1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #73!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In our podcast today, we will discuss the hedge funds industry with Raymond Kerzerho, PWL’s Senior Researcher
Enjoy!
2) REVIEW OF HEDGE FUNDS: DO THEY MAKE SENSE FOR INVESTORS
François Doyon La Rochelle:
Hello, James! How are you today?
James Parkyn:
I'm very good, Francois. And how are you?
François Doyon La Rochelle:
I'm fine, thank you! Hello, Ray, and welcome back to the podcast. We're pleased to have you with us today.
Raymond Kerzerho:
It's my pleasure to be here.
François Doyon La Rochelle:
Okay, great. So, we've invited Raymond to join the Podcast today because he has recently published a series of articles covering the hedge fund industry, and we thought that it would be of interest to have him on the show to cover the main findings of his research.
If our listeners are interested in reading Raymond's articles and perhaps gain further insight into that industry. The articles are available on the PWL Capital website in the Learn section, and we will make sure to provide links to the articles with this podcast for easy access.
So, Ray, let's start with our discussion today with a basic question. The term hedge fund is widely used. But what exactly is a hedge fund for listeners?
Raymond Kerserho:
Yeah, hedge funds are quite particular. They share a series of characteristics. First and foremost, they involve complex financial strategies using a combination of short sales, derivative products, and or leverage.
François Doyon La Rochelle:
Ray, I’ll stop you here. Can you explain for our listeners what is a short sale?
Raymond Kerzerho:
Yes, François. A short sale is simply like selling a stock that you don't own in the hope of making money if it goes down in price.
François Doyon La Rochelle:
Okay. So, it's the opposite of buying a stock in the hope it's going to go up.
Raymond Kerzerho:
Exactly François! So, there's these complex strategies. One thing that's important to understand about hedge funds is that it's difficult to generalize about them. Some of them are extremely volatile, and some others are very conservative, and they provide bonds like expected returns.
Another thing that is common to most Edge funds is that they have a complex fee structure, usually involving a combination of base and performance fees. Another thing is their opaqueness. Usually, hedge funds are very reluctant to divulge anything about their investment strategies, or at least to divulge some details about their investment strategies. Usually, they say it's competitive intelligence, so they don't want their competitors to know what they're doing. And the last thing I would say is that in the case of individual investors, usually most hedge funds are sold to accredited investors.
James Parkyn:
Ray, I'd like to take a moment for our listeners here to help them understand what an accredited investor is. It's part of the securities regulations in Canada. For instance, the Ontario Securities Commission Rule 45, 5, 1. Exempt distributions spell out in its definitions on page one, what an accredited investor means. And there are 27 different types of accredited investors. But two types apply to individual investors. So, the first is an individual who beneficially owns, or, together with a spouse beneficiary, owns financial assets having an aggregate, realizable value that before taxes, but net of any related liabilities exceeds a million dollars. The second type is an individual whose net income before taxes exceeded 200,000 in each of the 2 most recent years, and whose net income, before taxes, combined with that of a spouse, exceeded 300,000 in each of those years. So again, it's very technical. But it assumes that because you have that high income or those high assets, you're a sophisticated investor for whatever that means.
So, Ray, I have a second question for you about hedge funds. For most of our listeners. The hedge fund industry really is a mystery again. Like you said. You know, it's difficult to generalize about them. But could you give us a high-level summary of the type of hedge funds and their strategies?
Raymond Kerzerho:
Yes, of course. So one thing that's important to understand is that there are dozens of strategies that are utilized by hedge funds. However, most, if not all, of these strategies can be grouped into three categories.
The first category is relative value. And so basically, a relative value strategy is a strategy that combines long and short positions in highly correlated stocks. I'll give you a very simple example. I buy shares of Royal Bank, but I will sell shares of another bank, let's say TD Bank. So that would be a relative strategy.
François Doyon La Rochelle:
So, you’re selling short to TD Bank, right?
Raymond Kerzerho:
Short. Yes, absolutely! So, these are 2 bank stocks, so they tend to move in concert. By being long, one and short, the other one, it tends to kind of edge your risk if you will. I would like to mention that with this type of strategy, somehow, we tend to feel more secure about it because we're edged. However, many of the worst disasters in the hedge fund industry occurred due to relative value funds, namely, one of them is probably the most famous failure. The long-term capital management which failed in 1998, due to a position in Russian debt and the edge. So, the short position they had to edge it did not work properly. The other example that I can give is the failure of the US. Bank Bear Stearns in 2008. So relative value hedge fund strategies may appear to be less risky than they really are.
A couple more categories of strategies are event-driven. An event-driven strategy is a strategy that tries to take advantage of an event. For example, a merger announcement. So, if there's a merger announcement, typically, a hedge fund will take a long position in the stock of the company that is being acquired and a short position in the stock of the acquirer and try to take advantage of the mispricing between these two stocks.
