The Compound and Friends - What Happened to Hedge Funds? (with Michael and Ted Seides)

Episode Date: November 27, 2019

Ted Seides stopped by the Compound to talk with Michael Batnick about the struggles the hedge fund industry has faced over the last decade, and what might happen to stem the tide. 1-click play or subscribe on your favorite podcast app   Subscribe to the mini podcast on iTunes or Spotify    Enable our Alexa skill here - "Alexa, play the Compound show!"   Talk to us about your portfolio or financial plan here:  http://ritholtzwealth.com/   Check out our channel "The Compound" over on YouTube: https://www.youtube.com/thecompoundrwm Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer: https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Live from the Compound. My name is Michael Baddick. I'm sitting here with Ted Seides. Today, Schwab announced that they are in talks to buy TD Ameritrade. On the same day, Louis Bacon announced that he is closing his hedge fund after 30 years. These two stories are so emblematic of what happened in the asset management industry over this decade. What's going on? What happened to the hedge fund industry? Stick around. We'll get into it in a minute. So Ted, thank you very much for being here. Pleasure. Good to see you, Michael. So Louis Bacon has been doing this for, I think, 30 years. He's got $8 billion under

management, has seen all sorts of market regimes. Where is this money going to go? Yeah, well, that's a great question because we all know what the scrutiny has been because of returns on the hedge fund industry. I think there's a pretty good chance that that money doesn't necessarily turn around and go to another hedge fund. It's just kind of another reason for people who have been around to recycle it somewhere else. So if it's not going to a hedge fund, this is not retail investors, right? They're not going into SPY. So this is institutional money, endowments and pensions primarily. Where are they going? Are they staying in the alternative space? I would imagine that's like the bucket that this is in. So what do you see them going? Yeah, the huge demand's been in

private equity. There's a private equity and private credit to some extent. So if you look across asset classes as an institutional, think about it. You have your traditional buckets, equities and bonds, then you'll have private equity, have some real estate, typically have hedge funds, which are these other strategies. Most of these institutions don't think they're going to make their spending needs with just stocks and bonds given the pricing. So where else are you going to go? I have always been, or always recently been bewildered by this idea that we know to the extent that we can, that future returns for stocks are going to be lower, certainly for bonds, that's the case. Why do we think that if public equity returns are going to be lower, that private equity returns would be higher? So I think that's a fair question. It depends. And again,

let's break down private equity. You have venture capital, which is a completely different risk return profile than, say, leveraged buyouts. The leveraged buyout side, pricing's high. And that's a real question. There are some structural benefits of the private assets, and most of it has to do with human behavior. So as much as it seems like, well, you're giving someone your money for 10 or 12 years, well, what happens is you have an investment team that makes a recommendation to an investment committee. The committee approves the investment. And if something goes wrong in year three that works its way out in year seven or eight, the committee can't do anything about it. The investment team can't do anything about

it. The money's there, and you get the returns of compounding over a long period of time. So structurally, it's an advantaged vehicle. And you do have this question of price and our price is going to be more compressed also. So one of the, obviously it's been an extraordinarily tough decade for hedge funds across the board. I mean, with a few exceptions. Is one of the arguments that it's been such a long protracted bull market that it's just hard to keep up with the giant names. But I guess the other point is like hedge funds didn't have that problem in the 90s, did they? That was a long bull market and they seemed to do very well. So what changed in the last decade specifically? Well, there's a couple of things that are different.

And the first thing is you have to caveat it with, are you really comparing this to the S&P 500? Obviously, for a long time been in the spotlight of that comparison with the bet I made with Warren Buffett, but it's not the right comparison. But there is change. And there's two meaningful things that have changed, say, in the last decade than the prior decades. The first is just competition. So there's more and more money in the hedge fund space. There's more dollars deployed into resources to kind of mine for alpha. And that makes that excess return harder to come by. And that's permanent.

That's not going away. The other, which may be permanent, maybe not, is just the nominal level of interest rates. So if the U.S. short-term interest rates are 5% or 1%, has no real impact on the return of the S&P 500, You have stocks, maybe there's some correlation. But with a hedge fund portfolio where you have long position, you basically have long positions, if it's stock, long short equity, you have long positions, short positions and cash, and you earn a return on the cash. And so if rates go from 5% to 1%, you have 4% less return. And that's just structural to the vehicle of a hedge fund

that doesn't exist in the equity markets. So you said that this money is leaving hedge funds, as it has been in draws for the last 10 years. Do you see a scenario in which this could return? Is it simply that it takes a bear market? What can make the money come back? Well, first of all, that premise is actually wrong. Which one? That money's left hedge funds. Okay. So hedge fund assets as an industry are probably at all-time highs.

