OK, one more post on the book I mentioned last time. The conclusion of this 2007 book has one of the best paragraphs I’ve read on the financial system – with the benefit of 20/20 hindsight, of course (emphasis mine):
Market crises are not born from nature. They are not transmitted by economic or natural catastrophe. The machinery of the market itself can take a small event and distort it. The more closely we try to follow the ideal, thereby adding complexity and more tightly coupling the actions of the market, the more frequently crises will occur. Attempts at that point to add safety features, to layer on regulations and safeguards, will only add to the complexity of the system and make the accidents more frequent. And when blowups happen in the future I can guarantee that the focus will be directed improperly: not at the issues of market design but at hedge funds where the events are observed. They will be implicated for the simple reason that they are engulfing more and more of the risk-taking landscape. The perception of hedge funds being what it is, they will take the blame and become subject to increased regulation. But blaming hedge funds is a little bit like The Simpsons episode in which a meteorite hits Springfield and the townspeople gather, shouting, “Let’s burn down the observatory so this never happens again!” True, the hedge funds are the institutions that have the appetite for the risk; but there is nothing inherent in hedge funds, nothing that they represent as a unified set, that makes them the singular cause of anything.
- A lot of financial alchemy transforms one type of risk (e.g. liquidity risk) into another type of risk (e.g. correlation risk). An example from 2007 was the proliferation of RMBS CDOs and their synthetic cousins: they took a simple, illiquid asset (a mortgage) and created a liquid asset with a sting in its tail (the CDO). The latter risk wasn’t obvious until the horribleness of 2008 occurred.
- The fallout from the credit crunch/financial crisis did indeed focus on hedge funds, both the investor-funded versions and the bank-funded prop desks. But this was misguided, in my opinion: the gains made by Paulson and others were massive, but were only a symptom of underlying issues with the US housing market. Remember: once these liquid RMBS CDOs were widespread, and default correlation assumed constant, we believed there was no longer need for mortgage underwriting scrutiny.
- Regulators have had a field day with adding considerably more safety checks/switches since the crisis; the uncertainties around Dodd-Frank and several other pieces of legislation (e.g. how will they ever implement and police so many new rules?) may lead us back to crisis. For example, we now have banks which have cut lending to shore up capital positions; ‘shadow banking’ to fill the gap in credit; hedge funds specifically designed to arbitrage the capital treatments of different sources of bank capital; etc. How will it end?
In sum: in many situations, more rules may not equal better risk management. Probably good to know for trading, as well as life in general.
Much in recent press arguing against hedge funds. Probably related to news of another large pension fund divesting completely. Plenty of vitriol around; a good summary of why not to invest in HFs from Barry Ritholtz is here, which further sources material from FT regarding ‘zombie funds’.
Let me highlight a couple reasons I’m still happy to invest in hedge funds:
- Problem with averages + performance persistence = opportunities. I recently wrote about how alternative asset managers (including HFs) show much more persistence in returns, unlike conventional asset managers. Thus, as often thrown in as a throwaway comment in the articles above, there are managers out there which consistently beat the averages to provide attractive returns. Unlike picking the best-performing long-only equity manager, hedge fund managers tend to show more consistent outperformance.
- Risk premium diversification, at needed risk level. Though most articles focus on how not diversifying hedge funds are as a group (probably because HF indices tend to have a massive overweight towards Long/Short equity and credit, which have high correlations to long-only equity), there remain several investment strategies which provide true diversification (e.g. managed futures/CTA). Though some of these diversifying strategies are available in more conventional form – e.g. through an ETF or mutual fund – I appreciate the additional capital efficiency provided by higher-risk versions in ‘proper’ hedge funds. More of a barbell approach to alternative investments (an aside – here is a new paper by Nassim Taleb et al. regarding mathematical justification for a barbell approach).
In sum: hedge funds can be massive wastes of fees, particularly if their performance starts to look very much like long-only equity. However, even a small bit of due diligence can yield solid managers with solid track records in solid diversifying strategies.
Who is dumb enough to pay 2 and 20? Me, actually. Source: Google Images.
The alternative investment world (namely private equity and hedge funds) has grown fat on the 2 and 20 fee structure. For those unaware, that means 2% p.a. management fees, plus 20% of all investment gains, paid by the investor. Sounds steep, right? It is. With the poor relative returns of alts the past five years (versus a screaming S&P 500, I mean), there has been much vitriol over the old fee structure. A watershed moment may have been Calpers’s decision to close its hedge fund portfolio; I say watershed mainly because of the publicity generated, rather than the impact on the alt investment business. With $4bn in hedge funds, Calpers wasn’t close a huge hedge fund investor.
As I was walking today I reflected on the fee structure. Why did it happen, and why or why not pay that amount? My notes:
- Genesis: I imagine a smart guy working for a big bank or asset manager. Suppose he comes up with a great strategy:
- Will the bank or asset manager compensate his for this luck/skill? Maybe: it definitely worked for a guy like Andrew Hall.
- But maybe not: what does this guy do then? Perhaps he starts trading his own money, or those of a close circle: thus begins prop firms, which are ubiquitous in the business. Especially for strategies that are low-capital outlay and/or high ‘edge’ (e.g. discretionary macro or HFT market making, respectively).
- Finally: he decides to start his own fund, managing public money. He needs enough capital to do 2 things, preferably simultaneously:
- Pay the bills: office expenses, Bloomberg feed, etc.
- Incentivise the manager: this guy supposedly has a great idea, so he wants to be compensated for making others rich.
