The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

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Source: FT.com, January 27, 2012

Last week, I gave a very informal presentation to an audience of sophisticated HNW investors. Lots of family offices, none with less than $10m net worth; I’d ballpark the median > $50m. They get together regularly to discuss investing issues they are wrestling with.

The presentation was very general, including my (non)outlook on the economy, markets, investing, etc.

During the Q&A portion, issues of asset allocation, indexing, tactical adjustments, rebalancing, behavioral economics, and more were batted about. One of the questions that came up was fund manager under-performance. Starting with the usual data points — 80% of managers miss their benchmark, etc. — we then discussed why family offices, foundations and institutions were so willing to pay 2+20 for what is sub-par performance. Yes, 2011 was a rough year, but the problem seems to go much further than that.

One of the questioners asked, and surprised himself with the answer:  “Based on all this, then why do we bother picking hedge funds anyway? Why shouldn’t we simply index?”

Why shouldn’t you, indeed? I replied that I thought indexing made sense for many HNW investors, but I favored a form of tactical overlay versus straight Buy & Hold. (We’ve discussed the 10 month MA as a simple sell signal). We never got to discuss the incentives that drive consultants to sell these folks on the belief that they can consistently select managers who can out-perform; that is worthy of a full discussion some other time.

The most interesting part of the discussion was almost an afterthought. After stating that, yes, there were 100s of very talented hedge fund managers — out of a pool of 10,000 — I asked the group this: How can you find these outstanding hedge fund managers? How can you evaluate whether to give them your capital? How successful have you been at this?

No one had much of an answer.

We know exactly who the superstars are ex post facto. But we don’t get to retroactively go back in time to give our money to Jim Simmons or Ray Dalio. I told the group that I am “awful at selecting managers who don’t have a 10 year track record of out performance; (though I redeem myself by knowing when to fire a manager).”

But  the really interesting part came in the form of a challenge to the group: “Who is good at picking Hedge fund managers? Who amongst you has the ability to consistently evaluate managers who then outperform over time? Not only that, but outperform on an after fee basis?”

Their was a stunned silence.

I continued: “I do not have that skill set. Evaluating hedge fund managers based on the information that is currently shared is not my forté; more importantly, I doubt YOU have the skill set to pick hedge fund managers. (if you did, why are you here?)”

I pointed out the simple fact that most of us are not well equipped to evaluate managers. The ability to evaluate someone based on either understanding their approach and temperament was not what most of us were capable at. I continued:  “That is what Excel is for; You mark down the quarterly and annual track record managers you select (monthly performance data is mostly noise), keep a list of the qualifications you used to make that decision. Then you track their performance net of fees. How have you done?“

More silence.

Understand exactly what I am saying: Its not that there aren’t 100s of managers worthy of your capital — there are 100s maybe even 1000s who are. However, you simply are not well equipped to pick them. Sure, we can look at long-term track records. Bridgewater is Institutional only; Renaissance Technologies returned outside investor monies; There are lots of well known funds doing extremely well over a multi-decade plus period — but good luck getting them to take your money at this stage.

Time was up, the moderator thanked everyone, but the question remains:  How many investors can consistently select hedge fund managers who beat their benchmark over long periods of time after fees?

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Previously:
2011: Disastrous Year For Mutual, Hedge Fund Managers (January 17th, 2012)

When Do You Fire a Manager? (April 5th, 2011)

“Hedge funds have made massive mistakes. We are less and less willing to invest with these people because at the point when you need them the most, they’re worth the least.”

-George Feiger, chief executive officer of Contango Capital Advisors, wealth management arm of Zions Bancorporation. Feiger manages $3.3 billion at Contango and Western National Trust Co.

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In 2008, the hedge-fund industry had ~$2 trillion under management. But as Economist’s Buttonwood points out, that year was an annus horribilis for the hedge-funds. “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.”

