2012 is a year most asset managers would like to forget. With the S&P returning 16% and Russell 2000 up 16.3%, on nothing but multiple expansion in a world where risk has been eliminated despite persistently declining revenues and cash flows, a whopping 88% of hedge funds, as well as some 65% of large-cap core, 80% of large cap value, and 67% of small-cap mutual funds underperformed the market, according to Goldman’s David Kostin. The ongoing absolute outperformance of mutual funds over their 2 and 20 fee sucking hedge fund peers is notable, as this is the second or perhaps even third year in a row it has happened. And while the usual excuse that hedge funds are not supposed to beat the market but a benchmark, and generally protect capital from downside risk is valid, it is irrelevant if any downside risk (see ongoing rout in VIX and net position in the VIX futures COT update) is now actively managed by central banks both directly and indirectly, their HF LPs no longer see the world in that way. In fact as Bloomberg Market’s February issue summarizes, some 635 hedge funds closed in 2012, 8.5% than a year earlier, despite a far stronger year for the general indices. The reason: LPs and MPs have simply had enough of holding on to underperformers and get swept up in the momentum of performance chasing, and the result is redemption requests into funds who may have had a positive benchmark year, but underperform relative to the S&P for two or more years, which nowadays is the vast majority of funds.
Yet it is not fair to say that all hedge fund strategies have failed: the clear winner among them? Mortgages, driven by none other than the worst kept secret of 2012 – the arrival of QE3, and the $40 billion a month monetization in MBS. While at least QE3 and 4 once and for all sealed any debate over whether there is economic improvement in the US (there isn’t, hence the Fed’s monthly injection of $85 billion in flow), it was Pimco who was the beacon of what was to come as Zero Hedge readers were made well aware back in February with “Pimco Borrows A Record $88 Billion To Bet On Fed’s Upcoming MBS Monetization.” Anyone who piggy backed generated the highest Bernanke-assisted Alpha there was to capture in the past year.
Some other facts from Bloomberg Markets:
- Three of the top five funds invested in mortgage securities and two of them are run by the same company. Betting on mortgage securities outpaced every other strategy, with an average return of 20.2%, against an industry average of just 1.3%.
- Two of the top 10 funds are based in the UK.
- While Tiger Management Julian Robertson’s “Tiger cub” funds dominated last year’s top echelon (including Tiger Global fund at number 1), only one cracked the top 20 this year.
- Poor returns forced an estimated 635 hedge funds to close in the first nine months of 2012, 8.5% more than a year earlier. Even some big name managers threw in the towel.
While the bulk of hedge funds disappointed, the following were the Top 20 best performing hedge funds according to Bloomberg:
A quick video summarizing all of the above for the time-pressed:
There was the usual court intrigue involving the bad boys of the hedge fund world, fawned upon by what few investors are left, including David Einhorn, Dan Loeb, JANA Partners, Omega Advisors, Citadel (aka the NY Fed’s right hand fund in times of need), and Och-Ziff, whose fares were best summarized by Reuters in the following piece.
Yet the overall theme is that it is becoming increasingly clear that the fundamental premise behind hedge funds is slowly but surely being eliminated by the central banks, who are doing all they can to remove all downside risk, a strategy that will inevitably blow up, yet which will mean that in the meantime, everyone will be forced to chase upside strategies, and with retail investors long gone, instead having handed over investment privileges to their deposit-holding banks who daytrade on their behalf (sometimes with JPM CIO consequences), very soon the only trade on the table will be one, and any hedges applied to it will merely serve to accelerate one’s inbound redemption notices.
In other words, after destroying proper capital allocation, Ben Bernanke is also wreaking havoc with the fundamental premises of investing.
Goldman’s David Kostin explains the return picture from his firm’s perspective, and presents the firm’s client view on why mutual funds have underperformed so severely:
2012 was a strong year for stock returns but a poor year for managers: Nearly two-thirds of US equity mutual funds lagged their benchmarks. Our analysis of $1.3 trillion in US equity mutual fund assets reveals that 65% of large-cap core, 51% of large-cap growth, 80% of large-cap value, and 67% of small-cap mutual funds underperformed their respective benchmarks, S&P 500 (16.0%), Russell 1000 Growth (15.3%), Russell 1000 Value (17.5%), and Russell 2000 (16.3%). See Exhibits 1 and 2.
