Hedge Fund Results

Investment Analysis Clubs Saul’s Investing Discussions
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According to firm Hedge Fund Research, hedge funds suffered their largest quarterly loss in assets since the financial crisis during the three months that ended in September. The third-quarter saw the average fund lose 3.9% driven by slowing growth in China, sliding commodities prices and a likely U.S. Fed rate hike that sent stocks tumbling. Notables: Bill Ackman’s Pershing Square (OTCPK:PSHZF) has now fallen 12.6% for the year, while David Einhorn’s Greenlight Capital (NASDAQ:GLRE) is down 17% YTD.

I really and truly don’t understand this: David Einhorn is a heck of a smart guy, and he certainly knows a lot more about the market than I do, and has access to many more sources of information. How in the world can his fund be down 17% YTD at the end of Sept while my portfolio was up about 31%. That’s an enormous difference. It just makes no sense. In no way do I know more about the market than he does. Really!

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How in the world can his fund be down 17% YTD at the end of Sept while my portfolio was up about 31%.

Perhaps it is the same problem Buffett has referred to, having too much money to manage? He has said that the small investor has far more flexibility as they can invest in small companies without crushing them.

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I really and truly don’t understand this: David Einhorn is a heck of a smart guy, and he certainly knows a lot more about the market than I do, and has access to many more sources of information. How in the world can his fund be down 17% YTD at the end of Sept while my portfolio was up about 31%

Ignorance is bliss.

Cheers
Qazulight

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Hey Saul,

First off, congrats on your returns and thanks for all the info you post on the board.

I agree that it doesn’t make sense, but I also think a few factors play into this.

The hedge fund world is controlling increasingly more assets and order flow, they are fairly large fish in a large pond, and a lot of them end up in crowded trades. As they get bigger more and more of them will revert to the mean because they make up such a large amount of the overall market.

If we think of the market in recent years, hedge funds have endured the ultimate pain trade. The “value” they were supposed to provide via active management and their expertise simply got trounced by the rise in the indices in 2013 and 2014 (though '14 had more dips along the way). But those 2 years, regular index investing and dollar cost averaging provided great returns, and simply holding quality stocks did even better.
Basically in those years, you got paid for doing less in the markets rather than more.

Over the past 12 months, as volatility started to come back near the end of last year, imagine you were a manager of a large fund who was being beaten by passive indexes who needs to somehow prove your value to your investors. Everyone is trying to be the smartest guy in the room, but only 50% can be better than average, though all think they are in the top 10%.

So, in that position, how does this fund manager find the end that puts them ahead of the market? Maybe they were shorting all year betting on a collapse and taking losses up until August. Now what? Do they bet on more downside from here or do they go long? If they were short they are getting killed on the current partial price recovery.

Let’s say the market gets closer to all time highs again as we get to year end, now they either need to go long again at worse prices or decide to play the short side again and hoping you don’t lose your shirt.

All of this then happens with the regular timeframe checkins with investors or earnings releases (for the public companies), so there is a need to show performance on a different timeframe then the possible thesis for a position, which often leads to riskier positions and setting themselves up in less ideal risk situations.

Can’t say I can explain it all, but that is my take in summary. The good thing is that as individual investors, you can make your own rules and decisions about timeframes, holdings, and strategies.

While the big fish make the waves, the small fish can make out pretty well by riding the right waves while they are there, and getting off the waves once it starts to break (i.e. BOFI recently)

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Thanks, Mike, nice discussion.
Saul

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Warren Buffet pointed out that part of the problem is that as hedge funds grow in size, their compensation structure actually makes outperformance nice, but unnecessary.

If you run a small, hungry hedge fund with, say, $500 million under management, you would always get a 2% fee, or $10 million dollars, just for the act of operating the fund. Pretty sweet! But you also get 20% of anything over a certain benchmark. So, if your fund posts a 40% return in a year when the benchmark returns 10%, you get to keep on fifth of that excess gain. One fifth of 30% is 6%, so you just netted an additional $30 million dollars. That kind of extra money is serious incentive to work harder.

