Tales from the Hedge Fund Graveyard (as told by William Shakespeare)
“A hedge fund can die but once.” Cautionary lessons about those who have fallen, regaled for those who wish to survive.
The life cycle of a hedge fund often mimics the arc of a Shakespearean tragedy. Our protagonist enters the scene with an optimistic flourish, they soon make a big mistake connected to a tragic flaw, then it all comes tumbling down.
Granted, some arcs are more dramatic than others. Not everyone is a Macbeth, Othello, or Romeo—with ambition, jealousy, or young love (respectively) elevating to the point of murder. Sometimes it’s more of a Timon of Athens situation: they run out of money and eventually die.
Hedge fund managers must face the unexpected yet inevitable twists and turns the market shamelessly provides. Shakespeare’s Pericles celebrates the unforeseen; the title character shares,
I see that Time's the king of men,
He's both their parent, and he is their grave,
And gives them what he will, not what they crave.
Time is perhaps the most all-encompassing cause of expiration for hedge funds. Whether a fund got the timing wrong on an investment, or time presented a challenge too difficult to mount, many funds can claim “time was just not in my favor” as they leave the arena.
Yet it isn’t all Time’s fault. Gathering data from hedge fund closures that made the news over the past 20(ish) years, we found that fatal flaws are commonly the true cause of death. While past performance is not indicative of future returns, past malperformance can provide valuable lessons for us today.
There has been some optimism in the hedge fund space lately—2021 was a strong year, and even through the volatility of this year hedge fund liquidations are down and launches are up. This is welcome news, to be sure. So let’s gather round this All Hallows' Eve, and in the spirit of Shakespeare, glean what we can by listening to a few cautionary tales from the fallen funds of the past. Enlisting the help of the Bard felt only appropriate for our walk through the Hedge Fund Graveyard.
In connection with this project, we also refreshed our fan favorite Hedge Fund Survival Guide—which just might help your fund from becoming the next headstone.
Don’t be a criminal. Don’t work with criminals.
“Oh, that deceit should steal such gentle shapes,
And with a virtuous vizard hide foul guile!”
Duchess of York, Richard III
As the Duchess of York alludes, deceit can look quite pleasant to the untrained eye. It’s all yachts and estates in the Hamptons until the fabricated numbers are brought to light.
We’re going on the record, and making the bold claim that if you want to succeed (long term) as a hedge fund, don’t do anything illegal. If you want to invest in a manager, and their process smells funny, or better yet, they claim to deliver “superior returns with little to no risk,” take a page out of Fleance’s book: back away slowly, and then quicken your pace once you’re out of sight (if you need a refresh, Fleance is Banquo’s son—the guy that Macbeth kills, and it ends up being super good for Fleance that he ran away, like life-changingly-becoming-a-king good). If you are feeling tempted to pursue a criminal-yet-ambitious path, please read Macbeth, watch the 2010 BBC Macbeth featuring Patrick Stewart, and spend a long night perusing the SEC press releases for funds like Madoff Investments, S.A.C. Capital, Galleon Management. . . . beyond that, we really can’t help you.
Don’t allow your zeal for your investment strategy to overpower the voice of reason.
“The wound of peace is surety”
Hector, Troilus and Cressida
Ah, the excitement of a good idea! What a feeling. Yet the ingenuity of the idea can often overpower the practicality. Just as Julius Ceasar was warned to “beware the Ides of March,” managers must beware the following three potential causes of downfall:
1. Beware of leverage.
"For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry."
The above fatherly advice may be a bit aggressive, but it’s not too far off. RIP Polonius.
Long Term Capital was literally run by Nobel Prize-winning economists and renowned Wall Street traders. You can see why they had the confidence to give it a rather vainglorious name. Things started out strong, but the firm’s “highly leveraged nature” did not work to their favor when Russia defaulted on its debt in 1998—causing liquidity to dry up on these highly levered trades. Due to the massive size of the fund at this point, and losses approaching $4 billion, the US government had to get involved to ensure the collapse did not lead to a financial crisis.
Notably, this happened over 20 years ago. Technology has come a long way in helping fund managers more accurately estimate risk. See below:
One way to adjust for leverage is to compare a fund’s net adjusted return with a net adjusted benchmark return. While this can be a rather complex metric to pull, modern technology (such as The Novus Platform) does the grunt work for you. This comparison is especially valuable due to its close connection with risk.
2. Beware of abnormally large positions.
“I thank my fortune for it,
My ventures are not in one bottom trusted,
Nor to one place.”
Antonio, The Merchant of Venice
Because we all have blind spots, managers must be wary of abnormally large positions. Maybe a global pandemic will hit. Maybe a Reddit craze will cause a previously unfathomable spike in $GME. We can’t predict Black Swans.
Strategic position sizing can serve as a buffer when unprecedented calamities make their move on a fund. In practice, a position size less than $113 million—a position size of –0.51% of the total AUM for Q4 2020 per the 13F filings—might have caused less turmoil for Melvin Capital when up against $GME (and an army of Redditors). Above, we see how the Crowdedness Weighted Average climbed as AUM dropped at Melvin Capital circa Jan-April 2021 (based on their 13F filings, visualized with SEI Novus); this was while it shorted one of the most crowded shorts of the time.