The last type is the directional. I'm taking a directional bet on a stock. It could be on interest rates. It could be on a commodity or a currency. I'm simply taking a bet. The most famous so-called Directional Hedge Fund manager was George Soros, who made a spectacular gain by taking a short position on the British pound in the early nineties, making 1 billion dollars in the process. Another example of directional bet that is much more recent, is the people or the hedge funds who shorted, and I'm sure, a bunch of hedge funds were also long in the Gamestop mania of 2021. So, the stock was very volatile. These days a lot of hedge funds initially were taking a bet that the company would go bankrupt, but some other speculators and retail investors started buying the stock. So, the stocks were very volatile on the upside and the downside. So that's another good example, I guess.
François Doyon La Rochelle:
Interesting. So, Ray, another question here, we're under the impression that there is very little transparency with hedge fund investments, and their strategies are complex to understand for most individual investors. What are your thoughts on this?
Raymond Kerzerho:
Yes, of course. Well, the thing is before investing it is paramount to understand the contractual terms of the product. First, there's the fee structure, and I'll tell you more about that later. There's continuous investor info once you're invested with the hedge fund. You want to know in advance what kind of information they are going to provide to you to avoid any bad surprises.
And then the second thing that you have to look at is really the lockup period. So, this is important. Usually, when you invest with hedge funds in many instances, you have a lockup period where you cannot withdraw your funds for the first 3 years.
The third thing I would also check for those who are considering investing with hedge funds is really to check the reputation of the manager. I'll give you an example. Recently the Wall Street Journal published a story about a 2-billion-dollar hedge fund who found tricks to avoid returning money to shareholders despite advertising very high returns. I don't know what the problem was, but he wouldn't return all the money to investors when they asked for a redemption.
James Parkyn:
Interesting! Ray in your blogs, you write about the promises that hedge funds make to their investors. Can you elaborate for our listeners?
Raymond Kerzerho:
Yes, of course. In general hedge funds promise either two things or both. They promise either high returns or an uncorrelated return. So uncorrelated simply means that it adds diversification to your portfolio of stocks and bonds. In my research, what I've seen in the literature is that the best hedge funds. They do have skill, they're able to generate excess return. The evidence about diversification is mixed, but in general, they can add diversification as well. But there's no point in investing with skill and having diversification and if the fees are killing the returns. And that's the problem. The problem is not that the best hedge funds do not generate excess returns, is that the fees are absorbing a lot of these excess returns, if not most.
François Doyon La Rochelle:
So, If I understand this correctly Ray, Hedge funds generate quite a bit of return, but the fees are killing those returns for the investor, is that right?
Raymond Kerzerho:
The best hedge funds do, yes! The best, not the average hedge fund. That's another thing. You cannot just pick a bunch of hedge funds and expect you're going to make money out of it and get the diversification benefits. You have to be skilled in how you can choose hedge funds.
François Doyon La Rochelle:
Ray, most investors have a good understanding of the bond and stock market are regulated, Mutual funds and exchanges traded fund ETFs are also highly regulated to protect investors. Can you now help us better understand how the Edge Fund industry is regulated?
Raymond Kerzerho:
Well, I'm not an expert on regulation, so I cannot get into the details of that. But one thing that I understand is that hedge funds have a lot of discretion about what they have to disclose and what they do not have to disclose, so they can disclose pretty much what they want. And in general, they're very reluctant,actually, to disclose what they're doing in portfolios. So, what we have here is a combination of opacity and high fees. And combined I believe that it's really a problem.
James Parkyn:
Well, Ray, a lot has been written about hedge funds, private equity funds, and other alternative investments. The fact that they have high fees is well known. But can you share some facts about hedge fund fees, and how, at a very granular level, they impact the returns?
Raymond Kerzerho:
Absolutely, James. What listeners need to know is that hedge fund fees are quite subtle, and there are also some impacts that could be unexpected from holding several hedge funds. There's research that demonstrates that holding several hedge funds amplifies the impact of performance fees. I'll give you a simple example. Let's say you hold a portfolio of two hedge funds. One is very successful and generates high returns, and the other one loses a lot of money. The profits and losses of these two hedge funds offset one another. The problem is that the successful hedge fund is going to charge you performance fees. But at the end of the day, since the profits and losses of the two funds offset one another, you're not even making money. The performance fees, once you combine a lot of hedge funds, tend to cost a lot more than what is advertised in the legal documentation. And in the paper, I was talking about, in the end, they found that on a diversified portfolio of hedge fund, managers may end up with as much as 64% of the gross profit.
François Doyon La Rochelle:
Wow! That's huge.
