The Top Ten Hedge Fund Stories of 2010

The hedge fund industry is still dominated by America in terms of where the majority of assets are directed and invested. So I have given due weighting to U.S. focused stories in the top ten for the year – they are the first five stories, published by trade press in the States. My own viewpoint and concerns put global and regional stories into the top ten for the year – they are the second five stories here.

Expert Network Insider Trading

Hedge funds' use of so-called expert networks was called into question in late November when more than a dozen money managers were issued subpoenas for information related to a vast government investigation of insider trading.

Among those asked for information—but not accused of wrongdoing—were SAC Capital Advisors, Diamondback Capital Management, Level Global Investors and Loch Capital Management. All stressed they were subjects, not targets of the investigation (the latter, which means the government is likely to bring charges, would likely cause massive redemptions). Loch, which did not respond to a request for comment, is laying off most of its staff by year end, according to Hedge Fund Alert. Firms like Loch and Balyasny Asset Management, which was also subpoenaed, suspended their use of third party research firms as a result.

Drunkenmiller Quits but Team Lives On	"I have had to recognize that competing in the markets over such a long time frame imposes heavy personal costs," Druckenmiller wrote in a one-page letter announcing his plans to retire and close the firm, also citing the challenges of running a large fund.

Duquesne was reportedly down 5% at the time, which would have been the fund's first losing year in 30 if it did not snap back by year end, having returned an average 30% annually since 1986. As of November, fund returns had indeed turned positive, according to Bloomberg.

A group of former Duquesne Capital Management managers prepared to start a new global macro fund, Point State Capital, which will oversee roughly $5 billion, one of the largest launches ever, Bloomberg reported in November. The funds come entirely from Druckenmiller ($1 billion) and former Duquesne investors. In addition Wojtek Uzdelewicz, a Duquesne managing director who ran a roughly $500 million technology focused fund at the firm, plans to launch a fund, Espalier Global Management in New York City.

