Hedge funds: wounded but not sunk

Hedge funds have been under the spotlight recently and I believe there are consequently a few lessons for asset managers to be learnt from this turbulent period.

First, the facts. The first quarter of 2016, dominated by volatile and hesitant markets (Brexit, commodity prices, US elections etc. you know the story), has made many casualties, including flagship funds: Blackstone’s Senfina lost 15% of its value, a relatively good performance compared with Odey European Fund’s 31% loss. Add on top of that a high-flying regulatory investigation on a $11bn revenues company (Valeant) many hedge funds had bet on and you understand why investors have been fleeing, withdrawing $15bn from hedge funds over the period. This comes after a year (2015) that has seen the second-worst year in terms of investment performance (-1.1% on average over the year) and logically the worst in terms of number of closures since the financial crisis in 2008 – despite the fact that the 25 best paid hedge fund managers pocketed more than Namibia’s GDP.

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Nest-Egg-Retirement-Money-FinancialOn top of difficult market conditions, alternative investment has become a victim of its own success, with too much money chasing too few deals. In private equity markets this translates into exceptionally high valuation multiples by historical standards. In public markets, not only have some stock indexes (notably the S&P500) reached all-time highs over the last 12-18 months, but hedge fund managers’ risk-adverse bias has led some ‘beauty stocks’ to concentrate an abnormally high demand which may fly away at the earliest warning signal, creating significant instability – especially given the fact that volume of assets under hedge fund management has been multiplied by 6 since 2000. The shock would impact highly-levered hedge funds but portfolio managers as well, who wrongly believe that by putting their eggs into different baskets they have managed to create a ‘hedge’.

Private equity funds tend to be relatively more protected for now given that the capital they manage is committed for years and possibly by the fact that their added value is perceived to be higher than the one delivered by hedge funds. This, however, has not prevented listed private equity firms to see their share price drop – and none of the private ones has been boasting about its recent performance. I remain more reserved with regards to that asset class and I refuse to be alarmed for instance by Blackstone’s or Carlyle’s disappointing economic net income performance in Q1 this year, knowing how much this figure depends on exits performed over the period – and there were many across the industry in 2015.

Evolution of share price since IPO (rebased at 100) and since year start. Source: Yahoo Finance.
Evolution of share price since IPO (rebased at 100) and since year start. Source: Yahoo Finance.

Pressure also comes from the UK Government, which has targeted financiers in its latest budget. Although Mr. Osborne proved generous with many capital holders, private equity executives will still be taxed at 28% on their carried interest gains and possibly even more in the case of ‘quick flips’ – i.e. sale after less than 3 years of detention.

What does it tell us? Despite the rise of passive investment strategies (see my earlier post on the topic), alternative investment is definitely not dead, far from it. The $15bn outflow mentioned earlier in this article only accounts for 0.5% of hedge funds’ assets under management ($2.86tn as of April 2016) and, although it may seem paradoxical, private equity investing rose by 14% in Europe in 2015.

Divided on the attitude to adopt
Divided on the attitude to adopt

Moreover, the challenges faced by the alternative investment industry over the last 18 months should not occult the strong performance the same industry generated in the years before. Although some LPs, such as the New York City Employees’ Retirement System have decided to terminate its hedge fund investment programme as a whole, following the example set by Calpers, many, such as Metlife, have just decided to reduce their exposure in a move that could prove temporary.

Pierre-Lavallee-pic-e1432679343807-180x180“Hedge funds have added value to the total fund over the past several years.”

(Pierre Lavallée, Senior Managing Director at CPPIB)

Furthermore, markets are still desperate for investments with even barely positive net risk-adjusted returns, and so far the surprisingly high demand for negative-interest sovereign bonds proves that they have been largely unsuccessful in their quest. As a consequence, as soon as structural changes to the fee structure are made and the market tide turns, liquidity will flock back to alternative asset (including private equity and hedge) funds that have managed to through this crisis of confidence. Confident of the fact that this will happen, KKR bought back $388m of its own stock in April.

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What it means, however, is that hedge fund managers will need to adjust their pricing to the value they really provide to their customers. Otherwise, an increasing number of LPs will be tempted to in-source their trading operations or move away from the asset class as a whole. The historical ‘2 & 20‘ model with limited GP liability – i.e. GPs get carried interest if they make good investments but do not lose anything if they make bad ones -, initially designed for hands-on private equity investments, has become the norm in hedge fund investing, which arguably requires less effort and can be more easily substituted – even by computer systems. A few ‘long’ or ‘long-short’ hedge funds have thus decided to switch to lower management fees and/or to scrap the carried share of their compensation – although this latter fee structure could incentivise fund managers to maximise assets under management at the expense of performance.

Finally, it brings us back to the purpose of private equity and hedge funds. The former should benefit from the relative freedom of the private ownership structure to boost the development of companies – not just the level of debt on their balance sheet – while the latter should provide an effective market ‘hedge’ especially in downturns – something they failed to do earlier this year.

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Hedge funds will adapt and rise again as they have already done in the past. What may have happened in the meantime, though, is a (welcome) clean-up of the ‘battlefield’ and the subsequent extinction of under-performing entities. Getting rid of the wounds in order to stay afloat.