Raymond Kerzerho:
Yes, terrible! A few more points that are important to understand are the contractual terms in most hedge funds are quite brutal. For example, 86%, so the vast majority of hedge funds, do not have a contractual hurdle rate for performance fees. To explain what a hurdle rate is, let's say, I invest with a hedge fund. What they are telling me is that I'm going to pay a base fee of let's say, 2% of assets. But I'm also going to pay 20% of the profits on the hedge funds. But you need to calculate the profits, and in the early days of hedge funds, you needed to have a return beyond a certain hurdle rate. So, what it was saying, is that whatever value you generate in excess over the T-bill rate of return, then you can calculate the 20% of that. Like in the vast, almost 90% of hedge funds, they don't have a hurdle rate, which means, that as soon as the hedge fund covers its base fees, it starts charging performance fees.
James Parkyn:
Oh, that's wild!
Raymond Kerzerho:
Yes, that's wild. Because there's not much merit in beating 0. Right? That's beating their base fees and to me, that's a bit scandalous. A couple more: sometimes hedge funds collect performance fees if the fund performs well in the beginning. So that's the idea. You have very high returns in the early days, but afterward, the returns falter and become negative. Then over many, many years, you may be going to pay performance fees, but you don't get performance. Because yes, you've got a performance for a couple of years, but you've lost all those gains in follow-up years, right? Because performance fees are not refundable because the fund underperforms in the follow-up years. Once you pay the performance fees they're gone, forget about it.
The last point I'd like to bring up is that a major problem beyond high fees is the fee structure. So that's it. Most hedge funds have no hurdle rate and may not even have a high watermark.
François Doyon La Rochelle:
What's a high watermark here Ray?
Raymond Kerzerho:
A high watermark is another feature that we see regularly in hedge funds, so most hedge funds have it, but 1/3 of hedge funds don't have it. A high watermark sets a limit. It sets the level of the fund's net asset value, beyond which the hedge fund is allowed to perceive performance fees. Okay, let's take an example. I invest in the hedge fund; in the first year it loses 10% and in the second year it gains the equivalent of what it lost in the first year. I won't pay a performance fee, because I haven't gone beyond the high-water mark. Right? I'm still at the same level that I was at, at the time I invested in the fund. And this high-water mark goes up as the hedge fund creates value. In principle, it's a measure that is there to protect investors. But in reality, it's not hugely effective.
James Parkyn:
Well, I guess this is why Warren Buffett, always talks about how Wall Street manages to extricate fees out of investors, and it's not to their benefit. And I mean, it's scandalous how the regulation allows this to happen, and that's why, in the US in particular, there are so many multibillionaires that are hedge fund managers because they make all these fees. I guess it's a nice business if you can get it. But again, for the individual investor it sounds like, you're flipping a coin. Heads, the hedge fund manager wins, and tails you lose. So, it's more like a lose-lose proposition. But let’s get back to the institutional world in opposed to retail investors.
So, Ray, is there any evidence that large institutional investors have developed a methodology where they can best pick hedge fund managers?
Raymond Kerzerho:
No, I haven't seen evidence of that. Maybe it exists, but I haven't seen it. I can mention that Calpers, the huge California Pension fund had exited hedge funds many years ago, and I've read what they have published in the press release at the time. They justified their decision by basically saying that the opacity and the complexity weren't worth the results they were getting in return. I think the other thing I can mention is, there's no persistence in returns. So, the fact that the hedge funds have performed well in the past doesn't tell you anything about whether they’re going to perform well in the future and overall, I did not see any evidence of skill really.
François Doyon La Rochelle:
To conclude, Ray, I've got a last question here. Our wealthy clients are highly solicited by groups trying to sell them alternative investments. This is especially true with clients in private banking at large banks. These so-called advisors tell clients that they will increase the returns on their portfolio, all the while reducing the overall volatility. What do you think? Do hedge funds have a place in investors’ portfolios?
Raymond Kerzerho:
Well, François, the first thing I could say is when you're talking about an advisor working for the product manufacturer, I wouldn't call that an advisor. I would call them a salesperson, So, personally, I never take advice from salespeople. It's not a good idea in general. I think if you're not a multi-billion-dollar institution, the chances of improving your financial outcome with hedge funds are very close to 0. Hedge funds are very opaque, and it opens the possibility that investors will be taken advantage of because they don't have all the information to supervise what's going on with their investment.
James Parkyn:
Well again. The due diligence on just investing in one fund is incredible. You got all the legal documents, and then you got the financial analysis. Then, you don't know what you don't know, because it's opaque. So, it's what we call a black box.
3) CONCLUSION
François Doyon La Rochelle:
On that note I will conclude. So. Thank you, Ray, for your participation. Today I sure learned a lot, and I hope our listeners have found this topic of interest.
Raymond Kerzerho:
My pleasure, François.
François Doyon La Rochelle:
I remind our listener that Raymond series of articles can be found on the PWL Capital website in the Learn section. Also. Thank you, James, for your contribution again today.
James Parkyn:
My pleasure, François.
François Doyon La Rochelle:
That’s it for episode #73 of Capital Topics!
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