The Goldman-Paulson CDO Scandal Goldman settled with the SEC in July for $550 million, the largest ever penalty from Wall Street. John Paulson, for his part, was never dragged into the legal mess despite initial concerns that led him to let investors know that he was prepared for a possible legal battle and would personally cover any legal fees. One of those key facts, the SEC said, was failing to disclose the role that Paulson & Co. played in the portfolio selection process and the fact that the hedge fund had taken a short position against the product (Paulson made about $1 billion on the bet). In April, the Securities and Exchange Commission charged Goldman Sachs with defrauding investors by "misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter." FrontPoint's Annus Horribilis FrontPoint Partners, the once highly successful hedge fund firm, had a difficult year. In October, FrontPoint announced it was spinning out from Morgan Stanley, which had acquired the firm in 2006 when it managed $5.5 billion but was concerned about new hedge fund investment restrictions under the Dodd-Frank Act. But as FrontPoint restructured, an insider trading scandal hit its healthcare hedge fund, causing the suspension of portfolio manager Chip Skowron and the liquidation of the fund. FrontPoint faced large redemptions—reportedly as much as $3 billion of $7.5 billion, according to the Wall Street Journal—from skittish investors as the insider trading probe spread to more than a dozen hedge funds and put unwanted attention on the use of expert information networks. Buffett's Hedgie Successor Until late October, Todd Combs was a successful but largely unknown manager of a small Greenwich, Connecticut hedge fund. But Combs was thrust into the spotlight with the announcement that Warren Buffett has chosen him to manage a large chunk of Berkshire Hathaway's roughly $100 billion investment portfolio, one of the most high-profile money management positions in the world. Combs, 39, ran Castle Point Capital Management, a financials-focused long/short equity fund launched in November 2005 that managed $405 million as of September. The fund was down 3.93% through September, with a net annualized performance since inception of 5.93%, unspectacular performance compared with its peers. Hedge Fund UCITS Mushroom Whilst service providers and some of the managers were over-excited about the prospects of UCITS versions of hedge funds last year, in 2010 there have been some strong growth trends. There are now around 350 UCITS hedge funds, most of which have mildly amended mandates of the mother (offshore) fund. There have been some UCITS only fund launches, but not many. Early evidence is that UCITS provide a solution to the major drawback of hedge funds that was revealed in the Credit Crunch – the ability to deal in the funds at will. 76% of UCITS hedge funds offer daily liquidity, 21% offer weekly liquidity. The buyers of UCITS hedge funds are client types that put a premium on this positive feature – HNWIs that were much aggrieved at being locked into offshore hedge funds and are buying through wealth management networks; and insurance companies that have problems of admissability of assets when putting capital into offshore funds. UCITS hedge funds manage €27bn of capital. JP Morgan takes a BRIC Hedge Fund Bias JP Morgan's 2004 partial takeover of Highbridge Capital for $1.3bn was the deal which said that institutional flows into hedge funds were believed to be for real and for some time. Eventually Morgan bought all of Highbridge. In October this year JPMorgan Chase & Co. agreed to acquire a majority stake in Brazil's Gavea Investimentos Ltda., the fund manager founded by former Brazilian central banker Arminio Fraga. Gávea Investimentos has $5.1bn AUM invested in hedge funds and illiquid investments, and has a staff of 103 people. The hedge fund industry in Brazil is dominated by bank-run domestic retail flows, but JP Morgan likes the international appeal of Brazilian hedge funds. There are many international investors who use Brazil as a proxy for the best of the BRICs – high employment and industrial production growth, an appreciating currency, a relatively sound fiscal position and a commodity play to boot. One of the lessons of the post-Crunch period has been that the appeal of emerging markets to investors in developed markets has recovered as well as the prices of iron ore and coffee. Has the JP Morgan deal for Gavea confirmed that emerging market flows are for real and for some time? Renaissance is Back In 2006-7 there was a feeling abroad that Renaissance Technologies was going to eat the lunch of a lot of hedge funds by soaking up the flows into the industry as it looked to take in as much as $100bn into the Renaissance Institutional Equities Fund (RIEF). However the large capital inflows turned into outflows when RIEF was down 16% in 2008 and down 7% in 2009. The Renaissance Institutional Futures Fund (RIFF) fared no better in 2008 - it was down 12% when most CTAs were up on the year. The reverse happened last year – RIFF was up 5% and most CTAs were down. Overall firm assets were down 25% last year, and to cap it all founder James Simons retired as CEO at the end of 2009. After successor co-CEOs Peter Brown and Robert Mercer considered closing the two institutional products, it as well they didn't. This year RIEF International - Series B is up 17.00% YTD, and the Renaissance Institutional Futures Fund is up 17.14%. The latter fund did well enough on a 12-month risk adjusted return basis to win the Best Managed Futures Fund at the AR Awards in November. Renaissance is back. The Eurocrats Take a Grip In America the intense interest of politicians, regulators and the media was such that Anthony Scaramucci, founder of fund of funds Skybridge Capital, said "We have felt like a piñata - We certainly felt like we've been whacked with a stick." But it is the European end of the industry that will suffer more from actual interference. The politicians and Eurocrats have wilfully failed to understand the significance of their proposals, despite lobbying and submissions from the industry. The hedge fund industry gives employment, tax revenues and invisible export earnings – in return the industry got proposals treating all management companies as publicly quoted, regulations on how private companies should pay their employees, damaging increased disclosure of short positions, and little-island-thinking that would have created a fence around the European hedge fund industry. On top of that the UK, home to most of the European industry, increased tax rates to an extent that it has pushed some hedge fund companies and leaders into other tax jurisdictions. The country, continent and industry are not the lands of opportunity they were. Recovery by Madoff Receiver The story which has come back with new developments through the year is the efforts of receiver in the case of the Madoff ponzi scheme, Irving Picard, to recover cash from the 2,000 or so net beneficiaries of the scheme. These are the investors who withdrew more money than they invested with the fraudster, and around a thousand of them have been in the sights of the receiver. The list of banks, intermediaries, investors, friends of Madoff and counterparties to receive suits form Picard is long. Some have been obvious targets, like the 34 affiliates with ties to Madoff feeder fund Fairfield Greenwich Group. But he has been very thorough and looked through to where the "profits" have been deployed. For example, in July the court-appointed trustee took aim at three Madoff family entities, a family fund, an oil and gas properties business and a trading business, seeking $30 million that the family had invested in them. As the deadline approached for the receiver – he had until the 11th December, the two-year-anniversary of Madoff's arrest, to file the suits – activity accelerated. Picard reached a $625m settlement with Boston billionaire and philanthropist Carl Shapiro this month, and on the last day for possible filings, the receiver filed a suit against Austrian banker Sonja Kohn and dozens of firms linked to her for $19.6 billion—all of the principal he estimates was lost by Madoff's investors and more than twice as much as he has sought in any of the thousands of other lawsuits he has filed since Madoff's arrest two years ago. The single biggest settlement to date was $7.2 billion from the estate of Madoff investor Jeffry Picower.