But is that because of growth of the underlying assets, or is that more to do with flows? Because I thought there was outflows, but assets are at a high because the market's high. When you hear about the outflow numbers as a percentage of the total, they're tiny. Got it. The composition of the industry's changed. So you have more kind of mega-sized funds. It's kind of the megas and the minnows. And it's very, very hard for that kind of whole ecosystem of small funds to kind of make it work. But you have like a two sigma that's $50 billion. When I started the industry, the hedge fund industry

probably was $50 billion. So it's a completely different complexion of where the assets sit. But it's just not the case that the hedge fund industry, the assets invested by hedge fund managers are any less than they were. They're probably more. In terms of composition that you got into, you hear all the time, we're guilty of it. A lot of people compare hedge funds to the S&P 500 or a 60-40 portfolio. But it is really impossible to paint an industry with such a broad bunch because there are credit hedge funds, there are long short, there are long only. So when people are allocating to these strategies, how should they think about benchmarking them? How do they determine whether or not they've been successful? Yeah, there's two different ways that most of the

institutions think about it. If you want to call it the traditional way of alternatives really came from David Swenson, and that was to take these strategies into a bucket together. They called it absolute return or something like that, where the intention was a long-term equity-like expected return. So think of a 5% or 6% real return, 7% or 8% nominal return, with just less risk than the equity markets. So that's one way that, and that was really the traditional way. What you've seen more recently, say in the last five, 10 years, is the managers saying, okay, if it's a long short equity bucket, we understand what equity market returns are. We understand what the beta is and the alpha is. And you could take that and make it part of your equity allocation. You could take a credit or a distressed debt manager

and make that part of your bond allocation. So there are structural components of what the assets are underneath the hedge funds in some of the strategies that you can break out. And in others, if you think of a global macro trading or a true multi-strat manager, you might not be able to determine that there is much underlying beta. And then it's just you're betting on the skill of the practitioners to extract returns from the market. I guess one of the reasons why people have made this comparison is because it's not uncommon for hedge fund managers to compare themselves to the S&P when things are

going well. And then when things aren't going so well, you say, well, it's not really a fair benchmark. Is that just bullshit? Does anybody really do that? I mean, it might happen for a long, short equity manager focused in the US. It is a subset of the hedge fund industry that's doing that. And it's certainly when we're sitting here in the US and sitting here in New York, you hear more about that than the broader array of hedge fund strategies. But it's just a subset. So you recently went to a conference where you saw hedge funds present, and you did a

tweetstorm on the state of the industry. What's going on today? So there's been the shape of the ecosystem. Even though aggregate assets haven't changed, the dispersion of those assets has changed a lot. And so one of the things that I found was you had some really experienced people that are still in the game managing 10% or 15% of what they did at their peak. So think about an example of a fund that was $2 or $3 billion 10 years ago,

and today is $300 or $400 million and half is the principal's own money. That's just a super interesting proposition in terms of your alignment of incentives as an investor. They're going to make their money by compounding their own capital, and you're along for the ride, and your fees are helping them support the business to do that. That's totally different when people think about a $10 billion fund that's just collecting a 2% management fee and getting rich off the management fee. It's just really hard for those small funds to find where's the next investor going to come from. So it's a chicken and egg, or maybe a double-edged sword is the right way to put it, is that people have said that smaller funds tend to have better returns

or at least size is the enemy of returns. But are the days of three people with a computer setting up shop, is that over? Pretty much. I mean, it depends on what they're trying to accomplish, right? Because the way I used to describe it is if someone could find 10 million bucks

from their rich uncle to manage and they were going to get a $200,000 management stream off of that. And they were just terrible. And they were terrible at everything. This is like a D student throughout their life who never sort of got religion and got good. That person, that $200,000 job might be the highest job they're ever going to find. So does that count as a hedge fund who's staying in the business, probably detracting value for their rich uncle? Well, in the statistics, it does. Yeah. In terms of people that are putting money into these strategies, oftentimes there's intermediaries. We were talking earlier, there's very little in the way of retail dollars in these strategies. Is that right? Yeah.

How well do the allocators of capital on these boards understand the strategies that they're getting invested into? I think there's a great variety, depending on the type of institution. Many of the investors are not only sophisticated, but significantly more sophisticated than they were 10 years ago and 20 years ago. So this notion that boards don't really know what they're doing, complete nonsense? Mostly nonsense. Okay. I think it depends on the type of board. So without certain, so without pointing hard fingers at any one, you could think of a public pension fund where some of them are super sophisticated and have really investment driven people involved and others are more political

bureaucracies and the people on the board don't know much about investing. And so that's a very different decision making body across those two examples. So some of the, for lack of a better word, excuses that you hear from the prominent hedge fund managers, the Fed and interest rates, valuations, index funds is a big one. Where do you think that there's some validity? Where do you think is nonsense? What do you think about specifically index funds killing price discovery or anything like that? I think that's mostly excuses.