Hedge funds also underperformed. 88% of hedge funds were lagging the S&P 500 as of December 21st. With one week remaining in 2012, the typical hedge fund was up 8.1%, with a standard deviation of 10 pp. Two reasons mutual funds lagged: Sector rotation and stock selection. Violent sector rotations proved challenging to navigate as evidenced by mutual fund sector tilts and securities holdings patterns during 2012.
S&P 500 transitioned through three distinct performance phases in 2012 (see Exhibit 3). The market posted a historically anomalous 1Q return and had surged 13% by April 2nd. Rising Europe risk then sparked a 10% decline during next two months. Finally, central bank statements and policy in both the US and Europe laid the foundation for a 13% rise between June 1st and year-end, despite short-lived weakness following the US election.
Below these index gyrations, sector performance showed considerable differentiation. Financials and Information Technology had each rallied 23% through April 2nd, exceeding beta implied returns, and collectively accounted for more than 50% of S&P 500 index gains. However, managers chasing momentum premised in increased regulatory clarity / firming housing data for Financials and stronger spending patterns for Info Tech then faced 15% and 13% declines through June 1st as risk sentiment fell precipitously. Ultimately, willingness to maintain a Financials overweight throughout the year afforded considerable relative returns (+13 pp over the index), while those managers maintaining overweight exposure to Tech past June generated considerable performance drag (-6 pp of relative return).
Generally, across S&P 500’s three performance phases in 2012, only Consumer Discretionary consistently outpaced the index. The other nine S&P 500 sectors shifted between over-and-underperformance.
Holdings data suggest large-cap core managers had mixed success in managing these sector rotations. Starting 2012 with an aggregate underweight position in Financials, many missed concentrated gains in 1Q. Boosting exposure by April was penalized by below-market returns through June. However, managers continued to add Financials exposure in the second half, enhancing performance. Financials massively outperformed the S&P 500 from June 1st onward (+24% vs. +13% for the index).
Mutual fund managers proved more capable of navigating Information Technology. Market weight exposure meant most funds failed to capture 1Q strength. Yet, shifts to a substantial Info Tech underweight position from 2Q onward (2nd largest behind Utilities by year-end) proved prescient given that the sector lagged during this time (-5% vs. S&P 500 +3%).
Managers maintained a consistently strong overweight position in Consumer Discretionary throughout the year. Funds benefitted from this allocation given the sector’s +790 bp of outperformance in 2012.
In terms of cyclical vs. defensive positioning, managers remained consistently underweight Telecom and Utilities throughout 2012. Although funds missed the 2Q flight to safety, the tilt away from defensives ultimately proved advantageous as Telecom only slightly outperformed the index in 2012 (+2 pp) while Utilities lagged substantially (-15 pp). In contrast, a steady move from a market weight to a substantial overweight in Consumer Staples by year-end proved misguided, as market returns in 1H were followed by 4 pp of underperformance in 2H. A year-long overweight in Health Care worked well after 1Q, and now represents large-cap core managers’ strongest overweight position.
More cyclically, slight overweight positions in Materials and Industrials both generated mild drag across the year as a whole, with the sectors each lagging the index by 1 pp. Finally, while managers benefited materially from an Energy underweight in 1H (-12 pp of relative underperformance vs. the index), further decreases in exposure in 2H yielded no advantage as Energy modestly outperformed.
Stock positions also mattered. In 2012 stable, beneficial overweights for large-cap core managers included NWSA, AMGN, BK, EBAY and GILD (in order of importance) while beneficial underweights included XOM, INTC, IBM, MCD and NEM. Alternatively, major overweights generating headwinds to performance included CHK, HPQ, DVN, MSFT and APOL, while underweights creating drag on a full year basis included BAC, AAPL, CMCSA, CRM, and AMZN. On net, our analysis suggests that timing sector and single-name rotations proved difficult given the market’s macro drivers.
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Finally, for those curious how they placed, or how that fund next door did, here is the final HSBC report of 2012. On to 2013.