Going long: Managers collect fees and avoid shorts and high-water marks

By Katrina Dean Allen

When William von Mueffling, the founder of Cantillon Capital Management, announced in June he would shut his hedge funds and convert into a long-only traditional money management shop, the investment community was stunned. Cantillon was the first of the über launches, coming out of the gate in 2003 with what was then a stunning billion dollars.

Von Mueffling had been a star at Lazard, where he’d made his bones shorting the tech bubble. But Von Mueffling had always had a fundamental approach to stock picking and investors say he liked to hold onto positions instead of trade—none of which served him particularly well last year. In 2008, Cantillon Europe, Cantillon World and Cantillon U.S. were down 10.72%, 9.25% and 16.27%, respectively.

Cantillon U.S. was liquidated at the end of 2008, while the other two funds have been converted to cash and investors returned their money. Both topped HSBC’s list of the 20 worst performing hedge funds for 2009 through July. Cantillon World was down 10.87% and Cantillon Europe lost 10.30%. Meanwhile, the long-only fund von Mueffling launched in 2005, Cantillon Global Equity, which has $1.7 billion, was up 20.3% through September. (It was down 31.11% last year.) At its pinnacle in January of 2008, Cantillon had just less than $11 billion.

Cantillon’s long-only fund has no lockup and offers monthly liquidity. Investors pay between a 1% to 1.5% management fee based on the amount of capital invested plus a 10% performance fee over a hurdle rate: 1-year LIBOR plus 2.5%. There is no high-water mark.

The Cantillion decision casts a spotlight on the industry’s dirty little secret: Many hedge funds don’t like to short and prefer to go long. “It’s hard to consistently beat the market,” says Randall Rose, president of Rose Asset Management, a family office that invests in securities and hedge funds. “As funds get larger, it’s even more difficult because of the scalability issue.”

Investors familiar with von Mueffling say his decision to leave shorting behind has more to do with the lack of compelling shorts and his view that for the next five years being long will be more profitable.

Of course shorting is difficult, expensive and risky. The increased regulatory scrutiny on the activity by the Securities and Exchange Commission adds uncertainty that is hard to quantify. Limits on stock borrowing, the possible reintroduction of the uptick rule—as well as the memory of last year’s short-selling ban and the chaos it created—aren’t helpful.

At the same time, institutional investors have pulled hundreds of billions of dollars from hedge funds, and getting board approval to increase their commitments is proving difficult these days. Moreover, there’s a bull market under way. The answer for both investors and managers seems simple: Go long.

The trend is not entirely new. The $26 billion D.E. Shaw and $23 billion AQR Capital Management were the pioneers, adding long-only funds to their platforms in 2000. And with the stock markets rising from 2003 until last year, a handful of big names such as Cantillon, Caxton Associates, Highbridge Capital Management, Lone Pine Capital, Maverick Capital Management and Viking Global Investors followed Shaw and AQR in launching a series of long-only funds to grow assets.

The beauty of it? Most hedge fund managers charge hedge fund-like fees on these products, and investors have accepted their argument that the extra talent is worth it. These funds typically don’t have high-water marks, which helps in years following ones like last year. Long-only products may have lost more money than hedge funds last year, but their managers don’t have to climb as far uphill to charge incentives fees again.

“You can no longer separate the financial risk in your portfolio from the business risk,” says David Kabiller, a founding partner at AQR in Greenwich, Conn.

No wonder long-only funds are making a revival. This time, a few hedge funds are abandoning the hedge part altogether. Von Mueffling isn’t the first fund to do so. Last year, Viking Global Investors alum Peter Uddo did the same thing. Uddo, who launched Praesidium Partners, a long/short equity fund in 2004 with partner Kevin Oram, wound down the hedge fund at the end of 2007 to focus exclusively on a concentrated portfolio of 15 names.

Praesidium Strategic Opportunities began trading in March of 2008. Although the fund lost 16% last year, it returned 44% through September.

“We are seeing a renewed interest in these types of funds,” says Uddo. “We believe that instead of spending a significant portion of our time on shorts, we can create more value and protect the portfolio from permanent loss capital by finding the right handful of businesses with significant upside.” Uddo adds that the team has “high conviction in the names it chooses for the fund, and thereby believes that although traditional assets can go down like they did last year, the intensive research we do and the time spent working with the management teams to unlock hidden value at the companies it holds long positions in will protect capital and allow us to significantly outperform over a market cycle.” Praesidium can hold cash if it isn’t finding compelling investment opportunities and has been on average 20% to 24% in cash since inception.

Praesidium charges a 1.5% management fee and a 20% performance fee, which is split: 60% is tied to a hurdle of 6% and 40% is tied to the Russell 3000. The fund has no lockup, no gate and a 45-day notice period with a high-water mark.

