Is the Hedge Fund Game Over? Are We Chasing After T-Bill Returns?

Bloomberg has writen a News Feature on Hedge Funds and has enough commentary and quotes from industry professionals for several posts. The article starts off by saying

:"...the hedge fund industry entered the final months of 2005 with almost no hope of reliving its past glories, at least for now."

Returns this year for many strategies are below what they were in 1999 (the past glory?) and generating "standout profits" (whatever those are) will be more difficult due to competition and megafirms like D.E. Shaw and Bridgewater Associates.

William Sharpe contends:

"On average, the clients are going to get less than Treasury bills."

On some level, we agree: alpha is a limited commodity and the more funds there are pursuing the same or similar niches, the less opportunity there is for good returns.

But this is a rather simplistic, broad brush appraisal and deserves some further thought and research. We'll bring it to you over the next week.

Link: D.E. Shaw, Bridgewater Top List of World's Biggest Hedge Funds

Distressed: United Airlines Bankruptcy Terms Announced

One of the things I look for is real-life examples of alternative investments, which allow students to put sometimes unfamiliar concepts in some context. Distressed secuities investing has been a very good area over the last few years, partially as a result of the credit cycle and partially as a result of supply.

The United Airlines bankruptcy is one I have personally followed because I was short a small amount of common stock. So I'm keenly aware that the process has taken three years. Finally, a reorganization plan is on the table and February 2006 is the tentative date. The terms of the deal are contained in this Rocky Mountain News article.

Basically, the senior debt holders have been paid off in full and the unsecured junior debt holders are looking at 4-8 cents return on approximately $30 billion in outstanding debt. The payment will be in the form of new equity.

Several creditors faced with getting back five cents on the dollar indicate they are unhappy, but:

"If, in fact, unsecured creditors are getting what's left over after the senior creditors are paid in full, they can't say they're not getting paid enough because that's all that is left," said Douglas Baird, a University of Chicago law professor.

Since assets are not sufficient to pay off the junior debt holders, it follows that the old equity is worthless and the article makes this clear:

Stockholders will get completely wiped out and won't be able to vote on the plan.

But of course, the old common shares are still trading for 62.5 cents as of November 28. Even though the company advised in June 2003:

"...the company believes that its equity securities have little or no value and it is highly likely that the equity in UAL will be canceled under any plan of reorganization proposed by the company."

So much for efficient markets.

David Swenson: Questions Value of the Hedge Fund of Funds

Yale University's David Swensen topped the list of endowment returns in the latest fiscal year that ended in June, according to Bloomberg survey of 25 largest endowments.

It was no one-year anomaly either. Swensen produced an average annual return of 17.4 percent during the past decade. How did he do it? With significant allocations to alternative assets, including hedge funds, real assets (including real estate timber and energy), and private equity. It is not coincidental that the was also one of the first endowments to invest in real estate and hedge funds early, both alternative investment categories.

Swenson is not an enthusiastic support of mutual funds or hedge fund of funds, suggesting that the fee structures of these vehicles make it difficult to add value over the unmanaged alternatives that have become available.

In the hedge fund arena, the addition of a typical 1% management fee and 10% incentive fee (on top of the underlying funds' fees) does make it difficult for a fund of funds to outperform. However, fund of funds often claim their value comes from:

Access to funds otherwise closed to investors. We would amend this as access to superior management (whether closed or open.) If the "closed managers" underperform their strategy, most investors won't care that they're invested with closed managers.

Ability to optimally allocate to strategies and shift assets to outperforming strategies. This is the tactical asset allocation argument, applied to hedge funds. Several funds have alluded to this possibility.

Ability to leverage the hedge fund portfolio somewhat for extra return. Financing may be more available to a fund than an individual. If the fund of fund has done a good job in contructing the portfolio, some leverage at the fund of fund level may be reasonable.

Are hedge fund of funds able to use these techniques to overcome their management and incentive fees. As a group, probably not. But these are the questions an investor must ask if considering a hedge fund of fund.

Weekly Hedge Fund Disaster Series to Begin

We will be initiating a weekly hedge fund disaster series in the next few days, partly because, with the exception of Long Term Capital Management, we find it is not always easy to track information down on the basics of the fund and its downfall.
I find myself forgetting key elements of these infamous cases.

Often there are a few good articles written on the fund that may eventually be difficult to locate.

It is not my attention with this series to scare people away from hedge fund investment altogether. Frankly, it is important to identify common signposts in these examples and build a detailed due diligence process around it. Diversification obviously is a virtue, but we think it is possible to sidestep some of these meltdowns.

Our bias is to get as much information from a manager before investment as possible, to assess what he or she is doing, what the manager might do in adverse circumstances, and whether the organization and infrastructure behind him or her supports meeting these objectives.

