Pouring SALT on Hedge Funds’ Wounds in Vegas

Hedge fund managers claim to love a good contrarian bet. And right now, the most contrarian bet of all might be on their own future.

At this week’s SkyBridge Alternatives (SALT) Conference, the annual hedge fund gathering held at the Bellagio in Las Vegas, industry titans rubbed shoulders with business legends like T. Boone Pickens, political heavyweights such as John Boehner and Hollywood celebrities including Will Smith and Ron Howard. But despite the A-list delegates and luxe environs — some 2,000 conference guests enjoyed lavish pool parties, VIP dinners, private concerts with the Killers and the Wailers, a pop-up salon and free spin classes — the mood this year was almost somber. And it’s easy to see why: After years of mediocre aggregate performance, followed by a terrible first quarter, hedge fund managers are enduring withering criticism from investors. And some of these investors are voting with their feet.

According to Chicago-based data tracker Hedge Fund Research, investors pulled some $15 billion out of the $2.9 trillion industry in the first quarter, the largest quarterly outflow since the second quarter of 2009. Hedge funds fell, on average, 0.67 percent in the first quarter and lost 1.12 percent last year, according to HFR. In April the New York City Employees Retirement System announced that it is liquidating its entire $1.7 billion hedge fund portfolio, while the Illinois State Board of Investments also voted earlier this year to pull $1 billion out of hedge funds. Insurance giant American International Group said it will reduce its $11 billion allocation to hedge funds by half, citing disappointment over returns, while last week insurer MetLife revealed that it’s looking to redeem $1.2 billion of its $1.8 billion hedge fund portfolio, citing — you guessed it — frustration with performance.

Even the industry’s own denizens have piled on, with Point72 and SAC Capital founder Steven Cohen reportedly saying at the Milken Institute Global Conference in Beverly Hills earlier this month that he is “blown away by the lack of talent” in the industry. And in its most recent letter to investors, Daniel Loeb’s Third Point called first-quarter hedge fund performance “catastrophic”: “There is no doubt that we are in the first innings of a washout in hedge funds and certain strategies,” the letter said.

Similar sentiments were not hard to find at SALT this week. Speaking from her perch on the dais at the Bellagio, a representative from one of the world’s largest investors in hedge funds delivered an attack on the industry. “The past few years I’m sort of disappointed with the performance” of hedge funds, said Roslyn Zhang, head of fixed income and absolute return investments at China Investment Corp., which invests more than $20 billion in absolute return strategies. Zhang further ripped hedge funds for shorting the yuan, noting that numerous hedge funds have put on the trade regardless of whether it’s consistent with their overall strategy: “They really don’t know much about China, but they just spend two seconds and put on the trade. Should we pay 2 and 20 for treatment like this?,” Zhang said, referring to the industry’s traditional 2 percent management fee and 20 percent performance fee structure.

On some of the panel discussions this year, managers expressed a sentiment I haven’t heard in my previous years attending this conference: contrition. Longtime manager Leon Cooperman — whose New York–based Omega Advisors has already endured some $2 billion in redemptions following a period of poor performance and a Wells notice from the Securities and Exchange Commission over its trading in Atlas Pipeline Partners — admitted that managers have not earned their substantial fees and that the industry may see a contraction as a result.

“Money goes where it’s treated best,” said Cooperman. “Fees are going down. Maybe the hedge fund structure is the wrong structure.” On the same panel, Kyle Bass, the founder of Dallas-based Hayman Capital Management who shot to fame for correctly calling the subprime mortgage market crash in 2007, said of fees: “There should be a correlation to the risk-free rate. They have to come down.” Panelist Paul Brewer, CEO and CIO of London-based Rubicon Fund Management, observed that over the years the hedge fund model has changed. As firms have grown larger, the focus has shifted from performance to asset gathering, he said.

Of course, these and other managers offered familiar-sounding explanations as to why the industry as a whole, and their own funds in particular, had struggled to earn returns high enough to justify their fat fees. Managers for years have bemoaned persistently low interest rates and a lack of volatility in the markets, saying these factors make it much tougher to ply their strategies. Judging by the panel discussions at SALT, managers are not expecting it to get any easier to make money, and they’re having a tough time figuring out how to position their portfolios.

“Nobody knows what the hell is going on,” one veteran hedge fund investor told me. The conference sessions seemed to bear this out, with speakers disagreeing on whether and when a recession will take hold in the U.S., whether there’s still more pain to come in China and even who will be the next U.S. president.

Another investor told me that hedge fund managers have been blaming central bank policies and low volatility for their lackluster performance for years. But when managers finally got what they wanted — volatility returned with a vengeance and the U.S. Federal reserve finally raised rates late last year, albeit just barely — managers did even worse. This investor remarked on the bearish tone of managers at SALT and said it’s hard to get excited about any particular hedge fund strategies right now. Even the much-vaunted quantitative strategies, which performed well last year, are too dependent on leverage. More disturbing, this investor said, is how managers seem to be focusing on returns at all costs. Few are talking about Sharpe ratios or risk-adjusted returns, because they have to go further and further out on the risk spectrum to generate any kind of performance at all.

So what does this mean? At a minimum, the hedge fund fee structure, which endured such criticism for years, is finally changing. Anthony Scaramucci, the founder of SkyBridge Capital, which manages $12.7 billion in fund-of-hedge-fund assets, says: “We’re in a low rate, low return environment; the fees are going to come down, no question. I’m negotiating fee breaks for my clients.”

This new, lower-fee reality is proving hard for some managers to take. “A friend of mine who is a hedge fund manager asked, ‘Is this over?’ That’s where I think people get too extreme,” Ted Seides, the former president and co-CIO of hedge fund investment firm Protégé Partners, told me in an interview earlier this year. “The glory days for the industry are over, but hedge funds are definitely not going away. You have to recognize we’re experiencing both secular and cyclical headwinds simultaneously. The secular challenges are real and will cause a sea change in how hedge funds are packaged for investors, but the public scrutiny has been compounded by a particularly challenging cyclical market environment.”

At least one hedge fund manager agrees that the hedge fund industry will weather the current storm. At a media event held in New York last week, Mark Okada, chief investment officer of Dallas-based asset management firm Highland Capital Management, acknowledged that the first quarter was “traumatic” for the industry, and that for past few years, it’s been easy to make money simply being long the stock market. But he thinks this is an increasingly risky place for investors to be. “This is the best time to be thinking about getting into hedge funds,” Okada said. “The smart money will be smart again. I wholeheartedly believe that.”