At the same time, we’d be remiss not to mention the virtues of sizing up good ideas. Consider our Novus Conviction Index, which is a research portfolio that contains stocks with the highest number of managers invested with conviction. Our decade-plus research into this index suggests that when a manager places a large portion of their portfolio into a name, and especially when we see such conviction play out across multiple managers, such names tend to outperform. (For more you can listen to this podcast episode or check out the data for yourself.)
Note that the Novus Conviction Index only covers long holdings. Aggressively sized shorts can be a different story.
We shan’t advise on how much is too much, but perhaps there is a Golden Mean when it comes to demonstrating Conviction.
3. Beware of blind spots.
"There are more things in heaven and earth, Horatio,
Than are dreamt of in your philosophy."
Let’s say you’re a trader and you come up with a really good idea. To keep this scenario leagues away from investment advice—looking out for you, compliance team—let’s say you’ve become aware of an arbitrage opportunity in avocados. You’re going to buy up in March when avocados are cheaper and then freeze them (remember, I said imagine) to resell during the summer. You run the numbers, and the results are as solid as a frozen avocado. You back test the strategy 15 years, and again, the data support you. You get your firm’s approval. They think it’s such a good idea, they put over half their capital into the March purchase.
However, the year you decide to do this is the same year that a long-standing avocado farm with an April-October harvest season decides to double their production. They have such a successful harvest season that is triggers a surplus of avocados in the summer and prices actually drop—so low that you are unable to sell your frozen avocados at even a discounted rate. You lose a lot of money and everyone is very sad, with only frozen (unsellable) avocados to comfort them.
This is more or less what happened to Amaranth Advisors. An energy trader used a “calendar spread strategy” to bet that the spread between gas contracts in the winter vs. non-winter would increase; in reality, the gap shrank. The firm took a highly aggressive approach to what they saw as a “fool-proof” strategy, but that year the natural gas market “did something it hadn’t done before.”
As Ron Rimkus, CFA points out, they saw patterns and assumed causation, when it was really just correlation. The determining factor ended up being one the firm had not considered.
The above chart compares active contribution to passive contribution for Amaranth (according to their 13f) which a good way to identify the quality of a manager’s idea selection. Active contribution can be attributed to the manager’s decisions when it comes to security selection, position sizing, and timing, whilst passive contribution is attributed to market conditions. As you can see, September 2006 marks the month the results of their energy bet played out. The fund announced its closure in October 2006.
Deliver a Strategy that Lasts
“For I must tell you friendly in your ear,
Sell when you can; you are not for all markets.”
Rosalind, As You Like It
While some funds close due to scandal, and others due to blowups, some close because the strategy simply wasn’t that remarkable. These ones can often catch that they are not on the brink of something great, and close before the damage is too significant.
Moderately unsuccessful funds can Irish goodbye pretty well, with many never even making headlines. If they do, it’s for vague amounts of “losses” or “unacceptable” returns. These ones have the luxury of still keeping a bit of mystery. Funds cite reasons such as “lack of suitable amount of investment opportunities” or significant derivatives trading loss, without giving super tangible reasons. Or sometimes, they essentially say “we don’t want to do this anymore.”
Bailey Coates Cromwell Fund LP began their story arc in 2003, and boy oh boy did they start strong. Twenty percent annual returns in the first six months definitely didn’t hurt asset growth. The following year, the firm posted a return of about five percent. Soon enough, some investments went sour and the fund had to close in 2005, after running for less than two years. Exeunt.
The team probably had some good ideas; they definitely proved they could deliver “superior” returns. Yet they didn’t have enough good ideas. Their strategy wasn’t repeatable or defensible enough to last.
The above chart illustrates how an anonymized fund’s strategy performs through both up and down market performance. Comparing rolling alpha with market returns can give a reasonable indication of the repeatability and defensibility of a fund’s strategy.
If a fund does manage to generate alpha on both sides of the book in a down market and an up market, it probably isn’t going to close (unless you share David Tepper’s belief that you can make more money with less money, so you go the family office route). While there are numerous ways to phrase it in the letter to investors, the bottom line is that funds that close did not deliver on what they set out to do.
Or they did, and now they’re simply tired and want to do something else.
What You Can’t Learn From the Best
“O, this learning. What a thing it is!”
Gremio, The Taming of the Shrew
The Dunning-Kruger effect explains that people with a small amount of knowledge overestimate their intellect (think, Romeo and Juliet), while those who know more are more likely to acknowledge they know less (like Hamlet for the first few acts). Wherever hedge fund managers land on this spectrum, they bravely face a most capricious opponent. Never able to fully predict where the next punch will be thrown and how significant the impact may be, each manager bets that their strategy will outsmart our common, unyielding master: Time.
While it isn’t destined to always win, Time is guaranteed to outlast any contender. Just as every Shakespearean tragedy leaves the reader or viewer with a lesson to be learned, we can learn from the characteristics and mistakes present in each hedge fund's demise. As Time shows little mercy, each manager must face their fatal flaw—and hopefully overcome it—before The Opponent decides to “give them what he will.”
Not anxious to design the next featured headstone for the Hedge Fund Graveyard? Check out our Hedge Fund Survival Guide.
Information provided by SEI through its affiliates and subsidiaries. This information is for educational purposes only and should not be considered investment advice. The strategies discussed herein are complex and are not suitable for all investors.
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