Have hedge funds outgrown the market?

Hedge funds traditionally rely on exploiting market inefficiencies before other, slower-moving players can act. But with the recent growth in the hedge fund industry, strategies are becoming overused and arbitrage opportunities are drying up. Dalia Fahmy and David Watts ask whether it’s time the industry was trimmed down to size

In the past two years, hedge funds have become to the financial markets what the dotcoms were to the overall economy in the late 1990s. Since the massive $3.65 billion bail-out of Long-Term Capital Management in 1998 by a consortium of international banks, investors have poured about $600 billion into hedge funds, tripling the size of the industry in half a decade. Much of that money has gone into more established hedge fund strategies such as long-short equity or convertible arbitrage, however hedge funds that focus on credit have also been attracting money.

Though the momentum has stalled somewhat, there was a period, particularly in 2003, when every week saw a credit market guru leaving a prestigious bank or mutual fund to work at a hedge fund.

But, just as the promise of a new internet-based economy proved as tangible as the cyberspace in which it worked, will the unbounded profits of hedge fund investing prove to be equally illusive?

Recently, indicators have started turning against hedge funds. Deteriorating profits have sparked a debate about whether managers can continue to produce double-digit returns in a lacklustre market. Critics argue that the industry has grown too much for its own good, with too many investors swarming around the same honey pot.

Shrinking returns

Year-to-date, hedge funds overall have returned 2.75% compared with last year’s 15.44%, according to CSFB/Tremont Hedge Index. Credit performance has been slightly better, with fixed-income arbitrage yielding 5% versus last year’s 8% and distressed debt returning 7% compared with last year’s 25%.

But not everyone is convinced that the end of the credit hedge funds boom is nigh or that weaker numbers are anything to start worrying about. Duncan Sankey, a senior credit analyst at London-based Cheyne Capital, a hedge fund that buys and issues CDOs, suspects that the recent talk of a looming crisis in credit hedge funds is the natural result of the market having grown so much so fast. “Isn’t it people’s natural reaction to assume a bubble has developed when something grows very quickly?” says Sankey. But Sankey adds that just because this isn’t necessarily a bubble, it does not mean those investing in hedge funds shouldn’t be looking for uncrowded strategies.

There are good reasons both for why credit hedge funds are performing poorly this year compared with last and for thinking that the credit hedge fund boom may have some mileage in it yet.

This year’s poor hedge fund performance in all assets compared with last year’s is partly a result of low volatility in all asset classes. But in credit a much bigger factor is last year’s extraordinary performance of the credit markets as a whole: Merrill Lynch’s global high-yield index returned 28.2% in 2003 against the 9.18% it has returned this year to mid-November. Looking ahead, hedge fund managers are unlikely to see returns like 2003’s any time soon – but that doesn’t mean hedge funds won’t perform well. When spreads do begin to widen, hedge funds’ ability to go short and use new credit derivatives will mean they are much better positioned than many mandated real-money managers.

“In this kind of market environment, you’re not going to hit home runs very often,” says Peter Abramenko, managing director of Sigma Fixed Income. He adds that investors will have to dig for opportunities in yield curve dislocations, off-the-run sectors and structural mispricings.

Another reason for the decline in the performance of hedge funds is the large influx of new and relatively inexperienced managers into the industry. It’s a natural development: as more players enter the sector, the overall performance of managers begins to mirror the bell curve of traditional money managers. As a result, hedge fund returns begin to resemble broad market returns; they revert to the mean.

“There’s too much capital coming into the industry too quickly and in an effort to deploy all this new capital, hedge funds are looking for new managers and new strategies,” says Abramenko. In the rush, due diligence sometimes suffers. “A lot of hedge funds are expanding too quickly into areas beyond their expertise, and there are also a lot of new managers entering the industry who shouldn’t be managing hedge fund capital in the first place.”

Experts say that with time the mediocre hedge fund managers will fail, good ones will rise to the top and new entrants will continue to feed the cycle.

Definitive data on hedge funds is hard to come by, and most figures are only approximations, but according to numbers provided by CSFB/Tremont Hedge Index the number of hedge funds in all asset classes globally has grown from about 4,850 five years ago to 7,750 today, and their assets under management have tripled to about $900 billion.

There are concerns that the rocketing popularity of hedge funds could become their downfall, with questions being asked about whether too many hedge funds are chasing too few arbritrage opportunities. The problem is that many trading strategies rely on these arbitrage opportunities which take advantage of market inefficiencies – discrepancies in pricing that are overlooked by most market participants.

In the past, a few hedge funds could tap into those cracks without attracting too much attention, but as more players have entered the market, many strategies have become overtraded and the inefficiencies have disappeared. Already some of the cutting-edge strategies of one or two years ago are being squeezed. According to a head of credit prop trading at a US bank: “There are now very few arbitrage opportunities around. One that people were using was exploiting the pricing of different tranches on the tradable indices. But even that is starting to disappear as the models that the Street and the City use to price tranches begin to converge.”

Again parallels can be drawn to the dotcoms. In the late 1990s, online media – able to launch stories faster than other formats and with lower costs – predicted huge profits from advertising. But unlike newspapers and television, online media had no real barriers to entry and so rather than swimming in unlimited advertising dollars they were all chasing the same few bucks. In the same way, no one doubts that hedge funds’ investing style means they can capitalise on market inefficiencies, the question is whether there are sufficient opportunities for all the funds entering the market.

