hedge funds and the law of diminishing returns

More commentary in recent days on the real reason for “the wizard of Oz” Greg Coffey’s departure has piqued my own interest.

After a stellar run prior to joining Moore Capital, Coffey succumbed to the immutable law of diminishing returns with his two emerging-market funds losing 16% and 2.3% respectively over the last couple of years – a time remember when many emerging markets have delivered exceptional returns such as Brazil and selected Asia (China not withstanding). “Alpha” has well and truly escaped Mr Coffey just recently…

John Paulson

With John Paulson still heavily under water, even as the US stock market nears its all time highs, and star investor – Anthony Bolton continues to gain an “education” whilst taking a bath in China, many people in the industry are now asking if this is the end of the big-name trader? Jacob Schmidt, head of analysts Schmidt Research Partners, thinks so. “I think we have reached the end of the trend of the last 10 to 12 years of relatively easy money. Up to 2008, we had a fantastic run in the hedge fund business, but since then it has become much more difficult. The guys like Coffey who have had an easy run are thinking: ‘Why do I need this?’ That’s why they are leaving.”

Mark Dampier, head of research at Hargreaves Lansdown, agrees. He says: “Investment is like fashion. One moment it’s all flashy, the next it’s not. They are all fallible and when they start to think they can walk on water, that’s usually when it all goes wrong.” Hubris is the word.

The best “hedgies” achieved exceptional returns in the build-up to the financial crash in 2008. They weren’t alone in that: it was easy to make money in the boom years – most asset classes rose and copious amounts of leverage was thrown around so allowing the hedge fund managers to enhance their returns. However, what set the superstar traders apart was their ability to create the myth that they were infallible, tempting investors to put them in charge of billions of dollars. What is ironic however is the larger the capital pot you have, the harder it is to work that money and be nimble in the markets – think about your own experience in AIM stocks – have you ever tried to get out of an illiquid position? It’s the same with even mid cap stocks if you are a large fund manager – there really is no exit at certain times.

Coffey’s decision to leave now was likely due to Lewis Bacon’s desire to preserve the reputation of his firm and so the lucrative annual management fees before Coffey’s lacklustre run began to inflict more serious damage on Moore Capital, which he joined following a chance meeting with Bacon in the Mayfair car park they shared.

Anthony Bolton, has certainly been humbled following last year’s disastrous performance at his new China fund which fell 28% in six months – even more than the wider Chinese market. Even Bill Miller, once the most famous investment manager in the US, retired after an awful performance over the past few years. John Paulson, who became the subject of the book The Greatest Trade Ever (A must read by the way) after staking billions of dollars on the collapse of the US sub-prime market, just cannot seem to catch a break with his Advantage Plus fund still nearly 40% below his high water mark – made doubly worse by almost two third of the funds money being his and his employee. His mistake has been and early bet on a recovery in the US & eurozone and now he has boxed himself into Gold – just as it looks as if the yellow metals long bull run is running out of steam. 

Chris Rokos

Chris Rokos, 41, co-founder of Brevan Howard Asset Management, announced his retirement in August to “pursue other interests”, and last month Driss Ben-Brahim, 46, th former star at Goldman Sachs and one of the best-paid hedgies in London, earning over £50m in one year, left Man Group’s GLG Atlas Macro fund.

Even Arki Busson – celebrity trader and father to children with supermodel Elle Macpherson and actor Uma Thurman (Rosalind Arusha Arkadina Altalune Florence Thurman-Busson was born in July) – has been on the receiving end of negative headlines.

One theory for the decline of the superstar trader is the rise of the analytical nerd and computerised algorithmic trading. Schmidt says: “The superstars are confronted with a changing market. The punting around is not working. You now need to be either a traditional long-term stock picker, a very short-term person working on algorithms, or a combination of both. There is no future for guys like Coffey.”

“Ten, 15, 20 years ago you had an advantage with getting information before other people, but the internet ended that. I think the next superstars are the ones who combine gut feeling with proper analysis, really understanding the mid-term trends rather than short-term mindsets.”

Coffey’s short-term approach was perhaps most evident when he went on holiday. He would ask technicians at the office to ship trading terminals to his hotel so he could keep on top of his investments! Perhaps such a ferocious work ethic explains why he could retire at 41. But no matter how hard he worked, electronic dealing, taking just microseconds, would have the edge.

Clearly, there are some teething problems with algorithmic trading – Man Group’s system has been heavily slated and the one-day “Flash Crash” of 2010, in which the Dow Jones fell and rose by 1,000 points in a matter of minutes, was caused by computers getting a little over-excited. Nonetheless, some believe investment houses now prefer mathematicians to buccaneers.

Novelist Robert Harris, whose book The Fear Index tells the story of a fictional hedge fund algorithm that gets out of control, said in a recent interview: “They don’t hire anyone to work who has less than a PhD in the natural sciences or mathematics and that weren’t peer-reviewed in the top 15%. They don’t even want someone to come and work for them who’s got a degree in economics. It’s too soft.”

The use of algorithms has become so popular it now accounts for 75% of all trades on US stock markets, with the average stock held for just 22 seconds. 

Assets in hedge funds have still increased recently and are now above pre-2008 levels, at around £2 trillion for the first time although a lot of this growth is due to a general recovery in global markets as opposed to fresh capital commitments So far this year the hedge fund industry has underperformed the S&P 500 by around 10% – a gaping wide margin considering the typical 2% of fees charged. Even worse, when markets have fallen as in 2008 and the early part of the millennia, the benchmark hedge fund indices also fell sharply and so the myth of capital preservation remains just that – a myth. But one that the industry has cultivated exceptionally and that allows Coffey et al to walk off into the sunset with phenomenal personal fortunes when the luck runs out. Great work if you can get it!

YTD chart of hedge fund (weighted) – red index v S&P & Dow – green & blue