Gaming monthy returns – perverse hedge fund incentives

Why are so many hedge funds struggling this year?  Volatile markets should help active traders, and this year’s rollercoaster has given ample opportunity to demonstrate defensive skills.  Yet, many hedge funds are doing little better in 2011 than their conventional long only counterparts.  Does this reflect unusual market conditions, or might the key to the problem be in some underlying manager behaviours?

 One of the highest profile hedge funds, run by John Paulson, has almost halved in the first nine months of this year.  His other main fund has lost almost one-third.  Paulson was the star manager of the 2007/8 credit crisis, and has merely given back some of those spectacular gains.  But it does highlight a pattern in which many of the winners of 2007 and 2008 are not repeating their success this time.  Hedge funds in drawdown range from long/short equity to credit and macro.  For many, the pattern is the same – continued small losses, more months than not.  The same managers are at the helm, so are they doing something different?

 Fund strategies may differ, but there are remarkable similarities in managers’ tactics and behaviour.  Many have reduced gross exposure, effectively sitting on clients’ cash.  A number have also cut net exposure, with lower market and sector bets.  This seems to be a response to volatility, but does put more pressure on results from fundamental stock selection and market timing.  However, the component of hedge fund returns from leveraging market timing is fading, as in 2011 direction is proving much harder to call.  City research has always been weak on politics, preferring to focus on economics and company research.  Yet, recent market moves seem to be mainly a reaction to official announcements.  And, however bumbling official responses have been this year, they have not been as predictably bad as in the run up to October 2008. The edge that the best managers have has been diminished.

 Clearly something has changed.  Behavioural finance points to the impact of gaming; second-guessing the pattern of returns clients will tolerate.  If not big gains, then at least no big monthly losses.  Managers recognise the sensitivity of clients to extended drawdowns, and typically have cut portfolio risks.  Some seem to change exposures materially during the month – attempting to be opportunistic, but cutting exposure if losses emerge early in the month.  While some clients may be getting transparency on weekly results, generally intra-month patterns are hidden.  This means that the beta of directional bets can look like alpha.  Anxiety has become a third component of the risk and return objectives.  Hedge fund managers are demonstrating their skill at managing expectations.

 Hedge funds’ incentive fee structure tends to encourage risk taking – typically, they share in upside but not directly in losses.  However, for funds with continued losses – under their high water mark – the challenge has been just retaining funds and base fees.   In this environment, the fee structure and commercial considerations can encourage a lower risk appetite.  Clients may not have recognised that incentives may have driven a change in behaviour.

 Managers need to demonstrate that they are not content to manage cash, but can put risk back on at the right time.  This will be challenging psychologically for hedge fund managers, who are also facing additional regulation and trading restrictions.  If the pattern persists, it could drive a demand by clients to change incentives.

 The gaming of monthly returns might genuinely reflect clients’ wishes at present.  Many clients recognise this is an unusual period, and have faith in their managers to get past the current challenges.  However, there appears to be a determination by regulators and governments, particularly in Europe, to shrink the sector.  Psychology, as much as stockmarket returns, will determine how managers respond.  Clients should monitor fund incentives and manager behaviour as this happens.