– Friedrich Nietzsche
On June 18 to 21 the annual GAIM International conference was held in Monaco, close to where I live. I was travelling for work during the conference dates but I met some friends from the industry on the previous weekend.
GAIM International was founded in 1994 and has become the world’s largest global alternative investment event, known for its high intellectual content as well as the range, quality and quantity of the hedge funds and global investors it attracts. One of the speakers this year was Niall Ferguson, Professor of History at Harvard University and some years ago author of the excellent book (and television series) The Ascent of Money.
The conference is the annual focal point for global investors, to learn about the wider industry and the strategic debate within which alternatives operate, and it is also a platform to meet the most interesting investment schemes and best performing funds from around the world.
To provide the reader with an explanation, a hedge fund is an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns. An hedge funds success depends on the skills and algorithms set up by its managers and they very often leverage to a high extent, to also leverage net profits.
Hedge funds can be quite risky when their investment strategies do not work out, even when they are run by the best brains. To give the most prominent example, Long-Term Capital Management L.P. (LTCM) was a hedge fund in Greenwich, Connecticut set up by John Meriwether together with two two Nobel Prize laureates Myron Scholes and Robert Merton. It utilized absolute-return trading strategies combined with high financial leverage. The fund collapsed in the late 1990s after a number of improbable events occurred at the same time, leading to total losses for investors of $4.6 billion.
Other investment vehicles may have become pariahs in recent years but the hedge funds have remained stubbornly fashionable. Since 2009, investors have invested nearly $150 billion of net new money into them, allowing the industry not only to rebound from the crisis but to resume its expansion. By this summer, hedge funds manage $2.1 trillion in assets, more than they did on the eve of the financial crisis five years ago.
However scale is not correlated with return. Since the beginning of 2010, the average hedge fund has returned just 7 per cent, according to Hedge Fund Research. Equity-focused hedge fund managers have made a disappointing 3 per cent. It is the longest stretch of low return the industry has ever suffered.
Some people I have met from the industry blame their difficulties on the bad financial environment and it must be true that low interest rates and limited liquidity contribute to limited trading opportunities. But it is hard to avoid the conclusion that the huge scale of the industry is also a factor that limits their success.
Hedge funds are now too big and too numerous for their own good.
With the huge scale and large number of funds it becomes harder to devise unique and distinctive strategies. Funds find it more difficult to trade in and out of markets without moving prices against themselves, by the scale of their trades, and other funds following new trading initiatives ensures that profit opportunities are quickly limited.
At its peak in mid-2008, the total amount of capital managed by the hedge fund industry stood at an estimated $2.9 trillion and considering that hedge funds leverage, their total amount of investments must have been a multiple of this. The sheer magnitude of these numbers raises a very interesting question: with so much capital chasing a presumably limited pool of “mispriced,” and thus attractive, assets, how do hedge funds find unique investments?
In many strategies, like convertible arbitrage, risk arbitrage, equity event-driven, and others, the answer is: they really don’t. They end up owning similarly constructed portfolios filled with overlapping pools of the same assets. And given the total amount of leveraged capital they can deploy, they can end up controlling the vast majority of the entire outstanding opportunity set in certain strategies.
Considering game theory, the size has turned the industry into a “loser’s game”. This is one in which victory goes not to the player with the best offensive strategy but to the one who makes the fewest mistakes – and has the lowest costs. Hedge funds have become a loser’s game because the funds themselves are no longer the exotic and small offshoot of mainstream fund management they were in the 1990s. Increasingly, they are the market.
Thus the hedge fund industry has become a commodity market with hyper competition.
A good book about the rise and decline of the hedge fund industry is The Quants, written by Scott Paterson. The introduction to The Quants describes the real life, annual, high stakes poker game between Wall Street’s hedge fund managers and compares their trading styles to their poker strategies.
The book tells the story of the 2007 subprime mortgage crisis and how it helped trigger a sudden and massive unwind of complex, highly leveraged quantitative strategies. The book also delves into critical short-comings of many quantitative strategies, such as their tendency to lead to crowded trades and their underestimation of the likelihood of chaotic, volatile moves in the markets.