Though much has been written about LTCM, we expect we will discuss that fund early in the series. But some more recent examples (Bayou Group, Beacon Hill) will also be on our list for coverage.

Screening Hedge Fund Managers: Understanding the Investment Process

Mark Anson in his The Handbook of Alternative Assets discusses three fundamental questions as an initial screen before investigating further whether a manager might be suitable for your investment program. The three questions center on the manager's investment objective, investment process, and what makes him so smart (which we like to call "edge").

We think these are three very good questions. Unfortunately, Anson spends most of the discussion going through the hedge fund offering documents of a manager to discern these elements. The offering documents are legal documents, designed to protect managers from lawsuits. They are usually written in lawyer-speak and purposely contain much generality. Anson criticizes a manager who lists every trading instrument under the sun, but a manager may be protecting himself if there are multiple ways to get exposure or the area of focus is still evolving.

Instead, as an initial screen, we put some reliance on a manager's investment letters and marketing presentation in addition to the performance numbers. We want to understand what markets a manager looks at, his universe of investments, what inefficiencies he is seeking to exploit, how he invests and constructs his portfolio in a repeatable fashion. It is true that sometime the marketing presentations and investment letters are very bad (talking only about the strategy in general).

If the investment letters contain only the recent returns of the fund and published long-only indices, I begin to wonder if the manager is doing something unique. On the other hand, if the manager discusses some aspect of the market I have not thought about or gives me insight into a recent trade, I am more interested in the manager (good marketing!).

Really understanding at a manager's edge and process usually requires a meeting or meetings with the hedge fund manager himself. However, a hedge fund can offer through a solid marketing presentation and well-written monthly letters can provide strong hints of a clear investment objective and suggestions of a bonafide investment process.

The Handbook of Alternative Assets, Mark JP Anson. ISBN: 0-471-21826-X. Hardcover,
512 pages. May 2002.

Hedge Fund Assets: Growing, Especially in Emerging Markets, Event Driven and Long Short Equity

Tremont Capital Management 's third quarter hedge fund asset flows shows an overall growth of 1.6%, with emerging markets, event driven, and long short equity drawing the most capital. All three strategies have performed very well through September.

In contrast, outflows were experienced in convertible arbitrage and equity market neutral. Convertible arbitrage was -3.06% in the first 10 months of 2005 accordign to the CSDFB/Tremont convertible arbitrage index. Global macro and equity market neutral also experienced net outflows.

Link: Here it is

Lessons in Merger Arbitrage: The J & J/Guidant Deal

Yesterday's news included the revised deal by Johnson & Johnson for Guidant, the medical device maker.

PHILADELPHIA -- Johnson & Johnson will acquire medical device maker Guidant Corp. for 15 per cent less than previously agreed, rescuing a deal that nearly collapsed in the wake of safety concerns and litigation over Guidant's heart products.

The November 15 announcement with revised deal terms came at a particularly advantageous time for me, as I am teaching an alternative investments course at a local university and how various relative value arbitrage strategies work was a topic for discussion.

The J & J/Guidant merger is a particular good case study, as it illustrates several elements of the merger arbitrage strategy and the factors a merger arbitrageur weighs: the terms of the deal, the likelihood of regulatory approval, and the risk of unanticipated events on the deal completion. It gives an understanding of the return profile for merger arbitrage, with large kurtosis and negative skewness.

Though the original definitive agreement announced December 15, 2004 called for J & J to acquire Guidant for a cash and stock package valued at $76, revelations by Guidant beginning in mid-June, 2005 led to warnings or recalls affecting about 88,000 heart defibrillators and almost 200,000 pacemakers.Not surprisingly, this left the completion of the deal in doubt (and caused the premium to blow out-see above), with The Deal reporting October 28 that “arbs are scurrying to review law on “material adverse effect”, a clause which might allow J & J to get out of the deal without paying the break-up fee. Speculation in early November had the parties negotiating with different valuations in mind, Guidant at $67-68 and JNJ at $61.

The revised deal value of $63.08 ($33.25 cash and .493 JNJ)averted a court battle about whether the defibrilator and pacemaker recalls and warnings amounted to a "material adverse effect".

link: J&J to buy Guidant at a 15% discount

Welcome to Alternative Investment Zone!

Although we have several blogs already, the subject of alternative investments (including hedge funds, managed futures, private equity, and real estate)is at the core of our work experience.

We endeavor to search out relevant news, academic research, and paracitioner views on alternative investments, make original commentary, and provide unique content you won't find elsewhere.

I have been a portfolio manager and analyst for a major hedge fund of fund organization. In addition, he has extensive experience in equity trading and derivatives which has proved helpful in interviewing hundreds of hedge fund managers for possible investment. He has a BA in Poltical Science from Whitman College and an MBA in Finance from the University of California, Los Angeles. He holds the CFA designation from the CFA Institute and the FRM designation from the Global Association of Risk Professionals.