Joshua M Brown
July 1st, 2014
I know a small startup hedge fund that was flat last year versus the S&P 500′s 32% total return. He’s out of business, pack up the truck. Nothing he can explain or illustrate means anything to the handful of seeders who let him hold onto some money for a year.
Hedge funds have faced quite a conundrum recently. On the one hand, they’re expected to be “non-correlated” to the risk and returns of the broader market. It’s kind of the point of the whole thing, after all. Anyone can simply own the market.
But the trouble is, the cumulative annualized growth rate for the S&P 500 over the last three calendar years has been an astonishing 16 percent. That means a million dollars invested in the market on January 1st 2010 and left in through the end of 2013 is now worth almost $2 million.
And who the f*** wants to be non-correlated to that?
So we see a drift toward market beta happening across the $2.7 trillion hedge fund industry. No one should be surprised. Because the single most powerful, overriding force in finance is neither fear nor greed, it’s career risk.
The FT relays the results of a recent study carried out by the alternative asset manager AQR detailing exactly how severe this drift has become…
“Investors are getting screwed because they have beta elsewhere and now they are paying 2 and 20 [2 per cent of assets and a 20 per cent performance fee] for it,” said David Kabiller, founding principal of AQR, a 105bn hedge fund house.
Data compiled by AQR show the three-year rolling correlation of the HFRI Fund Weighted Composite index, a broad industry measure, with equity markets is at a near-record high of 0.93, comfortably above the highs seen before the financial crisis.
On the plus side, increased correlation with the market has been good for hedge fund investors – markets have basically gone straight up, after all. On the minus side, you’ve certainly been paying through the nose for this .93% correlation – if I sold you a Vanguard index fund and then deducted a 2% management fee along with 20% of each year’s gains, would you buy it? No? How about if I sweetened the deal by gating your assets so they couldn’t be touched most of the year, would that do the trick?
See what I mean?
For the hedge fund manager, being long the markets, generally, has been the money making trade. The trouble is that this hasn’t been a great deal for most investors (whom I assume couldn’t care less as they continue to shovel assets in through their wirehouse brokers at a torrid pace). The bigger trouble is that the positive correlation between the stock market and the hedge fund index is now back at a high not seen since just before the credit crash – and hedge funds did not exactly light it up in the crash because of that heavy exposure; average losses of more than 20% in 2008 were not exactly what the LPs thought they were signing up for.
But if you don’t play, can you keep your assets and clients? Maybe for a little while, but each passing month it gets harder. You can stick to your guns and continue to fight – as Seth Klarman is doing with a 50% cash position – or you can simply hang ‘em up like Stanley Druckenmiller.
And let’s be honest about the so-called “investors”… Most of them only like the idea of non-correlation, but can’t stand the actual sight of it when the bulls are fornicating on the corner of Wall and Broad.
What’s a hedge fund manager to do?