Trimming the Hedgies

Going through my daily abnormal returns browse these days makes me want to misquote Admiral Beatty at the Battle of Jutland: there seems to be something wrong with our bloody hedge funds. They’re crapping out left and right. What gets me is not just that they are all doing it at the same time, which is astonishing enough, it is that it seems to be getting worse. Given half decent risk management, this should not be happening. I was aware of the existence of hedge fund beta where it comes to Quants, but I had always assumed there was sufficient diversity of opinion within the rest of the popular hedge fund strategies, particularly in equity long short, so that they would have some sort of diversity in their returns. I had also assumed that these guys were smart and flexible enough to be able to stop themselves out, to switch stuff around and refashion their portfolios to find something that works. At the very least, they could have just stopped doing anything, cover shorts, sell longs, and go flat.

This is clearly not the case, and I have not yet found a convincing explanation for it. The Citadels, Atticus(-ses, Attici?), Tontines, Fortresses of this world seem to be deer in headlights. Their performance is deteriorating over the course of this year, not stabilising. September was the worst month ever, we were told, so it would not be a very difficult decision to retrench, take some action, gross down and change orientation some way. Instead we find out that October was worse.

What the hell is going on? Is it just that they are deeply stupid? Like the Janus and Nicholas Applegate long only guys in 2000-2002, holding on to Worldcom and JDS Uniphase until they were carried out? Is it that they are still leveraged? Is it because other strategies are losing much more money than the equity long short guys can be making or not losing? Is it because they are stuck with illiquid positions they can’t exit, or have to slowly and their own selling pressure is bleeding them white? Are they just structurally net long? How and why? Why can’t they change??

I suspect there are 2 main explanations. Firstly, while these big multi-strat managers may not actually be stupid, their problem is more that they are hidebound, cowardly and unimaginative. They are locked in a terrfied protective huddle in the same old positions, that makes them nothing more than a vast target. Secondly, they have squeezed everyone out of the market. Small hedge funds don’t get a look in. Long short equity hedge management as it is currently run is a vast crowded trade, and losses in the weight of money devoted to it outweighs the gains of the very few who are coining it. They can’t bet against the system like the old ones did; they are the system.

Last time we had a bear market, hedge fund fortunes were made. Andor Capital, William von Meuffling, Crispin Odey, Chris Hohn, even Jim Cramer when he was trading, all made out like bandits producing 20-50% returns on the short side in 2000-2002, many after having doubled their money by being long in 1999. This made them look, if not like gods, then at least jolly clever and deserving of an investment. Hedge fund managers were smart, nimble, slightly less eminent versions of George Soros, milking the patsies in the long only community for vast profits. Hugh Hendry would come on CNBC Europe and wow us with his acumen and shibboleth-smashing iconoclasm; everyone was wrong! Only he could see the truth, it seemed. Chris Hohn would rarely have a down month, let alone a quarter, and at the end of the year give half his profits away to charity, that was how much he thought of the armani-wearing, white-toothed, fake-tanned, long only growth managers whose pockets he was picking. The successful hedgies ran maybe $1bn, most ran less, and Andor, the biggest long-short manager, ran about $6-7bn. They were cool, they were urban guerillas who were also millionaires, and lots of them were eccentrics (apart from Andor. They were dicks).

The contrast with today is astonishing. Hedgies got institutionalised. Lots of them got listed, even. The meat of hedge fund assets are concentrated in a few $20-40bn funds, with 10s of $10-20bn funds and dozens of $3-10bn coming behind. A lot of the big ones have the same multi-strat structure, with books or products to sell running some or all of fixed income, quant/stat arb, macro, convertible arb, merger arb, event, LS Europe, LS America, emerging markets, maybe a couple of sector strategies. The managers themselves are anonymous prop-deskers, buttoned-down chino-wearing MBAs, backed up by a bollocks risk management system likely based on VAR, Barra or a combination of the two. The founder/head/CEO is further from investment decisions than he used to be, and runs not a portfolio, but a vast organisation with thousands of employees, gets interviewed on Portfolio.com, buys art, and the only unpleasant thing that happens to him (and it is a him, no women in this club as far as I can see) is that he may be the subject of nastily personal posts by crusty old TED. They now come up with mission statements like this:

Visionary organizations don’t chase the impossible; they focus on extending their reach to achieve the possible. We don’t let up in the face of challenge, and we don’t call it a day when an answer isn’t readily at hand. Relentless effort, relying on our teammates and colleagues, and remaining open to unconventional solutions are the keys to the XXXXXXX approach.

The older style hedgies wouldn’t have bothered with a mission statement, they were too busy. That mission statement is from Citadel, by the way.

Bollocks mission statements are mostly harmless; it’s the way these new hedgies seem to invest that makes them vulnerable. Their employees do the work, for sure, and stay up late, but they still somehow seem to move in self confirming herds. Mention a popular stock to one of these managers, and you are as likely to hear about which of their colleagues or competitors owns it (the implication being that Atticus and Citadel are smart and obviously know something, so you should own it too) as you are about its earnings prospects. You are not likely to hear an original investment thesis. This rather good article  from Felix’s rag (which I found just as I was about to finally publish this fricking overlong post making large parts of it redundant thanks a lot) expands on this, and a few other points covered here on this post.

