Several years ago, a trader of my acquaintance, who had just begun working for a hedge fund, informed me that there were more hedge funds in the United States than there were Taco Bell outlets. His assertion piqued my curiosity, so I looked it up and … he was right. The obvious question then became: Is there enough room for all these funds out there to survive and prosper?
At first glance, the answer was and is, well, why not? Assets under management by hedge funds currently hover around the $2 trillion mark (the specifics tend to be murky, as with so much data surrounding hedge funds). That is downright diminutive, when you consider that as of the end of last year, the capitalization of the world’s publicly traded equity markets alone amounted to $54.57 trillion. Theoretically, there is plenty of room for hedge funds to capture still more assets, perhaps by chipping away at the share of the pie dominated by mutual funds, which at the end of last year had some $13.3 trillion in assets (not including exchange-traded funds).
Nevertheless, the days of SAC Capital and funds of its kind are likely to be numbered, and not just because a team of aggressive SEC investigators and federal prosecutors have them in their sights. The indictment against SAC Capital, one of the biggest and best-known hedge funds, alleges a pattern of insider trading “that was substantial, pervasive and on a scale without known precedent in the hedge fund industry.” If true, that may be only because SAC Capital itself was larger and more aggressive than many of its peers. The real problem here is the nature of hedge funds themselves, and in particular those funds whose managers and traders utilize the same long/short strategy that SAC does, relying on the success of long investments and short sale ideas to generate trading profits.
It all boils down to the pursuit of alpha. Alpha is an elusive critter, as hard to snag if you’re an investor as it is to pin jello to a wall. Essentially, it’s the return that you get as a result of an investor’s ability to identify which stocks (or other securities) are going to do well and which will lag the market, and time purchases and sales of those securities so as to best capture the profits that will follow. (Alpha is in contrast to beta, which is the return attributable to the performance of the market, such as the S&P 500.)
Alpha is the measure of a manager’s skill and savvy; his ability to do accurate research, unearth market inefficiencies and take profitable positions based on them. But in the absence of a fully functional crystal ball, almost no one can reliably deliver large amounts of alpha on a consistent basis. There was a reason that Legg Mason’s Bill Miller was lauded when his mutual fund managed to outperform the S&P 500 for an astonishing 15 years running. When Miller’s winning streak finally ran out, it turned out that his nearest rivals had records only seven or eight years long.
But Bill Miller wasn’t even chasing alpha, just outperformance. Nor was he a hedge fund: Investors in his mutual fund paid a percentage point or two in fees. In contrast, SAC Capital charges its investors a management fee of 3 percent – and walks away with half of any profits. Mind you, it has earned that by beating the broader market consistently since its creation more than 20 years ago (although the losses of 2008 took a big bite out of the average return to SAC investors). The question at the heart of the SAC case is just what did the firm and its managers and traders have to do to create that long-term record?
You see, hedge funds just aren’t what they used to be. The original hedge funds were set up to, as the name implies, offer investors a hedge against what the overall market was up to. Adding the ability to sell a stock short, or bet that its price would decline, offered investors the chance to risk-adjust their returns.
Great idea, and for a while it worked very well in practice, too. But somewhere along the way, investors forgot that they were trying to use this as a hedge or an alternative asset class. Roger Ibbotson, a veteran observer of the market and a professor of finance at Yale, has calculated that on average from 1995 to 2012, the 8,400 hedge funds he studied generated 2.5 percent of that elusive stuff, alpha – or a return that couldn’t be explained by what the stock market was doing but only because of the manager’s skill.
The industry’s success may have become its own undoing, however. As the returns of the best and brightest hedge fund managers soared, more investors wanted a piece of the action. These days, institutional investors such as pension funds desperate for a way to boost their own returns and close funding gaps are driving much of the growth in assets. A recent Deutsche Bank survey revealed that 70 percent of pension funds boosted their allocations to hedge funds in 2012. For some reason, 79 percent of those pension fund investors are hoping that they will earn returns of at least 5 percent and as much as 10 percent on their hedge fund stakes, in spite of the fact that the HFRI Fund Weighted Composite index (one of several that try to take the pulse of hedge fund performance) rose only 3.55 percent in the first six months of the year.
Meanwhile, the S&P 500 was up 13.24 percent in the same period. In 2012? The HFRI composite index rose 6.36 percent; the S&P 500 gained 11.68 percent. Given that some funds – SAC among them – fared far better than that index and the S&P 500, those figures include a lot of laggards. Laggards to which investors are paying steep management fees (2 percent is the industry standard) and a typical 20 percent of any profits.
The problem isn’t with the theory but with the size of the market. With so many thousands of hedge funds out there, and so little alpha to be found, there’s little to go around. And so it’s hardly surprising that rumors long circulated about SAC relying on insider tips and other kinds of borderline or actually illegal activities to generate an information edge. The kind of information that can give a manager a temporary edge – and generate alpha – is scarce in the first place, and thanks to new rules on disclosure, is harder to obtain.
No wonder that, as the government’s lawsuit alleges, SAC Capital sought to hire managers and traders who could show they had networks of useful contacts who might provide tips (one candidate shared a house in the Hamptons with a Fortune 500 CFO), or that the hiring process emphasized a new recruit’s duties were to provide Steve Cohen with a series of “high conviction” ideas. Cohen and SAC profited from those ideas, while allegedly being willing to keep their eyes closed to just how they might have been obtained. (Cohen himself isn’t named in the indictment, although the SEC has taken separate action against him for a failure to supervise his employees.)
Many whose job it is to do due diligence on hedge funds have been wary of just this kind of scenario for many years, advising some of their institutional clients to ask tough questions before investing. There is a reason why SAC insiders have always accounted for a majority of the assets under management: It isn’t just because those insiders wanted to keep all the profits to themselves, but because at least some potential outsiders, whose capital SAC would have been happy to accept, decided to stay away, or asked too many uncomfortable questions and were told they couldn’t invest. (Shades of Bernie Madoff….)
Too much capital chasing too few ideas is what it boils down to. The insider trading allegations, whether or not they are proven, may well lead to the demise of SAC Capital as an organization. The odds are that Cohen will close its doors and turn it into a less-regulated private partnership or family office of some kind, or that so many outside investors will put out their capital that the net result will be the same.
The real question is what this means for the hedge fund industry itself, rocked for the last several years by insider trading allegations. Can the business, at its current size, generate enough alpha to justify those lavish fees without crossing the line? What is the right size for the hedge fund industry? Is it reasonable to expect better compliance and risk management systems if these eat into a hedge fund’s profits? These are the questions that we should be discussing, even as the headlines focus on the specific woes of SAC.