Third Point founder Daniel Loeb created quite a stir Wednesday when he asserted, “we are in the first innings of a washout in hedge funds and certain strategies.”
In the New York manager’s first-quarter letter sent to clients and widely circulated, Loeb points out that “most investors have been caught offsides at some or multiple points over the past eight months,” alluding to August, when the bull market suffered a major — and unexpected — swoon.
Since then the market has experienced a number of deep sell-offs that at the time seemed to indicate a new, vicious bear market was under way.
“The impulse to do little is understandable,” Loeb told clients.
However, Loeb, whose Third Point Offshore Fund lost just 2.3 percent in the first quarter, assured investors that this volatility is bringing about excellent opportunities, which, he said, makes him a contrarian. “We believe that the past few months of increasing complexity are here to stay and now is a more important time than ever to employ active portfolio management to take advantage of this volatility.”
As we have chronicled regularly, many hedge fund firms raced off to very strong starts in 2015, racking up double-digit gains through the first half and into July. However, when markets started to decline in August, many of these funds did not change their stance or make tough decisions about their sudden losers, and paid a steep price.
They include William Ackman’s Pershing Square Capital Management and David Einhorn’s Greenlight Capital, both based in New York, which were both down more than 20 percent last year, and Jonathan Auerbach’s Hound Partners, which finished down slightly for the year but was up 18 percent at the end of July.
Many funds wound up in the red because they clung to suddenly plummeting hot stocks like Valeant Pharmaceuticals International, Consol Energy and SunEdison. Others got hammered when health care stocks tanked in the fall and deal-related stocks sold off for a number of other reasons.
At the same time, managers such as Short Hills, New Jersey–based Appaloosa Management’s David Tepper, who during the summer lacked the conviction to get out ahead of the market and make big, new bets, played a sort of rope-a-dope and finished the year up 11 percent.
Multistrategy funds such as Kenneth Griffin’s Kensington and Wellington at Chicago-based Citadel and Israel (Izzy) Englander’s Millennium International in New York were up in the low to mid-teens, showing their deftness in balancing various markets.
And many of the computer-driven funds posted double-digit gains for the year.
However, things got worse in the first quarter, which Loeb focused on.
Valeant all but collapsed, and many of the other tech and Internet winners from last year took big hits, notably the so-called FANG stocks (Facebook; Amazon.com; Netflix; and Alphabet, the former Google), which Loeb points out.
“Further exacerbating the carnage was a huge asset-rotation into market-neutral strategies in late Q4,” Loeb wrote. “Unfortunately, many managers lost sight of the fact that low net does not mean low risk and so, when positioning reversed, market neutral became a hedge fund killing field.”
As the markets sold off in January and early February, many hedge fund firms had positioned themselves for a protracted decline. As a result, they were caught by surprise when the market sharply rebounded in mid-February.
Yes, a lot of hedge funds did make money in March, but many still finished the first quarter down in the mid-to-upper single digits to low double digits, a period when the Standard & Poor’s 500 stock index actually was up 1.3 percent.
You almost need to play “Where’s Waldo?” to find a hedge fund firm that squeezed out a small profit in the first three months of 2016.
Retail investors in low-cost index mutual funds, however, were perfectly happy to look at their first-quarter statements.
As I warned last August when the bull market suffered its first major decline, the next sell-off will be put-up-or-shut-down time for many hedge fund firms, especially those that lagged the rest during the bull market.
I said commodity trading advisers (CTAs) had to post strong absolute gains, as they did in 2008 amid the global financial meltdown.
Multistrategy funds had to show that a mix of disparate strategies is what is needed when stocks are tanking.
And stock funds would need to fall much, much less than the widely followed indexes, although it wouldn’t hurt if they made some money while they were at it.
Well, it turns out that CTAs and multistrategy funds earned their pay last year. And although many of the multistrategy funds were down in the mid-single digits in the first quarter, they still get a chance to reverse this loss thanks to last year’s strong showing, particularly among some of the high-profile funds.
Many of the long-short funds — especially many of the prominent Tiger Cubs and Seeds — are deeply in the red this year. However, in many cases they were in the black last year, so the jury remains out on them.
Still, over the next few years, as markets try to settle down amid what should be continued — even accelerated — volatility, investors will look back at this period to determine which hedge funds truly delivered their long-promised alpha and risk-adjusted returns and were able to avoid the big drawdowns, and thus justify their hefty fees.