The new hedgies take big, concentrated positions, up to 5% of the floats of their favourite stocks. They are in cahoots with each other and the sell side, and I am not kidding here, they help write the research. They do this by promising to get analysts who don’t publish positive research on their stocks fired. They can do this because they pay much, much more money in commission than anyone else. Sell-side analysts in turn pass on their feedback to company managements (who can’t give them preferred access because of Reg FD), give them 1st call when something new happens, or the analyst has thought of a new narrative to make the stock go up. Negative thoughts are surpressed by subtle threats. You can find out what are the biggest hedge fund stocks by a simple expedient — look up how many buys or sells on any stock. If there are a huge preponderance of buys, only a couple of holds, and very few sells, it is probably a hedge fund stock.

In tech, which is all I really know about, there are lots of hedge fund stocks. RIMM and Apple are for sure. Google used to be but has fallen out of favour. Accenture, Visa and Mastercard also count. The all-time classic hedge fund stock is Qualcomm, however. It has one Sell rating. The rest are buys. QCOM is famously owned by 10 hedge funds. All of these funds and their analyst “bitches” (not a technical term) have been spectacularly, devastatingly wrong, as shown by the quarter QCOM printed last week. Demand has fallen off a cliff for the cellphone chips Qualcomm makes, and the 3G phones they earn royalties on are not flying off the shelves, but rather are sitting there unsold, their dollar ASP shrinking as the Euro and korean Won tank, in this, the worst recession in our lifetime according to the CEO of Intel, who you would think was in a position to know. Then you read the analyst reports: “relax, it’s an inventory correction,” they write (right, for everyone else it is a demand correction, for QCOM it’s “inventory”); “QCOM are conservative, they’re low-balling,” we are told; “look forward, not back, it’s a buying opportunity!” Denial’s not just a river in Africa, girlfriend. Any other stock would have had some downgrades off this, but the analyst reaction, encouraged by their hedgie enforcers, simply maintains an atmosphere where the stock can’t capitulate, it can’t clear and have a chance of going up sustainably. Hopefully the Ten Hedgies are using the current rally to jump ship; by my reckoning the stock has another 30-35% still to fall.

In tech, the new hedgies are hanging onto the winners of the Great Moderation, and instead of selling them when they go wrong, their first impulse is to defend, manipulate, and hang on. None of the stocks I mention above, not one, will get through this without severe pain still, and the postponement of their doom will simply make it worse when it comes.

The other problem they have is that in many of these stocks, these big hedge funds are the principal buyers and sellers. They have created crowded trades. The purest and best example of a so-constituted crowded hedge fund trade, Volkswagen totally reveals the type of disaster that still may be waiting to happen in the asset class.

Porsche wants to buy Volkswagen. They found a loophole around German takeover laws; they discovered they didn’t have to make a risky tender offer for the shares at a vast premium, they could buy OTC call options (I don’t know the maturities or strikes, or how much exactly they own in this way) off a bunch of banks who naturally had to buy the stock and hold it for the life of the option to offset the risk. This drove the stock up, much farther than people thought it should. So the hedgies glommed on, forgetting the stock had been cornered by Porsche, to such an extent that they shorted, collectively, an amount of shares larger than the free float. This is technically possible if some of the long term, non-free-float holders fancy making a bit of money on the side by lending out shares. As far as I can tell, absolutely every hedgie who could shorted Volkswagen. And when one of them had to sell it, it triggered the most almighty single stock short squeeze I have ever ever seen. Silly Volkswagen at one point was the largest company in Europe on stockmarket capitalisation, and still trades at a 70x PE versus the market at about 10x. It was a disaster for the industry.

I have no idea what proportion of trading in the past few years was from hedge funds, but remember that $1 of hedge fund money produces a lot more trading commission than $1 of long only money; not only does a typical long short trader turn over his portfolio many more times, the impact of leverage magnifies that even more.

This combination of dumb investing and overcrowding is highly toxic. It struck me the other day that just as the 2002 rally that ended the bear market seemed to coincide with the going away of the go-go growth investors which had dominated the earlier bull market, then maybe we can’t properly rally until we neutralise the impact of the big multi-strats; either they get into some new positions and change the way they invest, or they get their assets so reduced that they no longer dominate. Reading the other day that pension funds intended to increase their allocation to hedge funds did not encourage me to think that this is going to happen any time soon.

The only conclusion I can make is that it is my job to shoot against these guys even more than I have been doing. I need to be long their shorts and short their longs. Even if I am wrong about the fundamentals I will have the wind of their redemption at my back, but as their stock holdings are still generally positioned for the last, bullish, cycle, and we seem to be headed into a really awful recession, I am more likely to be right.

