The dynamics of the hedge fund industry are changing and so are the managers. The days of expert networks, massive fund inflows and controlled trading are history. Hedge funds are seeing outflows compared with other investments, like high frequency trading funds and ETFs with lower fees. For the traders at mediocre hedge funds, it’s exit time.
A common hedge fund strategy in 2012 is to overweight in Apple (NASDAQ:AAPL). For many of the top performing funds, the performance can be attributed to concentration in Apple holdings, which are up 50% in the first quarter. UBS estimates the S&P 500's Q1 2012 earnings could rise twice as fast with Apple as without it. The star of tech sector is widening the gap from the rest according to Barclay's Capital (tech.fortune.cnn.com). The extraordinary performance of Apple has been crucial to hedge funds.
Uncorrelated + Uncorrelated + Uncorrelated = Correlated
Apple (marcopako)
Many hedge funds claim to have a “diversified model” with a variety of stocks or assets. The problem is most funds diversify with the same strategy, so what shouldn’t be correlated can become highly correlated in the aggregate. Crowded holdings can add risk or lead to systemic breakdowns, as we saw in the banking crisis when the funds were chasing the same trade. Investors are beginning to resist high fees for look-alike funds that ironically can deliver sub-par performance with very high risk.
The hype of being a hedge fund trader is over and the new generation of traders will have to adjust to tighter regulations, lower compensation and perhaps modest economic growth. With Apple driving returns, fund performance can be deceiving. Some funds have 20-30% of their holdings in Apple. Skillful stock picking didn’t lead to purchases of Apple, but rather a need to chase performance or "miss the move." Even income funds own Apple and they were relieved when it added a dividend. The funds that rely on popular strategies, like Apple or expert networks, may not have the adequate expertise to change.
So Long Sun God
As the outlook for hedge funds dim, traders must adjust to a diminished larger-than-life status. Tech investors are interested in a new wave of venture capital managers with social media holdings that could go IPOs. These hands-on managers work with teams of 20-somethings in incubators along with angel investors. The new-guard has tech expertise, good track records and humility.
In the past, the most powerful tech managers at hedge funds operated in opaque packs and gained competitive advantage with proprietary information or en masse raids, with predicable results. Even small-time managers benefited from the cliques as they invested on the edges, privy to major moves by the big boys. Pack leaders were driven risk-takers and made huge leveraged bets. Many had traits of psychopaths, that is, thrill-seeking with big egos and charm, but on the dark side, they were short-tempered, manipulative and quick to blame. In short, packs were powerful but pathological. A Greenwich psychiatrist said fund managers routinely asked for anti-anxiety drugs “to fade in.”
The Justice Department’s push led by the FBI stopped some illicit activity and many tech funds liquidated or cut back. At the same time, foreign investments slowed and the Fed pulled back on easing so the funds became volatile and unpredictable. Senior managers exited, but had enough cash to support lifetime of mega-houses, luxury travel and private schools, and maybe a sports team. Despite being set for life, the ex-managers lament the loss of their electrifying seat on the trading floor.
Masters of the Universe, Retired
John was “counseled out” of a hedge fund in Greenwich over a year ago and hasn’t found another job. He has plenty of cash, a big house and lots of toys, but nothing can capture the glory of the trading desk. He misses the action, whether screaming orders over the Bloomberg terminal or goosing up small cap stocks. His misses the big winnings, without having to risk his personal capital. Like many financial titans, John may have a borderline personality disorder, and doesn’t mix well. “I got rid of the nanny, not ‘cause I couldn’t afford her, but ‘cause she was in my way.” After a workout with a trainer at the gym, the hyper trader races on the treadmill flipping through the Wall Street Journal while CNBC hums in the background.
Old Polmont golf course, Scotland (Wikipedia)
Even the golf outing in Scotland couldn’t match the thrills of the trading floor. Eight buddies in the 1% club flew to Europe on a private plane and were greeted by chauffeured limos on the tarmac. For four days, choppers flew the group to golf courses by day and medieval castles by night. After vodka cocktails and an elegant five-course meal, they retired to the paneled performance halls for entertainment. One night was the “bus & truck” roadie cast of Riverdance and the next night, A Chorus Line. The butler broke out the leaded crystal for aged Scotch whiskey and Cuban cigars. After the luxurious weekend retreat, John landed back in reality with a thud at the private terminal in Westchester Airport. Prospects for a new job were slim.
Another ex-trader, Larry, misses the morning meetings run by his passive-aggressive boss, now in prison. With the fund closed, he hangs around Starbucks with moms and toddlers. Larry just came back from the Caribbean, where he rented a 300-foot yacht with a Jacuzzi and ten bedrooms for a group outing. His baby-boomer guests aren’t as spritely as they used to be. A former college diver tried a gainer off the ship’s third level and broke her hip. Medics airlifted her to a nearby hospital and had barely left, when the vessel sailed off for a scuba diving expedition.
Masters No More
The former Masters of the Universe still dine in style and are welcomed with open arms at a fine Italian restaurant in New York City. Envy hangs heavy in the air when the conversation turns to Steve Cohen’s bids for the Dodgers and the Mets. With a lighter mood, they trade notes on Knicks’ plays and compare season seats. But, without a table full of clients and endless rounds of drinks, the waiter turns his attention elsewhere.
In the Darwinian reality of Wall Street, these ex-titans will never see the inside of a major trading floor again. The hedge fund environment has changed and its chances of reverting back to old customs are nil.
Note: Identities are changed
