Legends Fund portfolio manager Ruud Smets interviewed Lansdowne Partners chairman Stuart Roden at the Legends4Legends Conference in Amsterdam on September 15th. Stuart provided some fascinating insights into today’s challenges of running a hedge fund and discussed how quant traders are creating an opportunity for hedge funds reminiscent of the collapse of the internet bubble.
Hedge funds’ recent struggle to achieve alpha
First, Smets and Roden discussed the disappointing recent hedge fund performance. Stuart declined to hide behind much heard excuses such as high correlations, the surge in passive investing, a lack of liquidity or the size of the industry. These factors could, maybe, influence results for 3 or 6 months, but cannot be an excuse for 2 years of poor performance. Instead, poor results in his view are a result of poor investment decisions by the managers themselves. Markets have shown enough dispersion to make money, and some managers indeed have.
Structural challenges to the industry
Asked what he sees as the biggest challenge to running his hedge fund business today, Stuart said that, especially in Europe, finding the right talent has become very difficult. And this is a real problem as 90/95% of their success comes from having the right people. He blamed the increased and often extreme focus on risk management: new entrants in the industry are allowed very limited degrees of freedom in their first jobs, and don’t get exposed to the type of risk taking that Stuart got early in his career. Also the institutionalization of the industry has made it much more difficult for new manager to start a fund, another reason for the talent pool to dry up.
For the industry as a whole Stuart sees a large danger that not enough risk is being taken. The problem with risk management driving the investment process is that all risks are being hedged out and very little return potential remains, especially in today’s low return environment.
What investors should expect in terms of performance?
Stuart said that 10 years ago, a typical hedge fund investor would expect net returns of 10-15%. Today that would seem out of sync with reality. Lansdowne Developed Markets Fund strives for Libor + 5-10% over a 5-year horizon, i.e. a middle of the range 7.5% return, which would probably put you ahead of the pack.
Should fees be lower?
Hedge funds are a binary business, if you perform you win, if you don’t you get sacked. Fees are not the real discussion, Stuart said. With two exceptions though. If you are starting a new hedge fund and you don’t have the track record to show, you will have a fee discussion. Also, if you can’t achieve high enough returns because your risk management hedges out all the risk, charging 1.5 or 2% doesn’t make sense.
We discussed investment outlook and opportunities. Lansdowne has been running with a low net exposure and high gross exposure. It is an illustration of the opportunities they see picking stocks long and short, while being wary of general market levels. While there have been periods in their 15-year history when Lansdowne felt it had an edge in taking a view on the macro environment, today the opposite holds. Lansdowne tries to hedge out the macro, i.e. the direction of interest rates, as much as possible.
Asked to choose one overarching theme in their stock picking today, Stuart named the speed at which business models are being changed. Advertising and retail were first to be hit but in the last two years it is hard to think of a single company that hasn’t been impacted by disrupting forces or will be in the next few years. Incumbents almost never come up with new models, new entrants disrupt. Stuart gave the example of peer to peer lending. It were new players that came up with this financing model, as the incumbent financial firms were afraid for the pressure it would put on margins. That is a fine argument until somebody else starts doing it.
An opportunity driven by quant investing
Stuart said he sees one investment opportunity driven by the growth of quantitatvie investing. He likened it to what we saw in 2000 and 2001 when tech stocks got pushed to ever higher valuations largely thanks to momentum driven models. At the time, utility shares that traded at 8 or 9% yields got left behind and when the bubble burst managers focusing on this valuation mismatch made a lot of money. Stuart sees something similar happening today with the quant community chasing stocks offering a 2 to 3% dividend yields even though their businesses are often declining and their models are at risk of disruption, such as consumer staples. More cyclical companies are being left aside and are offering significant value in his view. It’s a point that’s been made a lot in recent discussions with our managers.
While the Lansdowne Developed Markets Fund disappoints in 2016 with a 12% loss to September, the fund was up 16% in 2015 and achieved a net 12% annualized return over the last 5 years, beating equity markets with lower volatility and only little net market exposure. We expect to see a period of strong returns to follow the weak 9 months as some of the themes they have identified are being recognized in markets.