This is detailed in a new book by Simon Lack titled The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True. Mr Lack reckons that hedge funds have lost enough money in 2008 to cancel out the entirety of profits made in the prior ten years.

Mutual funds have not fared any better in 2011. Data from Morningstar shows that among 4,100 funds that invest in large-cap stocks, only 17% beat the SPX. That is the smallest percentage since 1997 beating their benchmark — the S&P500 — since 1997, when 12% beat the SPX. If we look at the percentage of funds under-performing by 250 basis, its the worst since 1998. (See chart below)

If you are looking for something to blame,  consider the unholy trinity of capital outflows, a flat 2011 market and high volatility. That was a challenging environment for hedge funds and mutual funds alike.

I suspect people are  disappointed when a mutual fund under-performs with fees of 0.75 to 1.75%. But the fee structure of Hedge fund managers — 2% + 20% of the profits — is why some of them face real trouble. Its bad enough to under perform, but institutions hate paying up for the privilege.

Perhaps 2012 is the year fund managers mean revert and redeem themselves. If they don’t they should not be surprised at massive redemptions each time their window opens.

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Click to enlarge:

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More Charts on under-performance after the jump

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Daily HFRX Indices

Source: Hedge Fund Research

We don’t fancy your kind around these parts. Sheriff, why don’t you show the man to his horse, . . . its best if you were to just mosey along, move out of town.

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Fascinating note from Chase to a Hedge Fund client of ours: “JPMorgan Chase will no longer provide financial services to Hedge Funds or Private Equity customers.”

Before you assume its Dodd-Frank regs, the services in question are 1) Checking account; and b. Savings account.

Astonishing . . .

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chase2hedgefunds dropdead

click for video

complete transcript after the jump

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CNBC interview yesterday with William A. Ackman, Pershing Square Capital Management:

Bill Ackman: Betting on Hong Kong

Thu 15 Sep 11 | 07:16 AM ET

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Ackman: Retail Risky, But Opportunities Exist

Thu 15 Sep 11 | 07:44 AM ET

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This morning, I got to listen to a (too short) discussion with hedge fund manager Ray Dalio of Bridgewater Associates at the Bloomberg Market 50 Summit (video here).

Ray Dalio is a fascinating guy . . . he has what some people describe as a very idiosyncratic approach, but I find it logical and intelligent. His numbers speak for themselves — $125B, 15+%/year, running the shop for 35 years. Those people who criticize his “Truth-driven, self-reflective process” tend to only trash his beliefs as, the numbers above reveal, they cannot trash his performance.

Following his presentation, I wanted to meet him and just say thank you. The guy was barely off the stage when he was mobbed by people pushing business cards and presentations into his hand. I utterly forgot what a pack of unruly jackals the Sell Side can be. I am mortified by the behavior, and go outside to grab an iced tea (Bloomberg events always have great food and drink).

As I head back inside, Dalio and the sea of hangers on are heading out. The salivating salesmen hoping for fat commissions seem to not understand his methodology, which does not have him waiting on a trading desk’s recommendation. He has a huge pile of business cards, and an assistant or Bloomberg aide has a stack of envelopes/presentations.

I hang back from the hyenas, annoyed by the thought I won’t get to meet him. But then there is the tiniest of pauses, and without thinking, I blurt out “Ray, I don’t have a business card for you, I just wanted to thank you for your emphasis on process.”

Dalio turns, extends his hand. I introduce myself, shake his hand, and add “I find your focus on self-reflection and error correction, on enlightenment refreshing compared to the rest of Wall Street.” or words to that effect.

He swivels around to face me full on, and says “Isn’t that what it is all about? If you don’t understand yourself, how can you ever meet your goals, in life or in investing?”

Exactly. I tell him the emphasis on what matters is inspirational –the rest of the Street is missing the big picture. We start to chat — I tell him a brief story from my sell side days about cognitive foibles and selective retention — he nods and laughs. Meanwhile, we’re talking a few minutes and I can feel lots of eyeballs staring hatefully at the one jackass not interested in commission dollars (the damned fool!).

