Leon Cooperman on Hedge Fund Cyclicality

I enjoyed Leon Cooperman on CNBC, speaking about the recent struggles of hedge funds. Here is a paraphrased summary of what he said:

Everything is cyclical. My favorite article, written by a very good reporter–Carol Loomis is one of the most distinguished writers on the staff of Fortune–in 1970 wrote an article entitled “Hard Times Come To Hedge Funds”. The largest hedge fund at that time was Steinhardt, Fine and Berkowitz, $49 million. The second largest was A.W. Jones at $30.5 million.

Clearly the call over time was wrong, because the industry back then was in aggregate less than a billion, and it grew to something like $2.5 to $3 trillion. But it’s cyclical. The golden period for my industry was 2000 to 2007. We became cocktail party talk, aided and abetted by your kind [CNBC’s] of programming, and the money was coming over the transom. Why? Because hedge funds were outperforming traditional managers, we were outperforming the indices, and we became cocktail party talk. “I’m with Omega”, “I’m with Pershing Square”, “I’m with Glenview” …

And then, all of a sudden, 2008 hits. Now the reality is: the hedge fund industry did perform their role. The average hedge fund, in 2008, was down 16%. The S&P [500] was down 34%. But a lot of people went to hedge funds not knowing what they were doing. They thought it was a license to make money, the question was: how much money are we going to make? And so, when they lost a lot of money, they decided to want to get out.
And the hedge funds did two things to hurt themselves. One, I talked about a moment ago that I would never do: gating capital and not honoring a high water mark. You get past ’08, into the 2009 to 2016 period, and you have a trending bull market. If you’ve elected to be in a hedge fund, you expect the hedge fund manager to be hedged, and if you have a hedge in a trending bull market, you underperform.

And so people now have turned away from being absolute-return oriented, focusing on relative returns. And they don’t want to pay some variation of 2-and-20 to lag some “mindless” index. So we are seeing redemptions. What’s happened basically is that people are tired of paying a premium fee for subpar performance, and there’s a certain amount of redemptions.

I think the industry is breaking down into two sectors: one sector is doing well, and that is the quantitative/algorithmic machines. I happen to have a view, which is not as well developed as I like it to be. I don’t like to pontificate about things I don’t know about. I think there’s a case of front-running in that sector, where I confronted the president of the New York Stock Exchange a number of years ago and I said, “How can you guys justify co-locating computers and these high frequency traders next to the stock exchange? You give them a split-second advantage over the public.” And the response was, “If we don’t do it, somebody else will”, rather than taking the high road and saying, “It’s morally wrong, get the SEC involved here, and level the playing field and restore confidence in the marketplace and the individual.” So that sector is doing ok, whether it’s front-running, or … I’m not the expert.

The second [sector]–I think is going to do well–is what I call “the long-term Warren Buffett investor”. Buffett didn’t get to be worth $60 billion by buying an index. The trouble with that sector is, if you’re facing monthly, quarterly, semiannual, annual redemptions, and you’re worrying about liquidity issues, you’re discouraged from going in full bore. It’s a problem that has to sort itself out.

You had a guest on, a friend of mine, and you sponsored a seminar 7 or 8 months ago and the topic had nothing to do with investing. The title of the seminar was “Closing The Gap”, and I have a big interest in income disparity. I’ve taken the Buffett Giving Pledge on giving all my money back to society, not half. At this conference, there’s a futurist who spoke. Now before I tell you what he said, I will tell you what Warren Buffett says about forecasters of the future: they tell you more about the forecaster than they tell you about the future.

Having said that–and I think this is somewhat commonly accepted–the biggest problem facing the economy in the next decade was 45% of the jobs being performed by the economy would be replaced by automation. There’s no alternative employment for these displaced workers.

I went home that night and I thought about it, and the implication on the investment business is passive vs. active management. And you cannot charge a premium fee, whether it’s a 1% mutual fund or some variation of 2-and-20, if you don’t deliver premium performance. You’re going to lose assets. Basically, this is what’s going on. Money is leaving the business, and the question of whether it’s leaving at the right time or wrong time only time is going to tell. But you have to deliver premium performance for premium fees …

Everything is cyclical. There’s an implication, and not just for hedge funds, by the way Think about the brokerage community. Passive management turnover, on average, is 3% a year. Active turnover on average is about 30% a year. Huge reduction in the commission pool for Goldman Sachs’, the Morgan Stanleys, the UBS’ of the world. So they have to resize their operations to a new reality of revenues. And less liquidity in the market, if there’s less turnover, there’s less liquidity to get things done. Then you look at the money managing business … if you can’t deliver alpha, you’re going to see a compression of your fee structure …

Money goes where money is treated best. It may take a bear market to get the hedge funds back in style, because they’ll outperform, and maybe they’ll stem the flow of money. Just as the money stopped flowing into hedge funds when they lost money in ’08, maybe the money stops flowing into the index funds when there’s no panacea in buying an index.
But I’ve got to say: if the ability to underperform exists, the ability to outperform exists.

My first bias to disclose is, as I get older, there are fewer people that make me feel young, and Cooperman makes me feel young. I fully agree with most things that Cooperman said. My minor quibbles:

Quantitative/Algorithmic Strategies: Yes, of course a lot of this space, especially in the high-frequency area, is about front-running. Not unlike what the floor traders did in earlier days when large orders came to the “downstairs” exchange floor from ancient days through the 80s, or the prop traders sitting nearby the sales traders on did when large block orders came by phone to the “upstairs” investment bank floors through the 90s. But now instead of slower “moist robots” (Scott Adams’ term for humans) front-running, high-frequency shops have fast robots who can do repetitive observation/analysis/execution millions of times faster and more accurately; where the choke point is how far the speed of light must travel via fiber.

But not all quant or algo strategies are front-running. There are plenty of low-frequency strategies (like mine). Stretched to the extreme, an index is just a portfolio of stocks with rules that changes infrequently. It’s all about the half-life or turnover of the rules, whether measured in milliseconds or in years. Even indexes need smart actors who are valuing each stock, in order to achieve the success that their established rules can deliver. If there are no more analysts and investors valuing assets competently, all the quantitative finance people who “assume the pricing mechanism and its inefficiencies” are cooked.

Cyclicality: The pendulum does swing. From the news cycle, to fashion trends … all the way to the variation of carbon dioxide in the atmosphere over millenia, change and volatility happen. Sustainable strategies need to either exploit the short term and survive the long term, or vice versa. And this means the strategies themselves will need constant tweaking, as history may rhyme approximately and stochastically.

Premium performance for premium fees: My favorite anecdote on this is Renaissance Technologies, who were charging 4-and-45 (yes, 4% management fee and 45% performance), with a waiting list of investors waiting to get in, and in the end, they still returned outsiders’ money to run their own. In my few years of working for an asset manager, post Volcker Rule, I saw that because the Cinderella funds are constrained from taking new money, investors must start looking at uglier stepsisters and pay similarly for dating them. And it is difficult to date younger and smaller than the accepted statutory limits established by due diligence folks as best practices. My 11-year-old daughter might be an awesome spouse someday (or not), but I wouldn’t expect a 15- or 20-year-old to ask me for her hand right now. Yet somehow, if that happened, I guess it would be strange if the person offered a 4-figure Amazon gift card, instead of a 5-figure engagement ring.  Treating my girl like a mail-order bride won’t get you as far as treating her like a supermodel or supermom, whether she deserves it or not.  Money does indeed go where it is treated best.