Numbers are not easy to come by for credit hedge funds, but market participants estimate that there are probably between 200 and 500 operating in the market. According to data from Allenbridge Hedgeinfo, 27% of all hedge funds are in fixed income, controlling assets of $2.6 trillion. Of this, $850 million is invested in credit.

On top of that the credit market is not only one of the largest, but also one of the most fragmented of all asset classes. Hedge funds focusing on corporate debt can choose from bonds, loans, promissory notes, commercial paper, trade receivables and more. And within each of those, rating boundaries and real-money investment mandates mean there are subdivisions, including high-grade and high-yield, leveraged and mezzanine bonds. Admittedly, many of these aren’t liquid enough for hedge funds to trade in, nevertheless the fragmentation is sizeable and that is without including credit hedge funds’ favourite instruments: credit default swaps and credit derivatives. All these barriers to investors, which don’t exist in equity or FX, provide hedge funds with numerous opportunities.

The combination of a fragmented market, the relatively small amount of hedge fund money in credit compared with other asset classes, and the development of new, only partially understood products means that the saturation affecting equity and macroeconomic hedge funds has not had much impact on credit.

As a result, not only do credit strategies have more room to grow, but they are also attracting capital from equity investors who have run out of strategies of their own.

“We don’t have a capacity problem yet in the credit space,” says Abramenko. “One of the reasons traditional equity, macro and commodity funds are expanding into credit is because they have capacity problems in their core businesses which don’t exist in credit.” While capacity could eventually become a problem as more money flows into credit, experts say it’s not an immediate concern, given the size and depth of credit markets.

Obstacles

But just because there are still plenty of opportunities does not mean that credit hedge funds are a sure bet: successfully managing a hedge fund requires more than a talent for managing money. Jacob Navon, a headhunter at Westwood Partners in New York, says that starting off with sufficient capital is one major stumbling block, and although initial capital of $100 million is considered by many to be more than adequate, it’s not necessarily enough to keep a fund running.

“People have to distinguish between barriers to entry and barriers to success,” says Navon, pointing out that $100 million will yield a base management fee of $1 million. “That barely covers the light bulbs. By the time you’ve got the office up and running, and you start paying the employees some salary, you’ve eaten through the $1 million and then some.”

As Tim Frost, a partner at Cairn Capital, a credit asset management and structured credit advisory business, points out: “The costs of setting up your own business are significant.” Hedge funds have to cover all the costs of technology, rent, support staff, marketing and PR – costs that may never occur to people within a larger institution. Frost adds: “In the credit space, infrastructure standards are still being established. It’s fine to have ambitious trading plans if you have the infrastructure to support them. Establishing this infrastructure is time-consuming, expensive and represents a real barrier to entry for the time being. Eventually the prime brokerage offerings from the major house banks will fill this gap, but that nirvana is still some way off.”

Navon says most funds fail because they lack start-up capital, which in turn results from hedge fund founders lacking the entrepreneurial know-how. “It’s endemic to Wall Street,” he says. “The people who make a lot of money don’t always have the best business management skills. They may be good traders, but they’re not necessarily good businessmen.”

Still, financial professionals continue to abandon established firms in droves in favour of hedge funds. “The best and the brightest are leaving,” says one source at a Wall Street investment bank. “People are talking about the brain drain.”

Usually, the meritocratic, fee-based pay structure is enough to attract talented money managers, but they also crave the freedom to invest as they see fit, without regulators peering over their shoulders and management boards demanding to approve every new trading strategy. Plus, there’s a certain amount of cachet in being a “hotshot hedge fund manager” as opposed to a “boring bond portfolio manager”, as Navon puts it, even though the nature of the work is the same.

This dichotomy reflects a contrast between hedge funds and traditional money managers that has defined their relationship over the past decade but which experts say will fade with time. “Hedge funds will become more like mutual funds,” says Antoine Bernheim, president of Dome Capital Management and founder of Hedgefundnews.com. “Hedge fund investors are going to become more commoditised, and will experience overall mediocre and disappointing returns. That does not mean that many hedge funds can’t be highly successful, but it means that the hedge fund investor universe which is looking to generate excess return per unit of risk will not achieve that goal.”

As hedge funds and mutual funds converge, the brain drain is likely to reverse itself, which will further equalize the two sectors. One of the original European credit hedge funds, BlueBay, is now also a manager of real money, but it uses the experience it has gained in trading credit default swaps and credit derivatives in its real-money funds. Cairn Capital manages both hedge fund money and real money.

Some argue that hedge funds just represent the latest incarnation of small, independent asset management firms, and that as they become more common, demand from both retail and institutional investors will continue to grow. To meet this demand, large banks and traditional investment funds have already been setting up or buying hedge fund units, and proprietary desks are employing hedge fund strategies to boost their income. Several institutional investment firms have set up internal hedge funds, including Gartmore, Threadneedle and Axa. Lehman Brothers is reported to be talking to GLG, one of the world’s largest credit hedge funds, about a buyout. And ING has recently set up a proprietary credit trading desk headed up by Andrew Munro, former head of credit trading at National Australia Bank in London.

Even if the predictions of overcrowding in the credit hedge fund space do become true in the future, at least the market can rest easy that it will not follow in the footsteps of famous failures like Boo.com – which proposed selling outdoors and sports products online to people too lazy to go to a shop.