- Why 2 and 20? How about some quick and dirty math:
- Yearly office expenses, including hiring a couple guys to make the fund viable (I have in mind a CRO/COO and a CFO/CLO, with ~$150k salary each) probably runs $500k-$1m. Starting capital for a fund is frequently targeted at around $25-50m. So 2% of this amount pays the office expenses.
- Of course the strategy type matters here, but let’s imagine the expected gross (pre-fees) performance of the strategy is 15% p.a. The owner of the fund company (the guy who came up with the strategy) gets 20% * (15% – 2%) = 2.6% of AUM p.a. in incentive fees. With $25-50m AUM, and a successful year, the strategy owner makes $650k-$1.3m for managing the fund. So our guy with a great idea made a million bucks (assuming he gets all the performance fee).
- Hopefully this quick illustration shows why 2 and 20 is so ‘standard’: at reasonable startup AUM, this is the sort of fee structure needed to pay office expenses + give enough incentive to the guy with the strategy in the first place.
- Where did/does it go wrong? I think 2 and 20 can be contrasted with a group like Vanguard (pre the news this morning that the latter may have used taxpayer funds to subsidise its operations).
- As AUM swells, the 2 becomes a larger and larger profit centre for the fund. At some point, the 20 becomes just an upside call, with 2 being the prime focus. That’s when fund volatility drops, institutional investors (wanting low volatility and lower fees for high-AUM checks) are in charge, and hedge fund performance starts dragging. I don’t think I’m unique in spotting that hedge funds relying on the 2 frequently begin to ‘calm things down’ to protect assets.
- Aside: I recall being on the road, listening to long-time clients saying ‘please don’t drop your volatility target…I am paying you for the volatility’. Thankfully there were enough of those investors to keep AUM at a sustainable level, so the target didn’t need to be compromised.
- Groups like Vanguard instead use the higher AUM to spread their office expenses wider and thinner… management fees as a % drop as AUM increases. Though this frequently happens with hedge funds as well (fee discounts become more and more common), the Vanguard model is more explicit and mechanical, and benefits investors equally.
- OK, back on point. When would I pay 2 and 20?
- I believe in the strategy. Clearly.
- I’m convinced the 2 is used to pay office expenses. That means the organisation running the fund needs that fee level to sustain operations. I don’t want the smart guy with the strategy fretting whether to buy a data set because the check will bounce.
- The fund owner(s) are satisfied, but a bit hungry, with the 20%. I want my asset manager rich, but I want him to keep trading my money. So not too rich to do silly things, nor so rich that he/she walks away. Also, not making so little that his/her opportunity to go back to the bank/big firm becomes the right choice. To be clear, having a high-water mark is a necessity: no multiple bites!
- I’m convinced the fund will hang around, and be consistent with strategy. One of the issues with small funds is their unfortunate tendency to blow up – hence why institutional investors tend to prefer large, steady return streams of big hedge funds. As a small private investor, I want the ‘juice’ of the strategy in as pure and concentrated form as possible while keeping the business alive. I will not pay 2% a year for a strategy expected to return 5% net of fees, for example. If it’s expected to return 15-25%? Now we’re talking…
Thoughts on the walk home from the City this morning:
A lot of trading & asset management, in particular the areas with which I’ve been involved, rely on the concept of scalability or capacity. That is, how many $$ can we put to work in a given strategy?
- The main concern in an institutional context is the limited scalability of many types of strategies. Any strategy with ‘arbitrage’ in the title fits in this context, as do many ‘convergence’ (i.e. purchasing/selling under/overvalued, related assets) strategies. For example, funds targeting convertible, capital structure, or merger arbitrage have a limited universe of securities to access. This limits fund size.
- The shorter the holding period for strategies, generally the lower the capacity. This is both due to explicit trading costs and available market liquidity. For example, latency arbitrage (a common high frequency trading strategy) has very limited capacity from an institutional perspective: one can put $millions to work, but not $billions.
- My experience is there’s a negative correlation between capacity and risk-adjusted returns. While Sharpe ratios of unlimited capacity strategies – such as long-only equities – tend to average around 0.5 (e.g. 7.5% return for 15% annual standard deviation), arbitrage strategies commonly have ratios of 2.0 or above. Several HFT strategies have Sharpe ratios so high the ratios lose meaning (is a ratio of 25 really that much worse than a ratio of 50?)
From a personal account perspective, scalability takes on a different importance. In particular:
- Many strategies and asset classes are too large for individual investors to access. For example, a diversified trend-following strategy should really have positions in 20+ futures markets to ensure adequate diversification; otherwise the strategy hinges on too large a proportion of the portfolio trending at the same time. The lot size for futures markets is such that a reasonable trend-following programme is likely impossible with fewer than $1 million AUM. Are you deep enough for this to be only a minority of your overall portfolio? I’m not…
- The fixed costs of implementing many strategies is simply too large for small investors to access. HFT is the most extreme example of this, in my opinion: data feeds, tech expenses, and co-location fees can run into the $millions/year. That’s a big nut to cover before turning a profit.
What are the lessons?
- Hire others to do strategies you can’t. If you can find HFT groups taking money (they’re basically non-existent), or can invest in trend-following funds (now freely available as mutual/UCITS funds), that’s probably the best/only way to access some diversifying strategies.
- Don’t pay others for strategies you can do. Long-only investing seems to fit here. Cheap ETFs, please!
- Take advantage of lower-capacity strategies which big funds have problems accessing. I put many options-related strategies here, as market depth & costs are reasonable for an individual investor, but prohibitive for most funds.