Friday, February 8, 2013

Fed Governor Stein on Credit Market Overheating

Jeremy Stein, a member of the Board of Governors of the Federal Reserve System, made some remarks at the St. Louis Fed Research Symposium.  His talk was titled,  "Overheating in Credit Markets." 

One of the subsidiary themes in Stein's paper was hedge fund performance.  As of June 2010, the Ivy League university endowments had forty percent of combined assets in non-traditional ("alternative") investments, versus about two percent in the global investment industry portfolio.

A raw performance comparison between hedge fund indexes and the Standard and Poors 500 equity index over 59 quarters ending Q3:2010, shows hedge funds returning 9.2 percent per annum versus 7.5 percent per annum for the 500 index, with hedge funds having lower volatility and higher Sharpe ratios.

Ivy League university endowment funds, led by Harvard and Yale, pioneered large portfolio allocations to alternative investments (hedge funds, private equity, and real estate).  Dave Swensen of Yale became the public face for popularizing the use of alternative investments.

As of June 2010, Ivy endowment funds had 40 % of their combines assets allocated to alternative investments, whereas global institutional portfolios has only about 2% allocated to these investments.

According to a March 2011, Prequin survey cited by PwC, public pension plans had increased their allocations to hedge funds from 3.6% at the end of 2007 to 6.6% at the beginning of 2011.

So, what's not to like about hedge funds?  The current consensus among financial planners is that every investor needs to have exposure to alternative investments, particularly hedge funds, in their portfolio.  Morningstar even rates long/short equity funds among their mutual fund universe, although this category had a tough 2012.  Unfortunately, hedge funds are truly "black boxes," which should always be viewed with skepticism.

A 2007 paper by John Griffin (University of Texas at Austin) and Jin Xu ( Zebra Capital Management) looked at whether or not hedge fund managers were smarter equity managers than their traditional portfolio manager counterparts.  Hedge funds, they found, tended to deal in smaller, more opaque equities.  According to the multifactor APT models, small caps are an equity sector that has historically provided excess return.  Hedge fund managers also had higher turnover than mutual fund managers.  Because these smaller cap, more opaque equities often trade by appointment, this had to mean the hedge fund managers made extensive use of derivatives.  Their key finding was rather surprising.

"Decomposing returns into three components, we find that hedge funds are better than mutual funds at stock picking by only 1.32 percent per year on a value-weighted basis, and this result is insignificant on an equal-weighted basis or with price-to-sales benchmarks. Hedge funds exhibit no ability to time sectors or pick better stock styles. Surprisingly, we find no evidence of consistent differential ability between hedge funds. Overall, our study raises serious questions about the perceived superior skill of hedge fund managers."
So, why would investor agree to pay a 2/20 (2% per annum management fees; and 20% of portfolio profits) for an investment strategy which, when measured appropriately, may not add value?

According to the New York Times,
"In September 2012, the average hedge fund still charged 1.6 percent annually in management fees and collected 18.7 percent of any gains, according to data provider Preqin. Through November of that year, the average global hedge fund investor earned just 2.6 percent, according to the HFRX global index maintained by Hedge Fund Research. In 2011, investors lost nearly 9 percent. The average annual return from 2009 to 2012, supposedly recovery years following the losses of more than 20 percent in 2008, was a measly 3 percent."
Behavioral economists would say (1) investors are greedy; (2) individual investors, and even public pension funds, are forced to reach for returns in a low return environment precipitated by Fed policy; (3) investors are easily seduced by the black box, APT argument that free lunches of excess returns available to smart managers, and (4) since the fee and trading cost structures are opaque, it is nigh impossible to get an estimate of the true value added by hedge fund managers above their risk-adjusted cost of capital.

Now, in 2012 Governor Stein references papers by Jurek and Stafford who present some interesting data that seeks to decompose hedge fund outperformance.  Overall, they find that hedge funds as a category are not market neutral, which is one of the features their brokers and sales people trumpet when funds are sold to institutions.

Jurek and Stafford find that they can mimic hedge fund performance with a replicating portfolio of cash and a short position in single equity index put options.  In a recovering market uptrend, a manager could easily outperform the SandP by inexpensively replicating the index and by selling out-of-the-money put options on the index; these would expire out-of-the money and the manager would earn the option writing premia, assuring outperformance.

In both severe and mild market declines, the authors show that their replicating portfolio generates the same non-market neutral performance displayed by hedge funds over their research period.

The authors results appear in Table V in the appendix to the 2012 SSRN paper linked here.  The sample period is 1996-2010, and the gross return to hedge funds is the Hedge Fund Research Institute Composite Index plus an estimated average annual fee of 350 basis points, equating to a gross return of 13.1% per annum.  The risk-free rate is 3.14%, and the required risk premium is the mean, annualized excess return attributable to the put writing strategy, which is 9.79%.  The total hedge fund alpha in this model, accounting for a required return/cost of capital is 17 basis points.

Remember that we have progressed from the 2007 paper which showed that hedge fund managers don't have any demonstrable advantage in stock picking or market timing acumen compared to their mutual fund peers.  Yet they appeared  to outperform traditional equity or balanced fund investment strategies.  Now, when the sources of their excess return are decomposed and an attribution is made for their "cost of capital" then their alpha is essentially zero, according to the 2012 research cited by Fed Governor Stein.

So, of course, investors are now rushing like lemmings into hedge funds.

Governor Stein notes that the 2012 historic new high inflows into high yield mutual funds and new issue spread compression suggest an overheating in the high yield market. He, however, stops short of calling it a bubble, because of some historical precedents for the spread behavior.

I thought that the hedge fund material, buried in some references was at least as interesting as the discussion of high yield and leveraged loans. As opposed to financial industry economists, academia and the Fed seem to be producing the most interesting, and disinterested, research.  A reader has to dig for it, though.

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