so run a tight ship, there is more to it than buy low and sell high.
This is no time as a manager to be bashful, the fashion these days is transparency, open the kimono.
Allocators buy a long term process, the more they understand the process and what drives it, the more comfort they have. The allocator doesn't have a CYA position if a black box bounces. The allocator needs the CYA for his/her risk committee, give it to them, explain or show what the process they are buying is. The more it is a process and less a person or some abtruse mathematical arcana the better (Rennaissance excepted of course).
Bets are being made on Global macro. and commodities. That says something about faith or lack thereof in the Dollar and the desire for thinking globally and flexibly. The interest in credit and distressed credit is an interesting countercyclical bet on things turning about soon, a bit too early for my taste, but every dog has his day.
It was a rough year for the Kingdom Hedge fund as most were down, not as down as the equity benchmarks, but down enough to make that 2% management fee a bit awkward to justify. Expect to hear a lot of harumphing and blather about non-correlation and relative return from the 2/20 crowd.
And now for a happy chart to make everyone feel more intelligent and deserving. Performance over the MSCI was promising over the last 10 years. It is probably best not to bring up the bond market returns at this point in the discussion as it could be a bit awkward.
Most are expecting good things in the Kingdom Hedge fundus next year with returns of 10-15%, with a 2:20 structure and the 2008 -18% average return, funds should be back to break even by 2010-11 assuming it all works out. Ah you can practically smell the return of the performance bonus in the air, please don't discuss siegels paradox for those funds 25% below the high water mark, the date of return to performance bonus can starts to feel Jetsons like.
If you manage a merger arb or event drived fund look out, the shrink ray is pointed directly at you.
On the political front, if the money flows are correct and Eastern Europe and Russia are challenged it could get rough. If you live in Germany stock up on Natural gas and jaegermeister to keep warm next winter, everyone knows how Russia has "technical difficulties" with the gas lines when it comes time to renegotiate the gas prices. Eastern Europe's fondness for Swiss Franc denominated mortgages isn't working out so well and the political situation is sadly deteriorating, being filled by an angry far right looking to the past for answers. This is not good for anyone.
If you are an allocator who got stuck with a lock up and want out, a surprising number of fund of funds will take your position off of your hands. You were nice to your fellow allocators weren't you? Humility, ethics & civil behavior are some of the great long term investments one can make in life.
Of course the price for fund liquidity may leave a mild burning sensation in your wallet, funny how those things like "liquidity" never show up in mean-variance and allocation models. It is always important to identify the "oxygen" in a business process, ie. what are we taking for granted but that we will miss a lot if it disappears. Most forms of Oxygen are hidden risk in plain site and fall outside most math models.
Most of the allocators have only been at this game for 7-9 years, that is a youngish industry that was "hot" in the last 5-6 years. Expect the "cool kids" to move on to the next big thing. I started building trading models and studying hedge funds in 1990 in central Iowa, tough to get less cool than that.
I look forward to being surrounded by people who appreciate the responsibility of acting as stewards of other people's funds and trust rather than just banging out the bonus for themselves. Alternative Asset allocation has an important social function, the bonuses should be an externality of that function, not the other way around.
In human behavior and society the optimal size of human relationships and organization is roughly 150 members and referred to as the Dunbar number.
In allocator land the equivalent is 50 relationships which is too high in my mind as the trade off of knowing something about a thing and knowing nothing about many things appears in action at this level. Purely mathematically and even from a regime change perspective one would assume diminishing returns after 15 allocations, but c'est la vie' de l'allocator.
If you are starting out a fund, expect the initial allocation or toe in the water to be $3-5million.
If you are in the business of replication such as an alphaclone type service or someone using a Principal Component Analysis approach, the hedge fund replicator space is big enough to be interesting at 7% which at a $1.5 trillion industry estimate equates to $105Billion.
Given the drive for transparency and desire for non-correlation, this sector should grow albeit with lower fees. Having developed transparent active indexes for Forex and commodity strategies in the past, I find this an interesting space, if you work with an institution interested in collaboration lets talk.
The industry perceives its challenges as monitoring and managing risk. An index product with a managed account structure could provide a useful solution for allocators looking to buy exposure to a process and not just a "manager" lottery ticket.