I appreciated the moment, and say something to the effect of “I know you want to get to you car, I just wanted to say thank you again.” He shakes my hand again, and heads to the car (Some other crazy stuff happened that I will save for another day).

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If you want to learn more about his approach, I suggest you read Dalio’s dissertation on Principles. Its his Magnum opus, and explains his fundamental Life Principles as well as his Management Principles.

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See also
Bridgewater Discussions on Culture (Videos)

Observing a Bipolar World
Barron’s March 12, 2011

Mastering the Machine: How Ray Dalio built the  world’s richest and strangest hedge fund.
John Cassidy
New Yorker, July 25, 2011

MarketFolly.com puts out quarterly subscription research — Hedge Fund Wisdom newsletter — that follows what the top hedge funds are buying and explains why.

Its worth checking out. Below is a recent version of a portion of the newsletter.  You can find out more by emailing marketfolly@gmail.com.

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Reducing Equity Exposure

Dan Loeb’s $4 billion Third Point Offshore Fund has decreased equity exposure three months in a row.  At the end of July, Third Point was only 23.3% net long equities, down from 42.6% net long only two months earlier.

The latest batch of SEC 13F filings depicts a less drastic reduction in equity exposure by hedge funds as a whole, but nonetheless a reduction.  Our friends at Alphaclone submitted their findings that “total market value disclosed and attributable to equities” decreased 2% from Q1 to Q2 (see the chart below):

While some funds were more aggressively entering ‘risk off’ mode in Q2, the volatility in August will certainly ensure that more risk has been taken off the table.

Consensus Buys

We track 40+ prominent long/short equity funds, placing emphasis on managers with solid stockpicking performance and longer investment time horizons in an effort to follow true investors, rather than funds more prone to trading.  Glancing at their latest portfolios, you can easily single out a few stocks that garnered significant capital.

One of the ‘consensus buys’ among long/short funds in the second quarter was Sensata Technologies (ST).  The company was carved out from Texas Instruments in 2006 as part of a leveraged buyout (LBO) consortium led by Bain Capital.

Since then, the company IPO’d in March 2010 and hedge funds have built up stakes in the company.  This past quarter, Och-Ziff and Hoplite Capital initiated new positions.

Also, many prominent hedgies added to their pre-existing positions in ST including Scout Capital, Lone Pine Capital, Blue Ridge Capital, and Valinor Management.  The brand new issue of our premium newsletter Hedge Fund Wisdom analyzes the potential investment thesis.  (You can download a free past issue here.)

Numerous top managers also initiated stakes in Expedia (EXPE), as the online travel-booking company was a consensus buy.  In a highly anticipated event, the company announced it will spin-off its TripAdvisor segment as the company looks for appropriate valuation for its fast-growing social media property.  This is exactly the type of catalyst-based investment many of the hedge funds we track like to play.

Mosaic (MOS) was also a consensus buy as numerous hedgies took advantage of the secondary offering as the Cargill family unloaded their shares and removed a big overhang on the stock.  Southern Union (SUG) was also a name that saw a lot of buying as well.

Buying One Bank, Selling Another?

While the tendency of many hedge funds was to reduce exposure to financials in the second quarter, there was an interesting dichotomy between shares of two of the sector’s titans.

Prominent hedgies such as Paulson & Co (John Paulson) and Appaloosa Management (David Tepper) sold off shares of Bank of America (BAC).

Yet at the same time, some potentially contrarian investors were stepping in to buy shares of rival Citigroup (C) ~ Lee Ainslie’s Maverick Capital and Bill Ackman’s Pershing Square to name a few.  These ‘rogue’ funds are somewhat of an outlier, though, as more often than not, hedgies reduced exposure to financials.

