Weekend Reading #30
This is the thirtieth weekly edition of our newsletter, Weekend Reading, sent out on Saturday 17th August 2019. To receive a copy each week directly into your inbox, sign up here.
How hedge funds lost their cool.
Hedge funds used to be cool.
Back in the day, they were rare and obscure vehicles for risk-taking. Smart, contrarian people left eye-wateringly lucrative jobs at bulge bracket firms to go it alone, seeking to generate that most elusive of things – alpha.
“Hedge fund manager” wasn’t a respectable job title. It wasn’t a career. In fact, it was a sure-fire way to torpedo your career, at least in the eyes of your esteemed colleagues (not to mention concerned friends and family). No. Starting a hedge fund was about having the freedom to express yourself. It was an existential statement, a way of giving two fingers to the system. This was an intellectual movement as much as a trend in the investment management industry. And if there’s one word that sums up this movement, it is this:
– The freedom to do your own thing.
– The freedom to take risk, on the long and the short side.
– The freedom to see opportunity everywhere, and profit from it.
The ultimate manifestation of this freedom was the multi-asset hedge fund, home to the purest and most irresistible form of risk-taking. Having the capacity to take risk across industry sectors, market geographies and asset classes – both long and short – gave funds the freedom to generate returns that were truly uncorrelated from benchmarks and analyst expectations. And it gave managers the freedom to wake up in the morning and express themselves without the shackles of arbitrary investment parameters.
So what happened? How did hedge funds lose their cool? How did an entire generation of fund managers pay the ferryman and lose their way in such spectacular fashion? And how can they regain their mojo?
A brief history of cool.
Every asset class has its moment, and every moment has its hero.
Before hedge funds, there was bond trading and investment banking. In the 1980s, the best in the business went to Wall Street. They traded junk bonds, raided corporate treasuries, did highly questionable leveraged buyouts and generally bathed in the abundant liquidity of capital markets that were still navigating their awkward-but-oh-so-exciting adolescence. Michael Milken was the poster-child of this epoch, and Gordon Gekko was his cultural spirit animal.
Then, in the 90s, the hedge fund arrived on the scene. A new breed of risk-takers set up their own shops to generate absolute returns (often with alarming degrees of leverage). Words like “arbitrage” and “alpha” swirled around the plush coffee shops of Greenwich and Mayfair, to the chagrin of bankers who lacked the hardcore quant skills or financial security to go it alone and pit themselves against the market. The now infamous Long Term Capital Management debacle proved only a temporary blip in the journey of the hedge fund from financial market oddity to bogeyman of the mainstream press. It turns out John Merriwether’s ingenious but ill-fated strategy of hoovering up quarters is still a thing, albeit with run-of-the-mill hoovers that cannot justify exorbitant management fees. The late 1990s saw a gold rush in venture capital which ended in tears with the Dot Com crash. Many prominent venture firms were significantly under water and were forced to write off the bulk of their investments. Some survived, and continue to this day. But before we get to them, we need to talk commodities.
The 2000s played host to a commodities bull market that saw the price of food, oil, metals, chemicals, fuels and the like rebound after a nightmarish period in the 80s and 90s. It was a boom comparable to the commodity supercycles that accompanied the post-war period and the Second Industrial Revolution in the latter stages of the 19th century. In short, it was a fun time to be flogging commodities. This almost decade-long party was really a function of the structural expansion of emerging markets and the rise of the aspirational consumer in key markets such as China and India. This was a great time to be an oil trader, a long-only EM fund manager, or indeed Jim O'Neill, whose annoyingly catchy brainchild “BRIC” has graced the screens of Bloomberg and CNBC ever since, capturing a pivotal moment in economic history but simultaneously homogenising a diverse collection of economies in a way that only a Goldman Sachs economist could pull off!
Of course, the 2000s were also the golden age of private equity. The Sarbanes Oxley legislation, passed in the wake of corporate scandals at Enron, WorldCom etc etc etc, created a new regulatory regime that made many large corporations see private equity ownership as more attractive than remaining public. Cue a resurgence that resulted in the completion of 13 of the 15 largest leveraged buyout transactions in history. Names like Schwarzman, Kravis and Zell entered the vernacular of financial markets and “Sure, I work in Private Equity” become the go-to calling card for alpha males and females in the bars of the Manhattan and London’s West End. And for good reason – this previously obscure pocket of the capital markets was now front and centre, a beautiful marriage of old school investment banking elitism and new school venture capital-style innovation. It continues to this day, with unprecedented levels of investor commitments. One cannot help but wonder if it’s doomed to end in large-scale value destruction upon the inevitable (but seemingly indefinitely postponed) death knell of the current debt cycle.