Transparency probably speeds the sales cycle for a fund manager. The due diligence process is 3-6 months, but the sales cycle from first contact to close is probably closer to 12-18 months.
When I had hair and was a runner in the 10 year t-bond options pit, a friend asked which commodity was the most valuable on the floor. I immediately replied, it wasn't traded on the floor., it was trust. Trust, is a commodity behavior and relationship that takes time and patience to establish. It is consistency of behavior and actions matching promises. The fund game isn't a get rich quick overnight business and it shouldn't be, it is too important.
In regards to trust, the following chart shows 5-10 full fund redemptions from allocators. With roughly 50 allocations on average per allocator this equates to 10-20% annual turnover, not exactly a high trust business. Allocators under perform the hedge funds they invest in just like retail mutual fund investors. Investor "sophistication" isn't a subset of human behavioral traits.
Allocators invest in a process and need to believe and understand that process in order to weather the storm, transparency increases trust and ultimately fund sustainability. It should be noted that few hedge funds survive the retirement or demise of their founder. It is early in the industry, but as a young industry many of these vehicles aren't built to last a process based index or replicator factory could be.
For all the media hype about Madoff and the perceived evils of hedge funds, they didn't get to too leveraged as an industry (the LTCM boneheads being an exception). Heavily regulated and rated industries such as banks and mortgage monopolies like Fanny and Freddie are another story.
By the way didn't Fanny and Freddie by definition crowd out the local lending green shoots in your hometown years ago, not sure more govt monopolies and regulation make things better. Regulation often provides the appearance of safety allowing the dim or lazy to suspend suspicion and proper due diligence. Regulations get gamed. Behaviorally, long term I would trust a lightly regulated system with nervous diligent actors, than buffoons substituting a regulator or rater's stamp of approval for common sense and wariness.
The average lock-up is 1-3 years which works for some members of the Kingdom Hedge fundus, but not all of them. Hopefully those on the buying and selling end of illiquid assets like PE, CLO's etc. will look into the listed funds business and hopefully the US will offer a sensible regulatory environment for it similar to various European regimes.
If you are managing a group and looking for allocations the magic number is still between $50-100m. A good transparent index might be able to make a go of this or structure itself as an ETF. This cheap alpha if you will may not be at at the top of the Hedge fund Kingdom food chain in terms of performance, but an allocator gets transparency, liquidity and comfort in the process they are buying.
The duration of these processes should also outlast their creators, just like good index funds. Consider the S&P index as such a treatment for what was once considered exotic, namely equities in the 50's. Don't make me bring up the mean monkeys again :)
Now here is something interesting, many allocators indicate they don't need a track record, otherwise it is 1-2 years, not sure what to make of that.
And finally my favorite issue risk. Years ago I testified before the US senate in conjunction with the CIA, World Bank and State Dept. about international banking settlement risk, it has always been a favorite topic of mine. Most allocators indicate risk aversion above a 20% drawdown mark which probably again depends heavily on the fund type.
Buffet has 50% drawdowns, but it worked out OK. Drawdown has a high correlation with Vol, so consider your leverage or exposures accordingly. Swinging for the fences may give you an 80% year, but that 40-50% drawdown might keep the AUM at $50m and volatility plays to Siegels paradox in many types of systematic "non-value" type investments making it very tough to recover.
I would like to mention an "oxygen" type risk that many managers and allocators should be aware of, namely inflation. I wrote about it here. Last night, I sat at the Harvard Field club in Greenwich listening to a presentation to the Connecticut Hedge Fund assocation. The mood was anxious and a thick choking fog of inflation fear was in the air and the Fed acronym machine is redlining, with each new iteration of alphabet soup bailout program tacked to another multi hundred billion dollar figure.
To paraphrase Casablanca, Maybe not today and maybe not tomorrow, but sometime and someday inflation will loom... If you run a fund or FoF's and can think beyond the next quarter, run some regressions on your allocations and approaches with respect to an inflation proxy, don't just rely on the flaky CPI, that thing has been massaged more than Eliot Spitzer.
Low inflation is the oxygen we have all been taking for granted. Today's hot selling Non-correlated 15% returns could rapidly fall out of favor if they don't have a positive correlation with inflation. Remember your game as an allocator and steward of people's money is delivering a long term absolute wealth maximization process.