You have to come up with a story. And by the way, when you talk to hedge fund managers, that's not really what they point to. I mean, they might point to that in terms of aggregate. So, oh, like hedge funds in general are struggling. We know that in terms of the number of hedge funds, not the industry as a whole. And people have to evolve. And it's because money is going into index funds and away from active management, broadly defined. Hedge funds are kind of an

uber form of active management. That's true. You don't really hear managers one-on-one very much use that as an excuse for why their performance isn't great. So this is a good point because I think that a lot of what we hear, like laymen like me who just see like a tweet or whatever, and it's not really representative of reality. So maybe you have a better sense of what are people saying? What's gone on and what could potentially change? The part that's gone on that's hard is that competition piece. To give you some simple numbers, when I started in the business in the early 90s, a crowded short was 2% of the outstanding float. Now, what's Tesla? Tesla's probably 60%. I mean, some of these numbers get

crazy. So there are just many, many more participants chasing after the same things, and it creates difficult tendencies. There are a lot of recently retired hedge fund managers, say long short equity managers that I talked to, who think that shorting as a practice, the way that they used to be able to make money, they just can't do it anymore. That you have on the short end, you have quant. And on the long end, you don't have the duration of capital to just be able to short something for four or five years. So in terms of there's obviously a misnomer that the industry is dead or under assault or something like that, Obviously, competition has gotten a lot stiffer. It sounds like there's not going to be a sort of capitulation where investors are like, all right, this doesn't make sense anymore. That's not going

to happen. If it was going to, it probably would have. So what happens is in the decision-making units, you have teams and you have boards, and you need long periods of time to pass for there a trend to shift. So for example, after 2000 and 2002, where the public markets did poorly, but hedge funds in general, again, let's say long, short equity hedge funds did well. Today, we'd call that a style bet. They were long, small cap value and short high flying growth. But then it was just a strategy. And that was the only way you could access it. It happened for long enough, and then the returns sustained themselves for five or six years, that the board started saying, how come we don't have this hedge fund thing that's working? And you're hearing that in private equity today.

The boardroom today is like, well, why do we have these hedge funds? And there's more and more scrutiny. That won't reverse because what you know is the fees are high. Well, the scrutiny won't reverse. Yeah, the scrutiny is not reversing. I think that's a very, very slow melting ice cube, depending on where you are, right? If you're Lewis Bacon,

you might've just melted your whole ice cube today because you chose to. If you're a very, if you're two Sigma and you're Citadel and you're still able to generate the returns that people want, you're going to be around for a long time. So the whole principal agent thing, you have these people that are intermediaries

that have recommended these funds. If I was in their shoes, I would say, well, look where the market is. All-time highs, valuations, protracted length of the bull market. Are you really going to take away this hedge today? I think that's exactly right. So most of these institutions look at and say, well, it's easy to say 60-40 would have been great or just buy the S&P 500 10 years ago. By the way, next to nobody's easy to say, you know, 60-40 would have been great, or just buy the S&P 500 10 years ago. By the way, next to nobody's retired from super rich because they owned index funds 10 years ago or 15 years ago. So, but if you look at where bond yields are today, or where the, you know, say the S&P is at 17 or 18 times, and your implied earnings yield is like

five or 6%, a 60-40 isn't going to get you the 6% or 7% liability stream that you need for these pools. So it's not just a question of, oh, we think hedge funds are bad. It's, OK, well, what do you want to do with the money? Because you need to try to achieve these returns. And most people, you could say, OK, yeah, we can't predict the market. We could go to negative interest rates. That's true. We could. But over a long period of time, this isn't a great starting point to own those assets. And so people are looking for other ways to meet their spending needs. So we know that the average hedge fund is having a really hard time. Talk about the dispersion of returns amongst the best to the worst. And how could somebody or a foundation or endowment get access to the best of the best?

What's going on in that space? So dispersion of returns is always pretty wide. I mean, if you march across asset classes, like in bonds, it's super tight. In stocks, it's wider but still pretty narrow. You go to international stocks, it's wider. Hedge funds is wider than that. Private equity gets even wider than that. And then across strategies, it can be really wide. So a lot of, you know, when people talk about stocks versus hedge funds,

they're really talking about long-sh short equity. That's only one subset. And by the way, US long short is a subset of global long short. And it's really only in the US where you've had this persistence of active managers underperforming indexes, really large cap and mid cap. It hasn't been the case the last 10 years in Europe. It hasn't been the case in Asia. So even just in the stock market, there's a lot of levers that people can play. So if you could get access today to the best of the best, what would you say? Yeah, do it all day long. What's the problem? Well, what happens with these institutions is that they have very desirable capital. You can go to one place and get a big check. And these people have sophisticated investment teams and

sophisticated committees. And that's really what the top managers want. So meaning the best hedge fund manager wants Harvard's money. They want Harvard's money. They want Yale's money. They want money from an institution that's going to be around for a long time with a long horizon. And they want the people behind the money to be investing for the long term. And there's a lot of those people down the block. There are a lot of them. I mean, there aren't a lot of them in the scheme of like how many of us are out there.

