Assuming you’re not the type of investor whose mood is synchronized with the daily gyrations of the stock market, October has been an interesting month. Although it’s not over yet so of course anything can happen, to this point October looks like a big, short-lived margin call. Leveraged investors and those who like to hedge their downside have had a torrid time and many must regard their recent activity wondering how so much frenetic portfolio adjusting could have been so harmful.

It will be especially interesting to see how hedge funds finish the month. Industry apologists long ago perfected shifting the goalposts of performance. What was once the Absolute Return industry moved to generating attractive relative returns, later supplanted by uncorrelated returns as each description of the performance objective was found to be at odds with the empirical results. Nowadays sophisticated hedge fund consultants promote downside protection as the raison d’etre of a hedge fund allocation.

So what to make of the way October is shaping up? Through yesterday, the S&P500 was down 1.6% for the month, an innocuous result that scarcely describes the wealth adjustment that was inflicted earlier. MLPs, in which we have more than a passing interest, were at one point down 14% before the V-shaped market move thankfully began its ascent.

Hedge funds, as defined by the HFRX Global Hedge Fund Index, are currently estimated to be down 2.5%. Many hedge funds, particularly those focused on equities,  have done far worse. Stocks may of course spend the rest of the month falling, but assuming they don’t one imagines there will be some uncomfortable conversations as investors contemplate the value destruction that’s possible when hedged strategies test the market timing skills of their practitioners beyond the level of their ability.

It’s a fair question to ask that, in a market environment characterized by a sharp trip down followed by an equally fast return, what exactly should a hedged strategy return? Presumably, if a hedge fund maintains constant exposure, the round trip ought not to be much different than for the long only investor. But it’s looking very much as if the risk management being practiced is of the “dynamic” variety, which is to say highly responsive to market moves, or perhaps less generously, prone to sell low and buy high.

It reminded me a little of the crash of October 1987, whose 27th anniversary of course just passed on Monday. Not nearly as traumatic of course, and spread over a longer period of days, but what both events have in common is the use of hedging strategies that rely on risk reduction in response to falling prices. In 1987 it was called Portfolio Insurance. Its 2014 version has more complexity and variety of implementation, but thematically is another version of taking more risk when prices are rising and less when they’re not. There are other ways to grow your savings.

 

 

 

CalPERS’ $4 billion hedge fund portfolio will cause barely a ripple in the $2.5 trillion hedge fund industry as it’s redeemed over the next several quarters. Some speculate that their decision will cause other public pension funds to re-examine their commitment to hedge funds, although you’re unlikely to find a public pension trustee who will admit to being a follower.

What struck me most about this news though was the fees CalPERS paid. They disclosed a 7.1% net return on their $4 billion portfolio during their last fiscal year, as well as $135 million in fees. In recent years there’s been some anecdotal evidence that the ubiquitous “2 & 20” (2% management fee and 20% profit share) was coming down. That may be so, but you wouldn’t know it from CalPERS’ experience.

They don’t disclose their actual fee structure, but an educated guess is possible. Given the information provided (investment size, net return and fee expense) 1.9 and 19 (i.e. a 1.9% management fee and 19% incentive fee) would make the numbers add up. 2 and 18.5 also works. Given that CalPERS has a reputation as one of the most aggressive negotiators of investment terms, it’s surprising that their realized fees during their last fiscal year were so close to the traditional 2 & 20.

Now, it’s possible that some of their funds lost money, which doesn’t alter their effective fee but could mean that they’d negotiated lower incentive fees but had failed to benefit. There are no negative incentive fees. And CalPERS does include funds of hedge funds in their portfolio so that again may understate the fee savings they negotiated with individual managers.

Nonetheless, it still adds up to $1 of fees for every $2 in investment return. Nice business for some.

The Economist turned its critical eye at quantitative hedge funds recently, noting the poor performance of such “black box” strategies since the 2008 Financial Crisis. The article’s headline (“Computer Says No”) is a wry reference to a British sitcom called Little Britain, a humorous touch that will have been missed by many U.S. readers.

Quant practitioners predictably note the absence of rational markets (isn’t that ALWAYS why managers lose money) and place the blame squarely at policymakers and artificially low interest rates as the reason their models can no longer make reliably profitable predictions. It may also be that this sector of the hedge fund business is overcapitalized, with assets having grown from $91 billion to $215 billion in four years. While the underlying markets such as equities and bonds offerplenty of liquidity, perhaps the inefficiencies such algorithms are meant to identify are being competed away, at least by the big ones.