When to give back the Bacon

My last two posts both were both very critical of ethics in the markets. Today I would like to give some praise. Louis Bacon, manager of a very large fund ($8Bn) of assets has decided to give back a quarter to investors. It is, in essence, admitting defeat. And that is something investment professionals seem to be very loathe to do.

Hedge funds do not like to give back money to investors, even when the investors themselves request it. More assets under management (AUM) means reduced management fees and less prestige. Giving back money also immediately says that you are unable to make money, that you are stumped, that the money is better invested elsewhere. Mr Bacon is giving up about $60m a year (but don’t praise him too much; he is worth over a billion. He is not giving up anything he cannot do without).

Mr Bacon, after recent poor returns, does admit that he just can’t make money in the current environment, not with such a large pool of assets. His fund seems to focus on macro-economic strategies, meaning it makes bets on macro-economic factors affecting countries as whole. Most notably, in this environment, that includes everything affecting the sovereign debt crisis. With all the government intervention and decisions by Ms Merkel (prime minister of Germany) and Mr Draghi (head of the European Central Bank) sending markets up and down, but with no decisive actions being taken, Mr Bacon feels he cannot make a bet on the market movements. He needs to bet something big will happen. And it just won’t happen. Probably Mr Bacon feels he cannot figure out what’s going to happen next, but he hasn’t gone quite as far as admitting that.

A large fund is not as agile as a smaller fund. With a smaller fund Mr Bacon will be able to take smaller positions that have a larger impact on the overall performance of the fund and be able to move in and out of positions more quickly. Hedge funds normally charge a performance fee – if the increase in performance is high enough it may offset the loss of the management fee mentioned earlier.

 Mr Bacon cares for his image. That is why he’d rather try to make a decent return on a smaller fund than poor returns on a larger fund. However, admitting his inability to profit from current market conditions is quite laudable for a man who made his fortune placing bets on other international events equally as murky. He also seems to take his responsibility as a custodian of other people’s money seriously. He cannot give the performance expected and so he has his investors put their money elsewhere. Unfortunately, for many, admitting the limits of their abilities does not seem to come as easily.

References 

• Chung, J. (2012). Louis Bacon to Return $2 Billion to Investors. Wall Street Journal. Retrieved August 3, 2012, from http://blogs.wsj.com/deals/2012/08/01/louis-bacon-to-return-2-billion-to-investors/ Herbst-Bayliss, S. (2012).
• Big hedge funds seen unlikely to diet after Bacon slims down. Reuters. Retrieved August 3, 2012, from http://www.reuters.com/article/2012/08/02/us-hedgefunds-idUSBRE8711VN20120802 Thomas Jr., L. (2012).
• Too Big to Profit, a Hedge Fund Plans to Get Smaller. Dealbook. Retrieved August 3, 2012, from http://dealbook.nytimes.com/2012/08/01/hedge-fund-titan-plans-to-return-2-billion-to-investors/

Imaginary Alpha

Alpha is what hedge funds sell. It is the skill of the investment manager(s), allowing them to earn a higher return than justified merely by the amount of risk they take. In practice this means earning more than a simple index fund. For this excess return, hedge funds charge higher fees. Presumably this is justified. In an efficient market alpha would be zero – there would be no way to earn (on average) higher returns than the market as a whole. No one (except economists and some MBA students) believes markets are efficient anymore. However, since 1998, hedge fund clients (in the US) have earned on average only half the rate of return on treasuries.

Self-selection bias

Indices of hedge fund performance suffer from a crucial flaw which make them (in my opinion) all but useless. Reporting to the indices is voluntary. And as such only hedge funds that perform well will start to report. Those that perform badly will stop reporting. The indices thus overstate hedge fund returns.

It has been argued that this may well be offset by the fact that the top-performing hedge funds may also choose not to report. They may do so because they have already raised enough capital or because they no longer need the exposure.

It would, however, appear that the latter effect is far smaller than the former, making any studies based on this data (which is most studies up to this point) suspect.

Damnation

A recent study by Aiken, Clifford and Ellis indicates that hedge fund alpha may well be much lower than previously thought. They find that, in fact, most of the alpha of hedge funds is explained by their decision to report (or not) in the commercial indices. In order to get past the self—selection problem they use the figures of funds of funds registered with the Securities and Exchange Commission. These funds invest in other hedge funds, whose returns can thus be scrutinised.

Funds that stop reporting afterward have dramatically lower returns than those that continue. The delisted funds continue to operate for some time and contribute zero alpha. This would still mean a positive alpha for hedge funds overall, but smaller than given by only examining the reporting funds.

Why not invest only in funds that do report returns? The hedge fund sector is illiquid – it takes time to get your money out. There is also a lag in the reporting of returns. An investor cannot be sure that a hedge will report its most recent returns.

Another problem (not tackled by the paper) is that some funds may perform well when they are small, which allows them to attract more money. This performance may or may not be simply due to luck. However, when (not if) the fund performs badly, its cash losses may well exceed all previous gains, simply because it now has more money. Investors, on average, lose out.

The above can be applied to the industry as a whole. When it was small, it was making high returns, and attracted capital from various sources. However, the losses in 2008, may have wiped out all cumulative gains in the industry going back ten years.

Caveats

The Aiken, Clifford and Ellis paper does suffer from flaws and these should be considered when evaluating the results. For instance, the period studied is from 2004 to 2009. It may be that a longer time period (or a future time period) gives different results. There is at least one study that finds no evidence of a selection bias due to the fact that funds that perform well may choose to stop reporting after having raised sufficient capital. The Aiken, Clifford and Ellis study itself has a selection bias, in that it only examines hedge funds that are invested in by funds of funds reporting to the SEC. The authors do, however, perform various tests which suggest that this results in no systematic errors. The statistical methods used are based on normal theory and as returns patently do not follow normal distributions, results should be treated with some scepticism. However, this latter point applies to most financial papers.

The dilemma

Hedge fund managers earn very large fees. They have done so, despite that their clients have walked away with meagre returns. This raises the question of whether the alpha displayed by some managers is anything more than mere luck. People have trouble believing in luck. They attribute high returns to skill. This is good for hedge fund managers, but it may be very bad for investors.

Some references

• Aiken, A. L., Clifford, C. P., & Ellis, J. (2010). Out of the dark: Hedge fund reporting biases and commercial databases. Finance.
• The Economist. (2012a). Hedge fund returns: More damning data. The Economist. Retrieved January 21, 2012, from http://www.economist.com/blogs/buttonwood/2012/01/hedge-fund-returns?fsrc=scn/fb/wl/bl/moredamningdata
• The Economist. (2012b). Rich managers, poor clients. The Economist. Retrieved January 21, 2012, from http://www.economist.com/node/21542452
• Wikipedia. (2012). Alpha (investment). Wikipedia. Retrieved January 21, 2012, from http://en.wikipedia.org/wiki/Alpha_(investment)