Hedge funds: No market for small firms
Fallout from coronavirus pandemic is favouring some of the industry’s largest names
Big US hedge fund platforms such as Izzy Englander’s Millennium Management, Ken Griffin’s Citadel and Steve Cohen’s Point72 Asset Management look set to emerge from the coronavirus crisis as some of the industry’s biggest winners.
After chalking up gains this year, they are on the front foot. Meanwhile, their unusually high fees, which have long proved a stumbling block to some investors, could now help them have the pick of talent in a hedge fund industry reeling from the S&P 500’s fastest descent into bear market territory.
Their gains reflect a wider phenomenon that is growing in prominence: the hedge fund industry is becoming increasingly concentrated in a small number of larger players, as bigger groups outpace some of their supposedly more nimble rivals.
“Larger managers, with a few exceptions, have managed well through this period of volatility, they've reacted well,” said Danny Caplan, managing director in Citigroup’s prime finance business. He cited managers with years of experience, who tend to run more money, as some of the better performers.
In March, for example, hedge funds managing more than $5bn lost 6.2 per cent, according to data from investor Aurum Fund Management. That beat by some margin the performance of funds with $2bn-$5bn, $1bn-$2bn, $500m-$1bn or up to $500m in assets. It meant that over the 12 months to the end of April, the biggest hedge funds were the only one of the five categories to make money.
“There had been a frustration that larger funds weren’t generating the returns that they did in the past, but going forward the smaller funds will struggle more,” said Stuart Fiertz, head of London-based hedge fund Cheyne Capital, which runs $7bn in assets.
Hedge fund managers with huge asset bases have been slowly growing more dominant for years, as ever-greater demands from cautious institutional investors and higher costs of complying with regulation have squeezed out smaller funds. Some two-thirds of the industry’s assets are now run by about 5 per cent of the managers, while just under half of the firms are small outfits that oversee under $100m, according to data group HFR.
“Covid-19 has accelerated a trend that was already under way in our industry,” said Mark Connors, global head of risk advisory on Credit Suisse’s hedge fund desk. “It’s only going one way. You need to have scale and resources.”
Meanwhile, the number of new fund launches has steadily been dropping.
More than 1,100 new launches occurred in 2011, but only 480 last year, the lowest level since 2000, said HFR. Launches are fewer but often bigger. In recent years mega start-ups include ExodusPoint Capital Management, the $8bn launch in 2017 from Millennium alumnus Michael Gelband; and D1 Capital Partners, which was founded by Daniel Sundheim, formerly of Viking Global Investors, and kicked off with $4bn in 2017.
The relative paucity of new launches reflects how traders would increasingly prefer to join an established name rather than take the business risk of setting up on their own. The big platforms take care of time-consuming back office and marketing functions, freeing up the traders to focus on navigating the markets. Launching one’s own fund “becomes purely a question of ego”, said one hedge fund investor.
Many of the biggest names have protected investor capital — and even made money — during the latest downturn. In the first four months of the year, Chicago-based Citadel’s flagship Wellington fund is up 10 per cent, Point72 has gained 1.8 per cent and Millennium is up 3.7 per cent, according to investors. Meanwhile, ExodusPoint gained about 3 per cent.
All of these funds often leverage up their winning bets, meaning their footprint in the market can be many times their asset bases. However, they are also known for the strict risk parameters under which traders operate, and for limiting losses by swiftly cutting risk and dismantling underperforming teams.
For example, during the violent market swings in March triggered by the coronavirus pandemic, Millennium shut several of its trading units in response to losses, and at least four portfolio managers departed Citadel.
Hedge fund consultants, who act as gatekeepers to vast swaths of the industry, have for years had concerns about the high charges at multi-manager platforms, which employ tens or hundreds of traders running their own portfolios.
They typically operate a “pass-through” expenses model that lets them charge investors for anything from paying their traders to hiring trading terminals. In effect, this can amount to a fee of anywhere between 3 and 10 per cent of assets, say industry insiders.
Consultants have been slowing coming around to the multi-manager platforms, and making money this year will only have helped their cause, prime brokers said. These funds emphasise their strong long-term track records, net of all charges.
“If you look at the platforms, historical performance over 10 or 15 years has been pretty good. Then they hit the turmoil and everyone's OK — that's what institutional investors are looking for,” said Citigroup’s Mr Caplan.
Prime brokers said the pass-through expenses model can help multi-manager platforms retain top talent during tough periods. Funds that charge a conventional fixed management fee may face the headache of how to pay a star trader who has done well when the overall fund has done poorly, as there will be no performance fees to share around. In contrast, the platform model of passing through expenses allows them to reward the traders they most want to keep, even if the fund’s overall returns are poor.
“This [crisis] will only help them recruit new portfolio managers,” said one hedge fund investor.
Underscoring the investor appetite for industry titans over minnows, several big funds — such as Citadel, Millennium, DE Shaw, Baupost and TCI — are raising billions of dollars from investors this year to take advantage of the market dislocations.
Larger hedge funds are also likely to have benefited during this crisis from a phenomenon seen in 2008 — because their business is worth so much to the banks they trade with, lenders are less likely to rein in a fund’s borrowing at short notice, according to Patrick Ghali, co-founder of Sussex Partners, which advises institutions on investing in hedge funds.
“Counterparties helped bigger managers more than smaller managers. Having a certain size was helpful,” he said.
A prime broker at a large bank said the lender had become increasingly selective among its hedge fund clients. “To get resources in a resource-constrained environment you have to be meaningful,” he said. “We have to be very judicious, and every prime broker is doing this.”
Though most industry insiders expect the trend to continue, not everyone is thrilled at the prospect of the biggest hedge funds becoming even bigger.
“If they become too big it’s a problem,” said Con Michalakis, the chief investment officer of Statewide, an Australian pension fund. “If you have a few lumbering giants and one of them mis-steps, you will have turmoil.”