Analysis: The great hedge fund humbling of 2011

Date: Tuesday, January 17, 2012
Author: Svea Herbst and Katya Wachtel, Reuters

Excuses, excuses and more excuses.

Some of the best-known hedge fund managers have offered lots of excuses for underperforming the major stock market indexes last year, with many large funds posting double-digit losses.

In letters to investors, managers pointed to things like Europe's debt crisis, a slower-than-expected economic recovery in the United States and unforeseen events like Japan's nuclear disaster all coming together to create a tricky trading environment that was characterized by big and often unpredictable swings in stock prices.

The result was a humbling year for the $1.7 trillion hedge fund industry, with the average fund dropping 4.8 percent and some stock-focused funds suffering an average 19 percent decline, according to research compiled by Hedge Fund Research and Bank of America Merrill Lynch analysts.

Investors who sidestepped hedge funds and instead chose mutual funds fared much better. For example, the Vanguard 500 Index fund gained 2 percent, and Pimco's StocksPLUS Long Duration Fund, 2011's best-performing mutual fund, enjoyed a 21.2 percent return.

Not everyone is buying the hedge fund managers' excuses. These skeptics are saying that no matter how smart the managers may be, they are prone to make mistakes just like everyone else and are not necessarily blessed with perpetual special insight into markets.

Industry observers say that what tripped up many famous managers in 2011 was that far too many traders were piling into the same large stocks.

"Investors anoint a new hedge fund demigod all the time," said professor Jim Liew, who teaches hedge fund strategies at New York University's Stern School of Business. "But they are bound to be disappointed, because the rule of thumb is that a manager who can be up 40 percent one year can be down 40 percent the next. They are absolutely human."

One example is Whitney Tilson. His $250 million T2 Partners LLC has generally outperformed the major stock market indexes, but last year was a far different story, with his main fund tumbling 25 percent after losing big on stocks like Iridium and Netflix.

"It has been an extremely frustrating — and humbling — experience," Tilson wrote in a recent letter to investors.

Some in the hedge fund industry say investors should exercise caution before throwing in the towel on managers who lost big in 2011. Industry analysts say that over the long haul, hedge funds have outperformed the major indexes, and last year may simply have been one of those rare times that trip up even the smartest and savviest traders.

After all, hedge funds, unlike most mutual funds, can bet that stock prices will fall by shorting a security, something that has helped them earn eye-popping returns in the past.

"I'm not saying hedge funds did everything perfectly, but it is hard to fight the type of head winds these managers are facing," said Francis Frecentese, who oversees hedge fund investments for Citigroup's private bank.

But analysts at Goldman Sachs found there was plenty of opportunity for hedge fund managers to make money in stocks last year despite all the market turmoil.

To be fair, some stock pickers fared very well, including Tiger Global's Chase Coleman, whose fund gained 45 percent, largely through smart short bets.

Other managers who did well include Philippe Laffont, whose Coatue Management gained 17 percent, and John Thaler, whose JAT Capital was up 13 percent.

In a recent research note, a team of Goldman analysts led by chief U.S. equity strategist David Kostin wrote that the poor performance of so many mangers in 2011 is surprising because the opportunity for stock picking was not much worse than in any other year over the last three decades.

Each quarter, Kostin's team assembles a list of the 50 stocks that "matter most to the performance of hedge funds." Last year, he found that this basket underperformed the broader Standard & Poor's 500 stock index by 5 percent.

"There were too many players chasing too few opportunities," Mary Ann Bartels, head of technical and market analysis at Bank of America Merrill Lynch, said of last year's moves.

Hedge funds have long said their returns would not mirror or be correlated to the stock markets. But Bartels' team concluded that the correlation between hedge fund performance and the S&P 500 hit historic highs late last year.

Bank pain

Some of hedge funds' biggest losses last year were rooted in their love for financial stocks such as Bank of America, which tumbled 60 percent. For hedge fund manager John Paulson, whose bet on gold earned him a record $5 billion payout in 2010, Bank of America's sharp drop dramatically tarnished his reputation. His Advantage Plus fund lost more than half of its assets in 2011.

Paulson and others reasoned that banks would begin lending again as the economy recovered. But their timing was off, and by the time they cut their exposure to Bank of America, Citigroup and JPMorgan Chase — some of the stocks that many hedge fund managers were invested in — it was too late to erase their heavy losses, according to investors with some big funds.

There were other big-name losers, too, especially in the technology sector. Managers, including Maverick Capital's Lee Ainslie, who lost 15 percent, were burned by underperforming Chinese companies like SINA Corp. and Youku.

Even for stars like Daniel Loeb, who had been up double digits earlier in the year, 2011 ended on a flat note. Loeb's Third Point Offshore fund finished off a smidgen, Richard Perry's Perry Partners International fund fell 7.37 percent and Bill Ackman's Pershing Square International slipped 2 percent.

As some managers drift to what critics are calling "group think," several investors reason that it was only a matter of time before the industry's close-knit ties — many managers went to the same business schools and worked at the same funds — were felt.

"It is scary how many managers cannot explain why they own certain positions," said Neil Chelo, director of research at Benchmark Plus Partners, which has $1.8 billion in hedge funds.

Last year's hedge fund losses are especially irritating to investors who have paid hefty fees for hedge funds when they might have fared better with less costly mutual funds.

"After 20 years of investing in hedge funds, I finally realize they are not the holy grail but an asset class with enormous fees, illiquidity, high leverage and hidden risk, given their lack of transparency," said Bradley Alford, chief investment officer at Alpha Capital Management.

But some investors worry that the very same things that led to problems in 2011 — Europe's festering debt crisis and too many large funds playing in the same names — are still around this year. In fact, in some ways the uncertainty may be worse, with millions of voters in Russia, France and the United States expected to go to the polls this year.

"2012 could be a rehash, if not worse, than 2011," said Kurt Silberstein, who heads alternative investments at U.S. Bank's Ascent Private Capital Management and previously selected hedge funds for Calpers, the biggest U.S. public pension fund.