With $11.4 billion in assets, Viking is also looking to take advantage of the market rally and attract additional capital. Andreas Halvorsen rolled out a long-only fund in January that is a concentrated portfolio of the firm’s long book. Basically, Halvorsen takes all of his ideas on the long side, excluding those that are built to be paired, and scales them up to be fully invested for the long book. For this, Viking levies a management fee and a performance fee over a benchmark, the MSCI World. So far, the firm has managed to raise $297 million. Viking Long has returned 36.40% so far this year through September. Viking’s hedge fund, Viking Global Equities III, suffered only slightly last year, managing to stay flat with a 0.10% return. This year, that fund is up 14.50% through September.

What’s not to like? “For many investors, both individuals and institutions, alpha combined with beta is part of achieving outstanding overall returns,” says Ben Alimansky, director of the manager alliances program at Glenmede Trust, an investment and wealth management firm with client assets of more than $17 billion in both traditional and alternative strategies. “Hedge fund firms characteristically are nimble, so they can provide a compelling alternative to the traditional providers of long-only strategies,” he says.

In the past, hedge fund managers also looked at these products as a way to generate additional revenues when capacity for the hedge fund was limited or closed altogether. But whether investors fare better in one vehicle over the other one varies.

For example, Bruce Kovner’s Caxton Associates has been managing a long-only product since 2005. That fund, Caxton Alpha Equity, has returned 28% through September, after its first down year—in 2008—when it lost 35%. Caxton’s hedge fund, Caxton Equity Growth, was down 8% last year and is up 7.61% through September.

Kovner employs a computerized model that extracts the largest long positions from its hedge fund’s long equities book and resizes them so they are fully invested for the long-only fund. The net result is a concentrated version of the hedge fund’s long book. The firm charges a 1.5% management fee and no performance fee on Caxton Alpha Equity, which manages $550 million.

Lee Ainslee’s Maverick Capital is another firm that used the long-only capacity of its long/short equity fund to add a new product. In 2005, it launched Maverick Long, which has had an annualized return of approximately 13.3%, depending on the share class. Across the board, the strategy gave up 40% in 2008 but is up 48.6% for the year. Maverick’s hedge fund was down 26.7% last year, and is up 19.2% through September—which means that the long-only investors have fared better during that time. (Maverick charges a management fee for its long-only portfolio that varies from 2% for a one-year investment commitment to 1.5% for five years and no performance fee.)

Fellow Tiger Management alum Steve Mandel has made a similar move with Lone Pine Capital, which manages two long-only funds—Lone Cascade launched in 2005 and Lone Dragon Pine launched in 2008. Lone Cascade lost 44.59% last year and is up 32.20% through September. Lone Dragon Pine, which began trading in April of last year, finished 2008 down 52.12% and is up 58.64% this year.

The success of these vehicles largely depends on the manager’s expertise. “The whole crux of the opportunity is relative to where the skill lies,” says David Gold, a research consultant manager at Watson Wyatt. “If the shorting component and use of derivatives has been the manager’s edge, the long-only product is less appealing.”

The facts, however, seem to indicate that there’s more correlation to the market than the hedge fund’s hype may have led many investors to believe, especially those who dove into hedge funds after they wildly outperformed the market crash of 2000-2001.

The average hedge fund correlation to the Standard & Poor’s 500 Index is well in excess of 0.5, says AQR’s Kabiller, which suggests that the average manager is net long. There is nothing wrong with that, say the critics, but they believe that means hedge fund managers should be charging lower fees for all their products. “An investor can passively achieve a 0.5 beta to equities without any assistance from a hedge fund manager,” he adds.

With the hedge fund industry at an inflection point, the debut of former hedge fund managers into the long-only arena may engender some level of cynicism. “Do these guys have superior stock-picking capability that is sustainable through time and can they beat the benchmark? The jury is still out on that,” says one hedge fund industry professional.

But if an investor can find really talented analysts and stock pickers, that is a valuable investment, says Rose, who ran a $100 million hedge fund, Tamarisk Partners, from 1986 to 1994.

Perhaps one of the most successful has been one of the leaders—D.E. Shaw. According to the firm, senior management were looking for a way to diversify the business and found that managing long-only assets provided stable capital and recurring revenues. It also opened the firm up to a larger universe of investors who were unable to invest in alternative products for structural, legal or policy reasons.

D.E. Shaw is still primarily a hedge fund manager, with about $26 billion in alternative assets. It manages $3.2 billion across its long-only and 130/30 strategies, which are primarily made up of separately managed accounts. The firm points out that these products are a way to get access to additional institutional money—not that which is allocated to alternatives but capital assigned to the equity bucket of plan sponsor portfolios. “There’s always an allocation to equities in institutional portfolios,” says Trey Beck, a managing director and a member of the executive committee of D.E. Shaw Investment Management, which operates the institutional asset management business. Beck believes D.E. Shaw’s advantage is that it already has an established track record, and the firm has proven that it can service institutional clients through established trading and operations infrastructure and provide excellent ongoing analytics.