Stamping the housing market

Credit: www.thisismoney.co.uk
Credit: www.thisismoney.co.uk

Last week the Financial Times used the latest Office for National Statistics (ONS) housing price figures to assess the impact of the stamp duty raise on the housing market. Since the beginning of the month, purchasers of buy to let property and second homes indeed face a 3% stamp duty surcharge. Some experts believed that prospective second home buyers would rush to complete their transaction before the deadline and would thus generate an artificial and temporary price increase.

The FT article took the opposite view and concluded that “UK house price growth weakened slightly in the year to February, to 7.6 per cent […] meaning that a boost reported by mortgage lenders and estate agents ahead of stamp duty changes for buy-to-let investors is yet to show up in official data”. This statement surprised me and I decided to dig further into the data. My take is the following: although the statement may be true at a global level, by performing the analysis for each Government Office Region separately, one could conclude that the impact of the stamp duty reform was actually much more significant.

k12985080To perform this exercise, I used two publicly available sources of data:

  • ‘Number of residents with a second address in a region, who are usually resident outside of that region’ and ‘Number of usual residents in a region with a second address outside of that region’ as per the 2011 census;
  • ‘Mix-adjusted average house prices by region’ published monthly by the ONS.

First, we need to understand that all UK regions are not equal. The more second houses a given area hosts, the more impact the stamp duty reform should have had. The most recent information on the topic comes from the 2011 Census which gives us the number of residents elsewhere with a second address in a given region – e.g. in 2011 184,616 people had a second address in the South East.

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Number of usual residents elsewhere with a second address in the area (2011). Source: 2011 Census

Separately, the ONS data gives us the year-on-year house price evolution in each area from July 2015 to February 2016.

Year-on-year housing price evolution by region. Source: ONS
Year-on-year housing price evolution by region. Source: ONS

Nonetheless we are not interested in the price growth rate but by the increase of the growth rate as the stamp duty implementation deadline approaches. I have therefore compared the average housing price increase (in percentage points) in January and February 2016 with the one witnessed in July and August 2015 in each region – I have taken a two-month average to smooth out any shock. The analysis shows wide discrepancies between regions – for instance the growth rate increased by 5.0 percentage points in London over the period but actually decreased by 2.7 pts in Yorks & Humber.

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Increase in housing price growth rate by region, January-February 2016 vs. July-August 2015. Sources: ONS, author analysis

Finally, I look for a correlation between the number of second addresses and the increase in housing price growth rate.

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Correlation between housing price growth rate increase and number of second addresses

The correlation between the two variables is clear and we could therefore conclude that the stamp duty change has ‘warmed up’ the housing market in the regions with a high number of second addresses. The stamp duty effect was indeed pushing buyers to complete the transaction as fast as possible, even if it meant paying a higher price (up to 3% more actually). The surge in gross mortgage lending witnessed in March by the Council of Mortgage Lenders supports this conclusion. On a side note, this is another piece of evidence illustrating the fact that the UK housing market remains a ‘seller’s market’ – in a ‘buyer’s market’ you would have conversely seen a drop in prices as sellers try to get rid of their property before having to pay the surcharge.

Stamp_Duty_Paid_mark_for_British_cheques_from_1956It would be interesting to keep an eye on the market prices in the future. Given that purchasers have by definition a limited purchasing power, was the bump just bringing forward future increases (in that case the market should cool off for at least a few months) or will future sellers be able to maintain enough competitive tension to use the ‘overheated’ prices as the new normal?

Burning down the house

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The purpose of this post

Readers living in South West London may have seen the opposite poster featuring prominently in a real estate agency’s (Acquire Estate Agents not to mention any names) shop front. It was probably designed with the best intent, but this is actually a very bad promotional mechanism.

Let us dissect the proposal. At first sight, the offer seems appealing. The poster indeed advertises a “flat fee of £700” which “includes VAT, EPC, floorplans and pictures” for home owners willing to sell their property. With the average London house costing as much as £531,000, a £700 fee is equivalent to 0.1% of the average transaction value, whereas other major real estate agencies typically charge around 3% of the priceIn that case, why should the prospective seller think twice before walking into the lion’s den?

The reasoning is detailed in-depth and supported by empirical evidence in Levitt’s and Dubner’s Freakonomics  – a book I have already had the chance to write about – and relates to the role of incentives. In a nutshell, with a flat fee, especially a low one, the real estate agent is not incentivised to maximise the transaction value on behalf of the seller but to complete the transaction as quickly as possible, even if it means making sacrifices on price. Quantity prevails over quality.

For the seller, the ‘great offer’ may thus backfire and leave him worse-off overall after the transaction. He will save an average of £15,230 in agency fees (3% * £531,000 – £700), but this saving can be easily more than offset by performing a marginally higher number of visits or by spending a little bit more time negotiating the buyers’ offers – especially given the fever surrounding the London housing market.

A good alternative mechanism could have consisted in offering lower fees as a percentage of the transaction value, which would have maintained the agent’s incentive – albeit at a lower scale.

Daniel-Kahneman-008
Daniel Kahneman

I have not been able to assess whether this marketing campaign ultimately proved successful for the agency or not. In any case, and to paraphrase Daniel Kahneman (2002 Nobel Memorial Prize in Economic Sciences) in Thinking: Fast and Slow, this is a perfect example of our ‘rational’ System 2 overriding the gut feels emitted by our ‘impulsive’ System 1.

P.S.: More on Kahneman and behavioural economics will be covered more in-depth in a later post.
P.S. 2: To finish with music…