 

Brevan Howard Adds Strategies to Increase Capacity

When you are Europe's largest hedge fund manager and run one of the world's largest hedge funds you are bound to run into constraints on the amount of capital you can run successfully. Brevan Howard Capital Management Limited has around $32 billion under management, and three-quarters of that is in the Brevan Howard Master Fund Ltd., a global macro and relative value fund focused on fixed-income and currency markets. 

The only respect in which the BH Master Fund is concentrated is in the number of  major decision makers running it. Alan Howard has the largest risk budget at the firm, and there are a small number of other senior risk takers - the trusted lieutenants of  Howard who have worked with him and for him since the launch of the firm. This small cadre take most of the risk in the Fund. There have been few changes in the risk-taking leadership of the firm in either personnel or number. Alan Howard has to trust this macro and fixed income elite squad, and this trust is not earned quickly. 

A consequence is that unless the style of investment changes, and/or the level of risk assumption across the team changes it is difficult for the Master Fund to take in new capital. Alan Howard has been explicit about this - he has had no intention of changing the scope or style of the Master Fund - so when he opened the Fund to new subscriptions last year it was for a short period and was soon over-subscribed. 

For the firm to grow, Brevan Howard has to add new strategies either in the existing fund(s) or add new funds dedicated to new strategies. The Baker Street based macro mavens have decided to follow the latter route it was announced this week with this press release:

  

"David Gorton and Brevan Howard are pleased to announce the formation of a new joint venture, DG    Systematic Trading LLP, to pursue systematic trading strategies.  David Gorton is the Chief Investment Officer of the new venture with responsibility for the management and development of trading strategies based upon a suite of systematic models which have been running capital since May 2006 including capital allocated from Brevan Howard Master Fund since 1 March 2010.   

 DG Systematic Trading LLP will be FSA authorised and will act as investment manager of Brevan Howard Systematic Trading Fund, a systematic trading fund which utilises Brevan Howard's risk management and execution platform. Brevan Howard Systematic Trading Fund has been seeded with $300 million from Brevan Howard Master Fund and has been successfully traded by David Gorton and his team since 1 March 2010.  For the period from 1 March to 30 September this strategy has delivered returns on allocated capital of 9.3% net of fees." 

For those who can't quite place the name, Gorton is the former JP Morgan trader who was co-founder and is still co-Chief Executive of London Diversified Fund Management. London Diversified Fund Management ran the London Diversified Fund and the London Select Fund, using a style similar to that of former hedge fund giant Vega Asset Management in fixed income/macro. The eventual commercial outcomes of the LDFM funds were also similar to those of Vega.  At the start of 2008 LDFM managed $5bn and today is thought to run somewhere North of $500m. It may be indicative that around $200m of those funds are in a managed account.

The Brevan Howard press release emphasises that the investment strategy to be utilised in the new fund are based on a "strictly quantitative approach". It is also important from the BH perspective that the new Fund utilises the Brevan Howard risk management and execution platform. Each trade and the overall risk profile of the portfolios can be monitored real-time by the BH risk professionals and compliance with the mandate can be verified readily. It is an interesting commercial arrangement in that a joint venture has been formed, and that David Gorton remains running an independent asset management entity, even if he has had to be additionally registered for FSA purposes at Brevan Howard.





