So there are two big Hedge Fund stories behind the WSJ pay wall today. The first is that my old boss, Paul Tudor Jones, is cutting his fees. Again. The second is that the Harvard Endowment, long an internal Hedge Fund of it’s own, is finalizing its long known plan to farm out virtually all of it’s management to outsiders, and going to manage its money by looking across the full spectrum of investment options.
Personally I think both of these strategies are going to be effective, but I have a great deal more to say about the Harvard decision than the decision at Tudor, even if the only thing I know about what’s what at Harvard is speculation. So let me speak to the Tudor story first.
Paul is smart. Very smart. He’s worthy of his legendary status, both professionally and personally. His firm is scrupulously honest, on a level thats is as hard to describe, as it is to fully appreciate. There are grey areas in the laws regarding hedge funds, but Tudor not only avoids breaking the law, and also the grey areas as well. They also avoid getting close to the edge of the grey areas, and sometimes depending on your perspective, even looking at the grey area or wearing something grey, is strongly frowned upon and will get you a pleasant but stern and seriously minded talking to.
In my opinion he’s cutting his fees not because he isn’t the best, but because being best in the old structure of the Hedge fund industry, isn’t worth what it used to be. Betting on Paul and his team is as good as it’s ever going to get. But it’s my opinion that's because of the way the markets have changed and the way Hedge Funds are structured to operate in them, it’s just not gonna get as good as it used to be. Not for a good long while at least.
So that’s said. Now the Harvard Story.
About six months ago I had coffee with another Wall Street Legend, serial Chief Risk Officer, Barry Schachter. He and I have known each other a good long time, and in my personal circles, he’s known for being a part of one of the most entertaining Senior staff meetings in Hedge Fund history, where he accused another senior staffer of having “Absolutely no idea what he was talking about” to the momentary shock and horror of all present. He was right of course, and demonstrated it. But the fallout from that was hysterical. ( insert obscure insider "Vega" reference here. )
Barry was head of risk when I arrived at Caxton, and when he left he went to run risk at Moore Capital, the place I had just come to Caxton from. He went on to run risk management at several other top tier firms, and no one is more respected or knowledgeable.
Barry was telling me some of the broad brush strokes of his latest venture, a smaller (10B>AUM<3B) fund. He would never reveal details about his work to a disinterested party which I was, but big broad brush strokes are fine, and we discussed it at that level.
He said the firm he’d be working with was Macro based – making bets on big sweeping economic inevitabilities – and that those bets would be both longer dated and ‘directional’. That’s a formula for relatively high volatility of returns, so it’s the kind of thing that hedge funds have avoided in the past. But he claimed, and I agreed, that it’s an area where there still may be a great deal of opportunity.
As an example, suppose you made a long term bet in this manner. If it’s doing well, you could theoretically be net up 13% in May, down 15% in June, and up 15% in July. So long as you are down 13% in August, this is a winning bet. The returns may be a very jagged line, but they’re a line with a strong upward trend, which means it’s inevitably profitable.
But it’s a winning bet that most hedge funds couldn’t make because of the structure of the industry where a 20% loss, even for a single day, means the end of operations. Well this new venture has solved that by establishing a different relationship with their investors that doesn’t necessarily set a trigger at a hard 20% draw down from peak.
The structure of the Hedge Fund world, with it’s fund of funds and layers of asset allocators who act as intermediaries between the cash investors and the funds, can’t really do this because it’s impossible to put a hard benchmark on the returns where you don't know for certain when the draw down is ‘expected vs. unexpected.” But the risks associated with those draws isn’t unknowable, and since there is a lot of data available for them, Barry felt that he could get a handle on it. If anyone can I’m sure it’s him.
This is an abandonment of the generalized “Market Neutral” low volatility high leverage approach, that has been squeezing Hedge Funds for the last decade. Disparities between the various markets have all been reduced to irrelevancy, and all hedge funds have felt that effect. That’s the real reason Hedge Fund returns have been low, sporadic and unrepeatable, even for the best managers. But there are so any people with a vested interest in that funding delivery structure, that no one wants to talk about it.
And what this has to do with Harvard is that they seem to be taking a broader, less explicitly “Market Neutral” approach as well. I don’t know the details of what’s being planned there beyond the WSJ article. But what they claim to be doing at least opens up the potential for a more directional, less market neutral approach. It also opens the door to more returns from private equity and real estate options, for which they are far more than adequately funded. And since I see that as the way of the future, I think it’s a good bet that this is part of their plan.
As always, the way a Hedge Fund works in principle is still about obtaining an “Information Advantage”. Barry’s new employers have cleverly figured that the structure of the Hedge Fund world has restricted most funds from taking the kind of bets they will be, and that gives them an explicit information advantage, even if it also gives them volatility. They have simply found a more structured way to manage that volatility, in a way that allows them to continue to operate.
I strongly suspect that Harvard is looking at things in this way as well. This opens up the possibility that they’ll move into markets which are inherently short liquidity like Real Estate and Private Equity, because it obscures (rather than eliminates) some of the volatility that comes with it.
That’s a structural change in funding as well, in a certain respect. But it requires a different set of expertise than the old model that is still being done as effectively as it can be, by guys like Paul Tudor Jones.
This says something important too about quantitative credibility. During the big expansion of the Hedge Fund world, it was often possible to get a gig managing money because your numbers looked good, even if you weren't one of those Exeter/Harvard/Oxbridge insiders. Well the opportunities in the easily quantifiable space are dwindling. So instead it's falling back on it's old method. Huge personal credibility works, as does "He knows the right people". But everything else is in for a very hard time.