“We Decided To Close Our Firm” – A Hedge Fund’s Lament

Several astute observations on the ongoing transition from active to passive management in general, and what is shaping up as the worst year for hedge funds since the financial crisis in particular, that are sure to resonate among our hedge fund readers courtesy of Eric Peters, CIO of One River Asset Management.

“We decided to close our firm,” read the email from a friend.

I moved it to a folder that’s filling up fast. Been a brutal year in an unforgiving industry. Change is in the air. It usually arrives slowly, quietly, fog. But sometimes change is a hurricane.

Today’s tempest is snapping saplings, uprooting oaks. A large state pension just announced a “Back to Basics” investment strategy; the commission voted unanimously to fully redeem from seven of the industry’s most prestigious hedge funds. They’re not the only ones heading Back to Basics.

Industry redemptions this year are $60bln; on track to match the 2009 record. Back then outflows were driven by losses. Now they’re driven by insufficient profits, high fees, and a general aversion by hedge fund managers to take enough risk to earn 8% annual returns.

Because that’s what investors must generate to meet long-term retiree obligations.

And if states can’t meet those obligations they’ll raise taxes, reduce investments, or cut pensions – leaving broke Baby Boomers diaper-less.

But raising taxes and reducing investment is self-defeating; slowing growth, reducing productivity.

So how will “Back to Basics” solve America’s intractable pension problem? With bond yields at 5,000 year lows, and stocks at valuations exceeded only during the 1929 and dotcom bubbles, a Back to Basics solution is an oxymoron.

Back to Basics is the exact opposite of what’s needed. Unless of course it means liquidating your portfolio and going short because everything’s overvalued. Or unless Back to Basics means market timing, because overvalued assets can still rally, just not indefinitely. And of course, shorting and market-timing are things that hedge funds do uniquely well.

Which is why we’re not the problem, we’re part of the solution. That’s why today’s hedge fund tempest presents extraordinary opportunity. For those who evolve, bend, and survive this storm.

* * *

“My company is in structural decline,” he said gazing across Gotham, high in the corner office.

“Made it through denial, anger, bargaining, and given that we’re having this conversation, I suppose I’m mostly through depression.” Which leaves the final stage of grief and loss; acceptance.

The transition from active management to passive has been devastating for those who’ve devoted their lives to the former.

“I wonder whether the deep pessimism that we confront every day in our own businesses helps explain why we’re so skeptical of all time S&P highs.”