Speaking of financial crises, past and future: since the horror story of 2008 (a cataclysm that still lacks a catchy and universally accepted name), it’s been all about technology. The beloved offspring of Zuckerberg, Jobs, Bezos, Hastings and Brin have received countless plaudits and inflows, but a long tail of innovative technology companies – and those that benefit from the application of technology to cut costs and revenue – have driven markets to new heights. As a corollary, venture capital has rebounded to reclaim the crown of coolest job in finance. Sadly, hedge funds no longer get a look in.
Who knows what’s next? We’re not particularly interested in trends. And we don’t care about being perceived as cool. What we care about is making money for our investors, and as a result, ourselves. To do that, we need to be agnostic. We need to assess industry sectors, geographies and asset classes on their own merits. Sure, emerging market equities, long and short, are in our DNA. But we’re not ideological about how we make money.
Looking at the way markets are developing – and financial services are changing – digital assets seem like the next frontier for investors seeking to break free from the herd and capture alpha, with the 2020s possibly set to become “the crypto decade”. But it’s still early days (following the “crypto winter” of the past 2 years, we need time to get comfortable with the underlying assets and the maturation of the digital asset class). That said, in the coming year, the investment management hypermarkets will almost certainly seek to colonise this space too, packaging up decentralised finance into “safe" centralised products (the irony!) and charging a healthy fee for the privilege.
The wrong model.
It’s fair to say that the hedge fund industry has not had the greatest start to the 21st Century. It’s an industry characterised by lacklustre performance, high turnover (the wrong kind), scandals and most worryingly, disaffected customers.
Of course, not all hedge funds are bad. Certainly, there are some brilliant managers out there who do a phenomenal job of managing risk and generating absolute returns for their investors. Magnificent managers with long term records of delivering again and again are few and far between. These superstars have earned the right to charge what they please and so they should (and they do). But for the rest (the overwhelming majority) there is a major problem. And that is fees.
The old model of charging management fees and performance fees has broken down in the face of passive investing’s devastating ascent. We’ll spare you the apocryphal story of Warren Buffet’s bet with Protégé Partners, but suffice to say that charging high management fees and generating meagre returns is not a sustainable business model. And yet, the industry limps on, winning some, losing some, and averaging the kind of returns that make passive behemoths like Vanguard and Fidelity lick their lips. In the long run, they will pick over the bones of the active management species, one that failed to adapt in the face of irrepressible evolutionary pressures.
But investors are grown-ups. They can read the terms and take advice before allocating money to a hedge fund charging 2/20 to underperform the S&P 500 by 25bps. The point we are making is that being a hedge fund manager is no longer cool because everyone’s doing it. And everyone’s doing it because it’s actually quite easy to be a mediocre hedge fund manager. Being a good one is a different kettle of fish entirely.
Of course, it’s hard to beat the market. But it’s very, very hard to beat the market after charging 200bps in fees. The question of whether a hedge fund should even care about beating the market is long forgotten as most are judged on a relative basis when the very genesis of the industry was absolute return over any given period. The business model that has made hedge funds a destination for MBAs, CFAs and a bunch of other less prestigious acronyms is the very model that’s sucking them in and spitting them out as tomorrow's failures. Next stop: business school and/or launching a restaurant selling sustainably sourced organic goats cheese or plant-based protein bars to other hedge fund managers.
The hedge fund industry has become circular, sclerotic and unfit for purpose. Nietzsche would have called it "decadent" – one can only surmise that a man of his profound sensitivity and courageous individualism would have made a fine hedge fund manager, or perhaps a Pulitzer Prize winning investigative journalist exposing the vacuity and moral turpitude of our beloved industry.
The origins of this circularity lie in the institutionalism of active management. What was once boutique is now mainstream, merged into the corporate superstructure. A natural result of the corporatisation of the intrinsically anti-corporate is the stifling of free will, as senior management, their consultants and shareholder base seek to eliminate unfettered risk-taking in the misguided belief that it is something to be eliminated rather than celebrated and nurtured.
Sure, boutiques survive. But they are cruelly exposed to the vagaries of track record, since they lack institutional support from a diversified financial services franchise that generates revenue from other lines. In time, they will be weeded out – by markets, team departures, health issues or simply that great cosmic adjudicator – time itself.