Additional: This week Brevan Howard announced that they are set to float a new investment company – BH Credit Catalysts limited - on the London Stock Exchange in December. As the name suggests the Fund trades in the credit markets, and in this particular case with a bottom-up catalyst-driven credit trading style. The underlying Fund is advised by DW Investment Management, headed by David Warren, and has been running for over two years. The DWIM Team consists of 22 professionals based in New York.

David Warren joined Brevan Howard in January 2008 with a mandate to build a credit team. The team spun out from Brevan Howard in June 2009 and continues to use Brevan Howard’s infrastructure and risk management. DWIM’s credit team has a strong track record producing total return performance of +44% in the period from May 2008 to August 2010, a period characterised by some of the most volatile markets in recent history (2008-2010). Over this period the existing credit fund has been the best performing fund at Brevan Howard.

The Listing of the investment company does not necessarily increase capacity for new capital at Brevan Howard, but does allow for the creation of permanent capital for the money management firm, as this is a closed ended vehicle. What Alan Howard did not do is allow more capital into the BH Master Fund and then allocate from that to the Credit Catalyst Fund. This is an externally visible signal that confirms the confidence that Howard has in DWIM.
 

Borrowing, Shorting and a New Wave of Talent for Hedge Funds

The International Securities Lending Association held a briefing last week which disclosed some good industry level data on stock/security borrowing: the arrangements that facilitate shorting.

One of the effects of the Credit Crunch of 2008/9 was that counterparty risk became a major concern. Who you lend to, the quality of collateral, and documentation related to these factors became major operational issues. In a climate in which it became difficult to know for sure who would be around to deliver either collateral or borrowed securities back again the next week, it was inevitable that the willingness to lend declined. Graphic One illustrates that the assets available to borrow fell by 30% in the 4Q of 2008.  

Graphic One

 

The low point for lendable assets coincided with the low for equity markets in March 2009. As a result of implicit government guarantees and the move to bank holding company status for some banks, clients regained comfort with the securities lending market, and lendable assets have been increasing to pre-Crunch levels.

Whilst the willingness to lend has returned to levels seen previously, the desire to borrow securities has not returned to anything like the same degree. On-loan balances, that is the amount of securities actually borrowed, remains at around half the level seen in the first half of 2008 (see Graphic Two).

Graphic Two 

There are a number of reasons why the volume of securities borrowed has declined and stayed at a new lower level. The borrowers of securities would be hedge funds and proprietary trading teams. Capital in the hedge fund industry dropped by 40% from mid-2008 to mid-2009. In the period of the Credit Crunch proper the capital used by prop desks was needed elsewhere in the businesses. In the period after there were regulatory inhibitions on capital devoted to prop trading.  For both types of borrowers of securities many of the those that engaged in running funds or prop capital had reduced risk appetites or measured such high correlation and volatility in the markets in which they traded that they need less capital to put the same amount of risk on. 

Graphic Three

Of course another, if not the, major factor was that financing new borrowings of any sort became extremely difficult - so leverage fell across all activities funded by short term borrowing, including prop trading and hedge fund position financing. The massive de-leveraging is illustrated in Graphic Three, which shows a 62% fall in leverage from 2008 to 2010.

Capital allocated to prop desks today is down by an estimated 90% from the 2008 levels, and will go lower as banks such as Goldman Sachs and JP Morgan have announced they will withdraw from the activity. 

Securities are borrowed in order to carry out a number of shorting strategies: hedging activity to offset long exposures, arbitrage trading to capture mispricing opportunities, and strategies to benefit from corporate changes such as mergers and acquisitions. Whilst there may still be a need for large scale hedging, and there have been gross arbitrage opportunities in the last 18 months, the volumes of M&A deal flow have been down significantly (see Graphic 4).

Graphic Four

The data generated and shared by the International Securities Lending Association also prompted a constructive thought for the hedge fund industry and those who invest their capital in it. A lot of great investment talent is coming out of the investment banks. Not all of them will thrive within independent businesses, but the precedent is strong. A lot of the best talent running big hedge funds now have come out of Goldman Sachs and JP Morgan, and they won't be the only banks to run down their proprietary trading desks further. Let's hope the new wave can reinvigorate hedge fund returns in 2011.