But now assume you run a GIANT hedge fund. It has $50 BILLION in assets. Now, no matter how well or badly your fund performs, you will get your 2% fee, which amounts to $1 billion dollars. So you don’t need to stretch and get the outperformance. As long as you don’t underperform so badly that investors start pulling money out, you are fat and happy.

Sure, the occasional great year will fund your trust funds and off-shore accounts nicely, but it really doesn’t drive you any more. You goal now is to just keep the funds from going elsewhere. You start making much more conservative investments, hoping to just place yourself in the middle of the pack, so you can continue to skim your $1 billion off of your investors every year.

There is more to it…others have alluded to the size disadvantage of deploying huge amounts of money into the market. But really, it is a function of incentive…

Tiptree, Fool One guide, no fan of hedge funds

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Einhorn’s biggest loser was Consol Energy (NYSE:CNX), his fourth-largest holding at 6.2% of his portfolio and almost 10% of its shares outstanding. Consol, which is struggling with low natural gas prices, has declined 66% from his average purchase price of $30 per share, to around $10 per share on Tuesday. Though shares have declined 69% year to date, Einhorn continued to buy shares of the energy company in the second quarter, increasing his position by almost 11%.

SunEdison Inc. (NYSE:SUNE), the world’s largest renewable energy development company, ranked as Einhorn’s second biggest decliner. At 9.3% of his portfolio, SunEdison also took second place among Einhorn’s top holdings. He has a total 49% paper loss on the position, having paid $18 per share on average while shares traded around $9 on Tuesday – near a two-year low.

He was also long Micron.

But cry not for Einhorn, for his $12B portfolio, he makes 2 and 20 on the up years and 2% on the down. And he doesn’t refund the 20 on down years. So he is still pretty darn smart :wink:

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But now assume you run a GIANT hedge fund. It has $50 BILLION in assets. Now, no matter how well or badly your fund performs, you will get your 2% fee, which amounts to $1 billion dollars. So you don’t need to stretch and get the outperformance. As long as you don’t underperform so badly that investors start pulling money out, you are fat and happy.

The “hedge fund business model” is generally structured around collecting and retaining lots of assets. Outperformance is hard. Collecting lots of assets and charging 2% for a 5 years or so is much easier.

I really don’t understand why people invest in them. Sure, if you find the one hedge fund that gives you 30% p.a. over 10 years, you’re golden.
But the chances of finding that one hedge fund are no better than finding a 10-bagger for your stock portfolio.
The vast, vast majority of hedge funds will just give you huge fees.
If you look at Buffet’s bet on the outperformance between the SPX index fund and the fund-of-fund hedge funds portfolio, it’s been a disaster for the hedge fund side (+20% since 2008 vs. +63% for the SPX index fund).

http://fortune.com/2015/02/03/berkshires-buffett-adds-to-his…

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Perhaps the most genius part of Buffet’s bet is really not an index vs hedge fund bet, but the fact that he managed to stack the deck in his favor by essentially picking the bottom for the overall market.

Now of course the outsized fees are a massive drag on returns as well, but the vast majority of hedge funds are really not much more than more expensive mutual funds… and the vast majority of mutual funds are not much more than more expensive index funds… and its fairly easy to have less risk with less diversification by picking good investments and having some cheap index exposure as a core.

Now, when hedge funds first came about, they did provide some value, but as the industry has grown it has increasingly shown a tendency to revert to the mean.

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Perhaps the most genius part of Buffet’s bet is really not an index vs hedge fund bet, but the fact that he managed to stack the deck in his favor by essentially picking the bottom for the overall market.

That is incorrect, the opposite is true. The bet commenced 1 January 2008, near the top of the market. As at 1 January 2008, the index stood at 1467.97 (the previous high in October was 1576.09).
It proceeded to fall by more then 50%, closing at 676.53 on 9 March 2009.

Buffet invested at record valuations just before a huge drop. The fact that the SPX still outperformed the hedge funds by such a large margin underlines just how catastrophic their performance is.

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