Institutional investors will be sharpening their scalpels in 2012, cutting managers that failed to provide what they promised: absolute return.
Last year was the second-worst year for hedge fund performance in the 22 years that Hedge Fund Research Inc. has been tracking industry returns, and the patience that institutional investors had for subpar hedge fund performance is evaporating fast, said industry sources.
Industry insiders predict 2012 will be characterized by significant manager rotation within hedge fund portfolios.
“The hedge fund investment trend won't reverse, but many institutional investors will be carefully evaluating how individual managers and strategies contributed to their portfolios,” Anita Nemes, London-based managing director and global head of capital introduction in Deutsche Bank's Hedge Fund Capital Group, said in an interview.
“This assessment is precipitated by huge performance dispersion in 2011 in some strategies, like long/ short equity, but investors will be making their assessment over the longer time frame of the past few years,” Ms. Nemes added.
Last year was only the third since the HFRI Fund Weighted Composite index's inception in 1990 in which the index's return was negative, at -5.02%. The 2011 returns of hedge funds of funds were even worse, with the HFRI Fund of Funds Composite index producing a dismal -5.51%.
By comparison, the Standard & Poor's 500 index returned 2.1% in 2011; the Russell 3000 index, 1.03%; the Morgan Stanley (MS) Capital International All-Country World index, -6.69%; and the Barclays Capital U.S. Aggregate Total Return index, 7.84%.
“2011 was a good testing ground for hedge fund managers who professed to be able to manage risk. Those hedge funds that were not able to preserve capital are going to be under scrutiny,” alternative investment consultant Stephen L. Nesbitt said in an interview.
“The tide went out last year and you could see who didn't have any pants on. Managers complained that everything was correlated in 2011 and they couldn't be expected to perform. There always is an excuse,” said Mr. Nesbitt, who is CEO of Cliffwater LLC, Santa Monica, Calif.
Searches to rise
With chief investment officers weary of excuses, Mr. Nesbitt said he expects “an above-average number of manager searches” in 2012, similar to the first half of 2009, when investors upgraded their manager rosters after the financial crisis in 2008. Mr. Nesbitt said Cliffwater's own clients likely will be among those making changes, but declined to disclose any names.
Deutsche Bank's Ms. Nemes said the biggest change for institutional hedge fund investors since 2008's financial market meltdown has been “so much more emphasis on bottom-up manager selection. And if you were not achieving your performance expectations, how you can effect a change going forward is through manager changes.”
“Fundamentally, institutional investors are not focused on changes to hedge fund portfolio construction as much as they are on assessing which managers will do best in the strategy weightings within their portfolios,” Ms. Nemes said. Part of that evaluation of hedge fund manager skill has to include assessment of the individual manager's ability to find investment opportunities regardless of market conditions, said Michael Rosen. As principal and CIO of Angeles Investment Advisors LLC, Santa Monica, Calif., Mr. Rosen advises institutional clients on hedge fund investments and manages the firm's $160 million hedge funds-of-funds strategy.
“You have to analyze the purpose of each hedge fund in your portfolio and what your expectation of that manager is. If a merger-arbitrage manager is sticking to his investment strategy and the market isn't favoring merger arb, then that manager may be meeting your expectations,” Mr. Rosen said.
Mr. Rosen said that in a manager-by-manager portfolio evaluation, the hedge funds he and his team are most focused on are those in which the manager's investment process has not worked and the manager seems “unsure about where to find opportunity. The question is not really so much about performance as it is about the lack of agility, the inability to see how they can make money.”
The $425 million Louisiana State Police Retirement System, Baton Rouge, is one fund that recently upgraded its hedge fund portfolio to improve performance (Pensions & Investments, Jan. 23). EnTrust Capital Management Inc. was hired in January to run $10 million in a hedge fund-of-funds strategy, replacing GAM, which was terminated for performance reasons in September.
Still, sources were unable to give specific examples of hedge fund and hedge fund-of-funds managers that have seen big redemptions or are among those most likely to be excised from institutional investors' portfolios.
But “drawdowns (negative performance) of a certain size will definitely put a hedge fund in the running” for replacement, said Donald A. Steinbrugge, managing member of third-party hedge fund marketing firm Agecroft Partners LLC, Richmond, Va.
Paulson & Co. Inc. is a large, institutionally oriented hedge fund manager that got a lot of attention last year for disappointing returns. The hedge fund management company that produced a 159% return in 2007 from stellar subprime mortgage bets in its Paulson Advantage Plus Fund sustained a -35% return in the same fund in 2011. The company's oldest fund, the flagship Paulson Partners Fund, was down 10% in 2011, and Paulson Credit Opportunities Fund dipped 18%.
Net redemptions across all of Paulson & Co.'s hedge funds last year were less than in 2010, which in turn were less than 2009 redemptions, said a source with knowledge of the company, who asked not to be identified. The company's assets totaled $28 billion as of Dec. 31, but dropped to $23 billion on Jan. 1 when redemptions and performance were factored in, the source said.
Armel Leslie, a company spokesman, declined to comment.
But Agecroft's Mr. Steinbrugge predicted that “any drawdown of 30% or more just is not acceptable and will not be tolerated.”
He said as investors upgrade, they will be looking for hedge fund and funds-of-funds managers with strong risk controls that enabled them to produce positive returns last year despite extreme market volatility and high correlations between asset classes.
One institutional hedge fund manager — Bridgewater Associates LP — produced 15.3% in its Pure Alpha II fund in 2011. It had annualized returns of 14.6% for the 20 years ended Dec. 31.
The institutionally focused hedge fund Renaissance Institutional Equities Fund, managed by Renaissance Technologies Corp., also had strong performance — 35% — in 2011, although net inflows were “negligible,” according to a source who asked not to be identified.
Jonathan Gasthalter, a RenTech spokesman, declined to comment.
Institutional CIOs might need to move fast if they want to upgrade to 2011's best performers, Simon Ruddick, managing director and CEO of hedge fund consultant Albourne Partners Ltd., London, wrote in an e-mailed response to questions.
“Capacity is fast disappearing with those better-known funds that performed well in 2011, so opportunities to switch into them may well become limited. After way more talk than action, 2012 might see some shift to smaller funds,” he said.