A happy ending.
So far, this has been a somewhat depressing article. We make no apologies for that. But if you made it this far, you are in for some recompense, because here at Three Body Capital, we believe we have an answer to the hedge fund manager’s travails:
Stop charging management fees.
Take management fees out of the equation and we alter the math of investing. Managers no longer start every year handicapped by a 200bps drag on their performance. They are not obliged to keep cash on the table if markets become hostile. And by aligning interests with investors, they are able to attract a new audience of supporters for their business, building deep loyalty over the long term.
Clearly, abolishing management fees poses huge challenges. It necessities a wholesale reappraisal of the business, and the very role of the hedge fund manager. More importantly, it stops this malarkey of having investors subsidise mediocrity in an over-populated industry. Business owners need to think like entrepreneurs and not just traders. They have to devise sustainable revenue streams that can supplement the fund management component of their business, enabling them to profit from the upside potential of investing in markets whilst capping their downside risk.
This is precisely what we’re doing with Three Body Capital. When we launch our fund in Q4 2019, it will carry zero management fees. We will charge a 30% performance fee, aligning us with our investors and enabling us to share in their success. In order to ensure our business is sustainable, we will derive revenue from our online deal platform for professional investors seeking to access opportunities in private markets. We are also working on some other exciting projects that will generate income that's uncorrelated to our investment management business.
To revisit the great ubermensch himself:
“He who would learn to fly, must first learn to walk and run and climb and dance; one cannot fly into flying.”
In other words, this is going to take time.
What is cool? Honestly, we don’t know. But we know what isn’t cool. And that’s charging investors silly fees for something they can obtain elsewhere for next to nothing. We don’t want to do that. So we have to be creative and look at the big picture, building a diversified business that can support the right kind of hedge fund – one that aligns interests with investors. We are going to give this our very best shot. We will stand by our performance, and by that alone.
The price we pay is the value you get. And what we get in return, is freedom.
What we're doing.
This week we've been thinking about building a brand.
As regular subscribers to this newsletter know, we have been creating content for the past 9 months, sharing our journey as a business with anyone who's prepared to listen! We believe that when it comes to the opaque and needlessly complex hedge fund industry, transparency is more than a corporate buzzword – it's a key differentiator.
So, as we ramp things up in the coming months with the launch of our fund, online platform for investing in private markets. and the other business lines we're working on, we intend to ramp up our content creation, too. In addition to the usual blogs and newsletters, we're interested in audio, video and whatever weird and wonderful media format comes next.
As part of our marketing plans, we've started to dig into our purpose as a business, the WHY behind WHAT we do, and HOW we do it. Ultimately, we're here to make money for our investors – and by extension, ourselves. But Three Body Capital is about more than value creation. It's about having the freedom to express ourselves as fund managers, entrepreneurs and people. This isn't a typical positioning for a financial services company, and that suits us fine.
Of course, this is how we perceive ourselves the the business we’re building. But what about you? Having read our newsletters and followed our journey in recent months, how do you perceive us? And what can we be doing better? Hit us up and share your thoughts.
What we're listening to.
Robert D. Kaplan is prolific. He's the author of 18 books and is widely regarded as one of the world’s leading thinkers on foreign policy, defence and geopolitics. He’s not just a theorist, either – the guy has advised Kings, Prime Ministers and Defence Secretaries all over the world. He knows his stuff.
Which is why we love this podcast from CapX, in which host John Ashmore quizzes Kaplan on the future of a bipolar world. We found it particularly interesting to hear his thoughts on how China bullies the Philippines as an example to the US. As we have argued before on the blog, the #TheGreatGame is putting countries caught between the two global superpowers in an impossible – and increasingly unsustainable – position. This podcast helps to explain why.
What we're reading.
We always enjoy reading Bestinvest's “Spot The Dog”. For the uninitiated, this is an annual report that lists the “dogs” of the fund management industry. It uses statistical fund performance data to identify funds that have performed badly compared to their benchmark. This time round, there are 59 dog funds with assets under management of £32.6 billion. If one line from the 2019 report really stands out, it’s this:
“Fund managers need to be really good just to be average.”
This is especially true when you consider the high fees that most active managers continue to charge. The report concludes:
"If you are going to invest in actively managed funds, you need to be very selective in choosing those managers with the skill to deliver superior returns that justify their fees. Most fund managers do not achieve this over the long term."
Depressing, but true. And as we argue in this week's blog post, it doesn't have to be this way.