I just mean in terms of the giant institutions, there's a bunch of them whose money these hedge funds would love to have. There's enough that there's a trillion dollars in hedge funds. And I would guess that 90 plus percent of that are these institutions, right? So this really has been a game for institutional

investors and not individual investors. So the Harvards and the Yales of the world have access to the best of the best. What would you say to a $50 million foundation if you were advising them in terms of getting access to alternative investments? Yeah, I mean, it depends who they are. It depends how they're staffed. They can do it. And sometimes there's a little toll to play. I used to be in the fund-to-funds business. They're a small subset of the fund-to-funds, I think, do a fantastic job and are able to access some of these managers. And that might be a good way for someone who's smaller to do it that wants to get the right kind of diversification and access but can't do it on their own. But it's not for everybody. And for me, when I was sitting at Protege or I was sitting at

Yale, I thought hedge funds were a fantastic investment strategy. When I'm on my own as an individual, I have relationships I can tap into and do at times to invest in hedge funds. But for the most part, it's just not something that makes any sense. Why is that? You don't have the resources to do the due diligence. When you say you, you mean the individual? Yeah, me as an individual as opposed to me sitting within the resources of an institutional team. Yeah. You don't have the resources to stay on top of it. You don't have the time and attention of that hedge fund manager.

They don't care as much about you if you have a little bit of money than if you have a lot of money. You're not as important of a client. So you don't have access to the information that you'd want to be able to continuously make that evaluation. So if you want to know what's going on, it's, yeah, get lost. Pretty much. So Lewis Bacon closed, as we mentioned earlier. A lot of people that have been in the industry for 20, 30, 40 years are having a really difficult time. What's next for hedge funds? What other areas are they exploring? Yeah. So as a starting point, hedge funds, that's what they're best at,

is evolving into different places. On the equity side, and particularly fundamental equities, which has been by far the most scrutinized, most challenged for performance and otherwise, the old school, I'm going to buy these stocks I like and short these stocks I like and I'm a generalist, is really like in the bullseye of the scrutiny. generalist is really like in the bullseye of the scrutiny. So where you're seeing evolution in that part of the ecosystem is more interest in deeply specialized funds. So it could be a sector or geographic region or someone who's just focusing on a subset of stocks and doing that really well. Quant obviously is particularly from the shorter end of time horizon has been really interesting. And then the other, and not most managers don't have the ability to pull this off, but longer duration investing. So meaning what exactly?

So take an example. There's a guy named Dan Sondheim, who was one of the co-CIOs at Viking, huge hedge fund, and left maybe two, three years ago. He launched a fund, multi-billion dollar launch from all these institutions that had the ability to invest in private equity, had, I think, three-year-plus share classes. You couldn't get your money out for three years plus. And that was the only money he would take. And he had a lot of money of his own invested alongside. So for the very small—and those, by the way, those are the managers that the top institutions want to invest in. They're massively capacity constrained, and they are structurally set up to succeed. And they can access whatever capital they want. Excess demand for a fund like that is through the roof. But those come up maybe

once a year. So the days of the hedge fund superstar in the public, people like David Einhorn and a while back like Leon Cooperman, you don't see those people coming back. Well, you know, what's different today is that some of those people are in the public. I would tell you that there are a bunch of those people that exist. You just probably have never heard of them. I heard you make that point, and I think it's interesting. But do you think that if the returns of these people were so extraordinary that they could stay hidden for long? Like, wouldn't the media find them? Or not necessarily? I mean, obviously, I'm not going to mention names.

But there are a lot of those people out there today. And if there's a commonality across them, they limit their assets, they keep a low profile, and they just invest on behalf of maybe 20 or 30 or 40 clients. And that's it. Those people exist. They are very well known in the community of these allocators and they're not known at all. So I think it was a T-Boon Pickens. I saw this quote recently, the baboon that climbs the highest gets shot in the ass. Anyway, so those days, those people don't want to climb too high on the tree for the reason that you just mentioned. All right. Well, Ted, this is a really good conversation. Thank you so much for coming by. Thanks, Mike. It was fun.

Thanks for watching. Let us know what your thoughts are on hedge funds. Are they misunderstood? Are they unfairly maligned? Let us know what you think. Hit subscribe and thanks for watching.