This is harder than you think. It means going against everything everyone in Wall Street tells you to do. It means shorting or avoiding AAPL, RIMM, QCOM, V, MA , GOOG, etc. It is lonely being short QCOM with no friendly sell siders to hold your hand and tell you it will be OK in the end. The other problem is that the hedgies are not stupid. The business models of these stocks tend to be very good; you have to get deep into the numbers to see where the flaws are, to do the intense work their owners used to in picking them in the first place.  Doing the opposite of what feels good, what makes sense, is apparently called “Chinesing”. Don’t ask me why. Actually it feels a bit racist. But the fact that there is a word for this implies that others are doing it, too.

There are some long-short funds doing well this year. But they are smaller, and up until now were relatively obscure. “Hedge fund” is not a monolithic description, and it is not like long-short investing is a recent fad, soon to die away, investors have been long of some stuff and short of other stuff at the same time since before the days of Larry Jesse Livermore, probably since the start of stockmarket investing as we know it, back in the Amsterdam of Spinoza’s time. It’s not going anywhere. Hell, go-go growth long only tech mutual funds didn’t die off after the popping of the bubble, there are still a few struggling along (one pays my wages). Moreover the mega multi-strat hedge fund offers an extremely convenient one-stop-shop to a frazzled endowment or fund of funds manager. Without them, they may (gasp) have to go off, take some risks on new managers, and finally do some work. I really have no idea when they will finally go away, though in their current form they must.

All I know is that right now it feels like something is broken.

12 responses to “Trimming the Hedgies

  1. “Even if I am wrong about the fundamentals I will have the wind of their redemption at my back”

    The easiest trade for small managers is to play redemptions at the moment – the overhang on some of these stocks is outrageous

  2. Roger Knights

    I think you meant Jesse Livermore, not Larry (last paragraph).

  3. Mr Moneybags

    It’s Jesse Livermore, not Larry. His middle name was Lauriston, though, so you’re no that far off.

  4. pedants

  5. I don’t think the hedge funds for the most part ever existed. Maybe 100-200 out of the 10,000. the other were just a compensation class. Yes I work for one and yes I am up for the year.

  6. Unbelievably awesome and accurate post.

  7. With the 13-F’s rolling in we will be able to see how much “they” have sold.

    Great piece, would have been absolutely genius 3-6 months ago.

    Shooting against them has been one of best trades ever. But what inning is it? New ballgame starts in January.

    But Ackman just filed on SHLD, he got out in 3Q,

    All they piggybackers on that trade have been carried out, broke ranks and scattered.

    But the days of these smart ass 30 year olds going uptown to Columbia to hear Bishop from Impala pontificate on airlines and fertilizer, and piggyback the next day are over.

    And Fund of funds are lemmings. Basel 2 was a joke, prop desks copied their customers.

    big is not better.

    RIP Hedgistan

    Certainly could go down more, but

  8. Hey Jock, what happens in January? Tell us more about this Ackman. What trades are left?

    Indeed it would be ironic if the “real” hedgies Herr Gogerty mentions formed a crowded trade betting on the crowded trades of the “fake alpha” hedgies.

    What would we all do then?

    Me, I remember it took a good couple of years for the go go mutual funds to become small enough and widely ignored. Maybe it will be quicker this time for the fake hedgies.

  9. Have none of you read “Reminiscences of a Stock Operator”? The “Larry” bit is an obvious bow to that book and Larry Livingston, the alter-ego of Jesse Livermore.

  10. Yes! That’s right. I am surprised you guys didn’t get the allusion. Well done Paul. A signed copy of Spinoza’s Theologico-Political Treatise in the original latin is on its way to you.

  11. So how did you come out on that trade?

    It was the 7th inning for the those trades, we were close to the bottom of price, not necessarily time, in things like CLF which was the posterboy for knuckleheads.

    Ultimately I heard Falcone never even lobbed a call into management before amassing that stake, something I find hard to believe but relayed but a reliable old time source.

    You had to turn the knife on Tontine etc first week of October to really ring the register but only the most plugged in and experienced people knew what was going on.

    add thest to you list MT CME SHLD etc

    you were too late with thesis, no?

    Citadel GLG Highbridge Brevan Howard all are generally alive and breathing, and in some cases ready to capitalize on some of the misfortunes of others.

    Harbinger will probably emerge as distressed fund, heard they are ready to make some changes.

    Gotta believe Atticus is all but done.

    But avoiding, or shorting AAPL and RIMM GOOG on November 13th?

    In hindsight, that trade was over.

    Hopefully one upshot of all this is that the smaller emerging managers are able to get taken more seriously, I knew of several that had pitched the likes of Fairfield Greenwich over the past years, only to be laughed at by the khaki wearing guys in those pristine offices.

    And many of the fund of funds and Euro’s were just as condescending.

    Regards,

    SJ

    • You know, Stock, I don’t even remember. It depends what I had on the other side, and how much of it I had. 2008 was actually OK for me on the long short side; other parts of it sucked very very much. I only do tech, so CLF et al was not the subject of my shorting.

      I was relatively late with the thesis, true, but I had been trading on it before I blogged it, so it worked out OK. Not a mega slam dunk, and horribly stressful, but I can’t complain.