Bruce Berkowitz Goes All-In on AIG

And speaking of rogue or contrarian funds, none fits the bill more right now than Bruce Berkowitz’s Fairholme Capital.  While he’s a mutual fund manager, Berkowitz certainly acts like a hedge fund manager by taking highly concentrated stakes in companies and getting involved with his investments.

In Q2, he more than doubled down on his already massive stake in American International Group (AIG).  This position now accounts for a whopping 23% of his equity portfolio.  For what he sees in the company, we extract a bit of analysis from our premium newsletter:

Based on the company’s latest reports, AIG’s core businesses can generate earnings of $2.50+, which would justify the current share price given that the sector trades at ~7x 2012 EPS.  Additionally, AIG has a book value of ~ $50 and trades at a little over 40% of that value, which is low compared to peers trading at 60-70%.

Also, AIG has significant deferred tax assets (DTA) from net operating and capital losses.  The reversal of the DTA valuation allowance, the successful IPO of its ILFC division, and stronger-than-expected sales due to the recapture of some previously lost distribution channels could unlock AIG’s value.

Conversely, AIG is a highly complex company with opaque financials.  The government still owns 77% of the company’s shares and will be selling them in doses over the next couple of years perhaps, which could put a lid on the stock.  You can read the bull and bear cases for AIG written by hedge fund analysts in our just released newsletter.

Hedge Funds Buy ‘Growth’ Tech, Sell ‘Value’ Tech

Over the past few years, Wall Street has witnessed a shift in the tech.  Customers traded in their Hewlett Packard (HPQ) PC’s running Microsoft (MSFT) Windows for new Apple (AAPL) iMacs.  Google (GOOG) replaced Yahoo! (YHOO) as the dominant search engine and itself became a verb (“google it”).

This shift has caused shares of MSFT, HPQ, and YHOO to trade at much lower valuations and all three were actually ‘consensus sells’ among the hedge funds we track in the quarter.  Yet in the carnage, there were a few notable value investors who found the valuation of MSFT too tempting to pass up.

Legendary investor Seth Klarman (Baupost Group) purchased a new $312 million stake in MSFT and David Einhorn’s Greenlight Capital boosted its position in MSFT by 63% and owned a $385 million stake at the end of Q2.

While those two widely respected investors took a contrarian stance, many other hedge funds were piling into the ‘growth’ plays instead.  Apple (AAPL) and Google (GOOG) were their preferred destinations as they were both consensus buys in the quarter.

And rounding out recent activity takeaways, we’ll close with a bit from Goldman Sachs’ Hedge Fund Trend Monitor.  The five most important stocks to hedge funds according to Goldman’s VIP list are: 1. Apple (AAPL), 2. Microsoft (MSFT), 3. Google (GOOG), 4. Citigroup (C), and 5. General Motors (GM).

Source:
MarketFolly.com,
Hedge Fund Wisdom newsletter

I’ve spoken to a variety of Hedge fund managers and traders this week who have been ridding this market up and down.

Consider this one Connecticut hedge fund manager I speak with regularly:

On the long side, he is heavy into gold mining and high quality multinations; On the short side, he’s been betting against large American and European Financials, Consumer Discretionary, Home Builders and Cyclical Semis.

Over the past month, we have been discussing the Economy, the Fed, the Markets and specific sectors. As to his own holdings performance, he writes:

“The performance this month is volatile to say the least: Daily returns this week, if monthly, would be too volatile for almost everybody out there. Monday: +8.2%. Tuesday: -3.8%. Wednesday: +5.5%. And not over yet. Get me some Dramamine.

Thursday (8/11) -4.09%; Friday (8/12) -0.89%; Mon (8/15), 1.67%; Tues (8/16), 1.1%; Wed (8/17), 0.82%; and Thurs (8/18), 5.32%. Numbers are gross, in more ways than one.”

-July, the fund was up +10%

-August (to date) is plus 23.7%; Quarter (to date) 33.3%.

Prior to the July/August period, the fund was down high single/low double digits.