Man against markets

Hedge funds are struggling at the moment. David Crook, former manager of the Tail Wind Fund, tells James Essinger about the problems managers face


Hedge funds have had a hard time of late. The remainder of 2013 is likely to see a continued shake-out of the market as managers come under increased pressure over fees, and as clients, unhappy with low returns, look to migrate some or all of their assets into other types of investment.

Deloitte said in its 2013 hedge fund outlook report (entitled ‘Some Gains, More Pain’) that “for hedge funds, 2012 was a backbreaking year to put it mildly,” and added that “heightened market volatility, stressed global macroeconomic conditions, and underperformance relative to traditional investment vehicles” were just a few of the factors that challenged hedge funds in 2012.

These problems have continued, so far, in 2013. Goldman Sachs hedge fund expert Amanda Schneider has reported in the firm’s Hedge Fund Monitor report that hedge funds are struggling to keep anything resembling parity with the market.

The current malaise
A particular hedge fund’s strategy will be detailed in the fund’s offering memorandum. Annual management fees will typically consist of two percent of the fund’s net asset value (the total of the investors’ capital accounts), plus 20 percent of the annual profits that the hedge fund has made for the particular investor.

Hedge funds as they are today started in the late 1980s in the US, though they can trace their origins to numerous private investment vehicles available to wealthy investors in the US bull market of the 1920s. Many hedge funds grew rapidly in the 1990s due to the involvement of clued-up and success-hungry high-net-worth investors, working with very smart traders. However, today it is usually the institutional investor who calls the shots in the hedge fund world.

To achieve the hugely difficult task of matching the market return, a hedge fund has to do a lot better than the market

Hedge funds have made many hedge fund managers and – in a good year – their investors, very wealthy, but at least one manager who has made a fortune from successfully running a hedge fund believes the current malaise in the hedge fund world is the symptom of something worse than just a temporary blip.

Riding the tail wind
David Crook’s career has spanned almost three decades. He recently took a step back from day-to-day management of his fund, and now spends part of his time writing and adapting plays – several of which have been produced to acclaim. Yet, despite his career rebalancing act, he still finds the investment industry in general – and hedge funds in particular – intellectually fascinating, and a conversation with him can switch from heroic couplets to hedge funds with energetic speed.

“Testing your mettle against the markets: finding ways of understanding the psychology behind the moves in markets better – that’s what I found and still find stimulating about the financial industry,” says Crook. “What’s really exciting is the challenge: the battle of man against markets. For me, making money is secondary.”

After taking a degree in Classics at Balliol College, Oxford, Crook had a highly successful decade-long career at Morgan Stanley Dean Witter, and then a spell at global investment banker Jefferies International in London, where he was Executive Vice President and Director of International Banking.

In 1994, he left to set up his own hedge fund: the Tail Wind Fund (TWF). For the first 10 years of the fund’s life, Crook was its sole manager, achieving the third best performance of any fund of any type worldwide, an average annual return of over 35 percent, an increase in net asset value per share  (that is, share price) over 15 fold, with moderate volatility – the fund’s standard deviation was 5.1 percent. By 2010, an initial investment of one dollar in the TWF hedge fund would have become $20, against $1.30 for an investment in the S&P 500 over the same period.

Starting at a disadvantage
Crook says: “It’s highly unusual for any investor to do better than the general stock market. Only 12 percent of conventional mutual equity funds outperformed the stock market annually in the period from 1970 to 2009. Even if an investor is fortunate enough to be in one of these winning funds, history has shown that the investor is likely to buy and sell that fund at the wrong time – just as those managing the funds clearly buy and sell their stocks at the wrong time.”

But, as Crook points out, those figures refer to conventional mutual equity funds with very low fees of one percent, plus a fraction of a percent, of invested assets each year. “Hedge funds start with the enormous disadvantage of very high fees,” he says. “To achieve the hugely difficult task of matching the market return, a hedge fund has to do a lot better than the market.

“In practice, there’s a raft of other factors that also stack the odds against hedge funds. First, their investors demand that they make their returns with low volatility. This limits the bets hedge funds can make. Secondly, if they borrow money to turbo-charge their returns, they have to shoulder the additional costs of interest on the extra capital.

“Thirdly, if they sell short, that too incurs incremental costs; borrowing stock can be expensive. Fourthly, bets against the market must penalise performance in the aggregate because of the market’s generally positive trajectory. Fifthly, hedge fund investors are usually very demanding: they often want a constant commentary on activity – they feel they are entitled to it because of all those fees they’re paying – but that’s painfully time-consuming.

“Finally, sometimes the underlying investors put pressure on the manager to act against his instincts. In particular, every time there’s a crash, many managers can be expected to be deluged with emails and calls urging him to pull back – just when it’s likely to be the wrong time.”

Success in the long term
If Crook’s comments on hedge funds make him seem less like a poacher turned gamekeeper and more a poacher turned vegan, he insists the data bears him out. “Recent performance figures are dismal. For example, the Hedge Funds Review Global Hedge Fund Index registered a decline of 14 percent over the last five years, against an increase in the overall market – using the S&P 500 – of nine percent. Other data confirm that picture.”

Crook concedes some hedge fund managers clearly do make good returns – the investors in his own fund among them. “Yes, of course, there are some exceptions. But not many.” He adds: “I think the only real test is how a fund performs over multiple cycles. It’s no good having someone who successfully latches onto something that’s going on in the markets over one period, only to lose out when things change.”

So how did the TWF do it? “My fund has had a long life. In the years from 1995 to the first few years of the new century, my fund mainly made structured direct investments in small American public companies. But uniquely amongst the many investors doing the same, I didn’t hedge, so sometimes we made huge amounts on individual investments. We also correctly identified a series of themes in the stock market very early, like the commodities boom, and made a series of good contrarian calls on the overall stock market, on the downside and up side.

“I also made mistakes, of course – plenty. For example, while I was short Lehman Brothers for two years I covered with a profit of about eight percent. That was clearly an opportunity spectacularly missed. Looking back, my biggest regret was not backing a number of my calls with confidence. It’s no good getting it right if you only marginally profit from it.”

Crook recommends that investors who want to win good returns in the current climate, while also benefiting from low costs, should consider basing their investment portfolios around a combination of stock-backed exchange-traded equity funds and government bonds.

As for hedge funds, what does Crook see as the prognosis of the industry? “I think it’s encouraging that the aggregate level of fees in the hedge fund industry has been coming down: that is certainly a move in the right direction. In fact, overall there is a gradual convergence of the conventional actively managed fund with the hedge fund, which I also think a positive and significant development.”