Unlike many other hedge funds, the firm is not charging hedge fund-like fees, and in most cases levying only a small management fee based on capital invested. D.E. Shaw offers clients three ways to customize their account. Investors can dictate which benchmark they want the portfolio to be measured against and how much risk they want to take relative to the benchmark. They can also structure the account as a 130/30 portfolio, which allows D.E. Shaw to add value through its proprietary models. The firm can charge as little as 30 basis points on a portfolio with a 1% tracking error, a measure of how closely a portfolio follows the index to which it is benchmarked. The long-only and 130/30 accounts do not have lockups.

D.E. Shaw Large Cap Core Enhanced Strategy has an annualized net return of 5.82% since December 2002, outperforming its benchmark, the S&P 500, by 121 basis points. Last year, the strategy outperformed the benchmark, which was down 37%, by 94 basis points. This year it has netted 20.42% through September and is outperforming the S&P 500 by 116 basis points. But the firm’s hedge fund, D.E. Shaw Composite, has outperformed the long-only assets over the past two years. It was down 11.20% in 2008 and is up 17.87% through September.

AQR recently added to its $15 billion menu of traditional products with a series of momentum indices and mutual funds. In contrast to Shaw, its long-only business now is larger than its hedge funds. AQR’s hedge fund assets peaked at about $10 billion at the beginning of 2008 and were down to $7.8 billion in July, a 14% decline for the past 12 months.

“If markets go up over time, we would like to have some exposure to that, and we can’t do it in a hedge fund structure,” says AQR’s Kabiller. “Hedge funds are not supposed to be giving you long-only market exposure, because they should be giving you diversifying returns.” AQR’s long-only business is designed to beat the indices by 2% to 3% per year. The AQR International Equity Enhanced Index, which is the firm’s long-only strategy, has an annualized return of 3.3%. The firm’s benchmark, the MSCI EAFE Index, has an annualized net return of 1.7% from February 2000 through September 2009. The strategy lost 43.4% in 2008 and is up 33% this year, whereas the MSCI EAFE was down the same amount last year and has gained 29% this year. AQR’s hedge fund, Global Asset Allocation, fell 18.7% in 2008, but has come back this year, up 25.4%.

Hedge funds moving into traditional asset management might be glad to be rid of the regulatory headaches associated with short selling, but potential conflicts for those who run both types of funds are high on the SEC’s list of concerns.

A firm’s trade allocation policy is the main issue. “I am concerned ... that managers are skewing investment decisions in order to maximize their own fees, including favoring some funds or accounts over others,” George Canellos, the SEC’s new regional head for New York, told AR last month. (“The Message is Going Out,” AR, October 2009.) The difference in fee structure might give a manager the incentive to allocate its best trades to the accounts with the most trading, where the most fees are paid. And depending on the organization and how the portfolio managers are compensated, there might also be a conflict of interest at the portfolio manager level.

“When addressing conflict issues, there is not one approach that makes sense for all managers,” says Ken Gerstein, a partner at law firm Schulte Roth & Zabel. “A manager needs to not only monitor the process to make sure the rules are being followed, but at the same time has to eyeball trading patterns and make sure there are not other things that are off, even though no rules are being broken.”

Most of the hedge funds that have separated some of their positions for a long-only portfolio use an automated system. And other firms, such as AQR and D.E. Shaw, run systematic portfolios that allow the hedge fund strategies and the long-only strategies to run independently. In the case of D.E. Shaw, the firm’s compliance division systematically reviews the fairness of trade execution.

This diversification of business lines allows hedge fund managers to trade on a strong brand and grow their business, especially when many larger investors have shunned the idea of hedge funds following their dismal performance last year. “There is a grooming of hedge fund portfolios,” says Greg Dawling, a director of hedge strategies at Fund Evaluation Group. “Investors are trading up in the quality of manager, reducing exposure from a level that was very high, much higher than your average middle-of-the-road plan, and also pairing back due to liquidity concerns.”

For example, the California Public Employees’ Retirement System—a leader for the institutional investor community—shrank its alternative roster following poor performance in 2008 and is looking for traditional investments with greater levels of transparency and lower fees in their place.

“Offering long-only strategies can broaden your market and increase the universe of people who may hire you,” adds Schulte’s Gerstein. “The additional product may also create more permanence in the business, an enterprise value that will outlive the manager and provide more revenue flow for compensation.”

Some traditional hedge fund investors remain skeptical of the trend to go long, especially as buoyant markets have made beta look more attractive. As Rose puts it, “I would rather have a hedge fund, and I would be willing to sacrifice some upside in a bull market for the protection offered by shorts in a bear market.”

GOING LONG