Titan Inv Partners – Hedge funds and why size matters (the rare occasion where smaller is better!)

8 mins. to read

Richard Jennings, CFA. Titan Chief Fund Manager

Hedge funds! The very words conjure up images of rocket scientists and tough talking traders in busy dealing rooms, surrounded by multiple screens and plenty of spondoola’s. Whilst those stereotypes are still probably not too far from the truth, the reality is that for many hedge fund managers the glory days seem to be over.

The downturn in the fortunes of these latter day “masters of the universe” can be traced back to the financial crisis that developed in the wake of the collapse of the US subprime mortgage market and associated securitised products. This in turn triggered a collapse in global liquidity which came to be known as the credit crunch or “Great Financial Crisis”.

Subprime “King” John Paulson

On the face of it, the Hedge fund industry appeared to have weathered the global financial storm very well with assets under management reaching a new peak. One could argue that it was not a mess of their making, and indeed, in several well documented instances (and presumably in many less well known cases), hedge funds and their managers made handsome profits from the crisis, as shrewdly placed bets came good and then some. John Paulson and his $4bn haul from betting against the U.S. subprime crisis being a prime (‘scuse the pun) example.

However the world had been changed for good by the events of 2007/2009 and we now sit with a very different investment and economic landscape to contend with. It is true that the liquidity gap that brought the global economy to a virtual halt in 2009 has been resolved (but not the debt hangover which still sits there like the elephant in the room) but this was been rectified by the all powerful central bankers through the continued pumping of fiat money into the system in re liquefying the commercial bank and trying to inflate some of the debt away.

The banking powerhouses that had historically provided leverage, stock borrowing and multitude other services to the hedge fund community had to pull in their horns substantially let’s not forget that two of their number Bear Stearns & Lehman Brothers fell by the wayside during the crisis), at least initially in preferring to retain the central bank liquidity for themselves rather than pass it on.

The term QE (or Quantitative Easing) is a catch all term used to describe a range of unconventional monetary policy tools which, until the aftermath of the credit crunch, had largely been theoretical in nature and rarely applied historically in recent times with the exception of Japan in the 1990s and which appeared to be ineffective. Make no mistake, QE is very simply the printing of new money. What has happened this time is that the money has been retained within the financial system and has not (yet) permeated into the wider real economy. There is no precedent for this not permeation not actually ultimately occurring however when considering the magnitude of the printing. The question is really when will the velocity of money rises again, as the “lag” has been very lengthy this time.

What with TARP, QE in the UK, “whatever it takes in Europe”, BoJ printing etc we have actually been witness to the biggest market support operation of all time. Jury is out on whether it went too far. Our money’s on the yes vote here.

The net effect of the central banks collective actions has been to buy assets and also produce a relatively benign economic climate in the USA and other developed economies. As some would have it – “a one way market”. We are old enough here to realise that there is no such thing as a one way market.

The multi-year rally seen in the S&P 500, which serves not only as benchmark for US investors, but also a bellwether for large cap international equities across the globe has been nothing short of astounding, particularly over the last two to two and half years. It’s true to say that American corporates, and indeed those in many other developed economies, are in much better shape than they were just a few years ago. Many critics would argue however that this has only been possible because of the massive expansion of the Fed’s balance sheet. So I suppose we can say on this measure alone that the support operations have been a success.

The loooong 5 yr 2 months bull market…

Meanwhile the trading landscape has changed dramatically too. Barely a month has passed since the autumn of 2009 without governments, bureaucrats or regulatory bodies seeking to introduce new legislation, which has prohibited some financial activities, made others uneconomic or, in the worst cases, forced banks and other financial institutions to reduce their balance sheets and the business areas within which they operate accordingly.

High Frequency Trading

At the same time, a new breed of computer driven trading has emerged, something that would come to be known as HFT (High Frequency Trading). These algorithmic systems, often with equipment co-located next to the servers of the large exchanges, operate at speeds beyond human comprehension or observation, across multiple trading venues and in so called dark pools. They look for tiny price differentials which they can exploit within just fractions of a second.

On top of this, the use of so called “expert networks”, deployed by many large hedge funds to gain an insight into particular industries and stocks has been deemed by the US authorities, in some cases, to amount to de facto insider trading. Indeed there have been some well publicised prosecutions and the dismantling of those expert networks. The SAC Capital story being a prime example.

In summary then, in just few short years, the majority of advantages that had been enjoyed by large hedge funds have disappeared or have been severely curtailed. Over the same period, we have witnessed unprecedented growth in the use and availability of ETFs and other index tracking instruments; many of which offer access to exotic asset classes, emerging markets etc to retail investors that had previously been the preserve of institutions.

So much for the history lesson then, what does all this mean in practical terms you may ask? 

The net effect of all the above has been to consistently diminish the returns made by large hedge funds both in real and relative terms. That is to say that the excess returns enjoyed by hedge fund investors prior to and immediately after the financial crisis have largely disappeared. At the same time, traditional long only and (perhaps most galling of all) passive index tracking strategies have been firing on all cylinders. In a recent research note on the hedge fund sector and its returns (flagged yesterday by the US finance blog zero hedge) U.S investment bank Merrill Lynch Bank of America noted:

“Since the financial crisis, Hedge funds have generated positive alpha of 0.0999%, which is lower than the 0.7922% of positive alpha generated before the financial crisis. Additionally, hedge funds are more exposed to market risks than before the financial crisis. Since 2009 the CAPM model has explained 75% of HF returns, but pre-financial crisis CAPM explained only 2.96% of returns. In summary, although hedge funds still offer positive risk adjusted returns, the investment is becoming less attractive as an asset class due to the lower alpha and less diversification benefits”

Put simply, large hedge funds have to run bigger and bigger positions to make money all the while being faced with diminishing returns and rising costs. By the same token, the outlook for smaller fund managers which are more nimble, are unconstrained by scale and face lower comparative administration cost paint quite a different picture…

All this doesn’t mean that there are no excess returns available to investors, but rather that they are unlikely to be generated by larger hedge funds in the foreseeable future. Indeed there are several academic studies which suggest that it is smaller mangers that have generated most of the positive returns posted in the hedge fund asset class over recent years.  Of course, small is relative but in this instance it refers to those funds with less than $50 million dollars under management.

Here at Titan we operate in a manner that is largely driven by dislocations of asset classes from fundamental value. That is we look to position ourselves at the point in the investing cycle when many other investors have given up the ghost or alternately, on the short side, the masses are “all in” blinded by greed. We hold core asset class plays in our Global Macro fund and attempt to add additional “alpha” around the edges through taking position in specific stocks – generally small and mid cap although we have ventured up the scale to play large caps too such as NFLX, BBRY & KAZ. We apply gearing counter cyclically too and all the while apply strict risk controls to ensure we are not too exposed to one particular stock. And most importantly, our fund sizes are not too large where we cannot operate nimbly.

Below is a chart of our returns this last year. To learn more about our unique offering that holds out the potential of “hedge fund” type returns and additionally, totally tax free*, click the banner below for more details.

Past performance is not necessarily a guarantee of future performance. Returns are gross before the application of our performance fee.

*All Titan Funds operate within a spread betting account which means gains or losses are currently free of tax. However, legislation can change in the future. Spread betting is a leveraged product which could result in losses of some or even all of your initial deposit. Ensure you fully understand the risks.

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