Apparently retailers aren’t the only ones discounting their merchandise to bring wary shoppers into their stores this Holiday season.  Asset management firms are now priced to move.  Since their top lines are levered to the absolute value of capital markets, asset managers have seen a precipitous drop in their valuations recently.  In fact, the following chart from Pensions & Investments shows how valuations have fallen further than the overall stock market and even further than their own 2009 EPS estimates.

Retailers are proving this season, such deep discounting is bound to drive up volumes.  As Pensions & Investments noted:

“While the big drop in shares of money managers has not led to a burst of industry mergers and acquisitions, insiders do expect to see more consolidation, starting with midsize firms with mediocre performance.”

Consolidation

This “consolidation” has been gathering steam.  Reuters reported last week that $9 billion hedge fund manager PAAMCO picked up a stocking-stuffer in the form of Asian markets specialist $700 million KBC Alpha Asset Management.

It seems that shoppers are particularly interested in merchandise that is slightly damaged, but can be easily fixed (think Ikea’s “As Is” section).  Venerable hedge fund GLG Partners attracted immediate interest last month when it reported a few scratches and imperfections.  Reported Thomson Investment News:

“Hedge fund firm GLG Partners said on Monday that it had been approached by a number of sovereign wealth funds or families interested in making an investment, as it reported lower net income and assets.”

Man Group CEO Peter Clarke told Reuters last month that he’s going to wait until after Christmas Day to see what kind of deals he can score.  Said Clarke:

“Consolidation is undoubtedly going to happen … Longer-term we’d expect to be a consolidator in these markets…”

Even relatively puny hedge fund players are looking for something to put under the tree this year.  Hedge Funds Review reports that $600 million SilverStreet Capital sees opportunity for acquisitions.  Its CEO tells the magazine that micro-funds will have to read the writing on the wall:

“When the hedge fund market was growing, they could realistically expect to grow to anywhere between $500 million and $1 billion in assets within a few years. However, in an environment where hedge funds assets are not expected to grow, and may even shrink, these companies will have to re-asses their future. There is a lot of potential for acquisitions.”

Convergence

Last spring Richard Heller with New York law firm Thomson Hine told HFM Week what he thought would eventually drive acquisitions:

“There is also a convergence between private equity and hedge funds competing for the same investments. As a consequence, it’s actually easier in a sense to buy an entire fund than to go after piecemeal investments in which some of these funds already have positions.”

We’re seeing examples of this convergence right now.  For example, traditional long-only managers are also shopping for alternative managers.  The CEO of UK-based money manager Aberdeen told Thomson recently that he’s checking out the bargains:

“Funds of hedge funds (FOHFs) and funds of private equity are a lot cheaper than they were six months ago, and they are significantly cheaper than they were two years ago…FOHFs, for example, were selling for 15 percent of assets under management two years ago. They are now down to very, very manageable levels, very attractive levels, and a lot of them are subscale, so I think there is an opportunity to consolidate in that area…”

But read the return policy

Alas.  Sometimes the perfect gift just doesn’t seem to work out.  As Wealth Bulletin reports, some lightly worn acquisitions can still be returned for a refund or in-store credit:

“The acquisition of the fund of hedge funds IAM by Dutch bank ABN Amro in 2006 was reversed this year by its management buyout from Dutch-Belgo bank Fortis, which had bought ABN Amro’s asset management arm holding IAM.”

It’s fair to say that the hedge fund industry as we know it would not exist if it weren’t for one critical, but often ignored function - securities lending.  Like the proverbial swimming duck, a steady flow of stock “borrow” used for short-selling hides the mayhem that goes on just below the waterline.

Through their custodians or on their own, institutional investors often make their holdings available for loan (although some argue that securities lending is not technically a loan).  Doing so routinely produces a small revenue stream with very little risk.  In other words, the closest thing to a free lunch that exists today.  According to the International Security Lending Association (ISLA), there was about $2 trillion worth of securities on loan at the beginning of 2008.

But the credit crunch is starting to eat this free lunch.  Demand has been hit by temporary short-selling bans around the world.  Spooked by what they regard as new counter-party risks, and motivated by a sense of vigilante justice against short sellers, several major institutional investors have unilaterally curtailed their securities lending programs recently.  The head of Citigroup’s securities finance group recently told Global Pensions that:

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It’s often said that hedge funds - and by extension active management in general - thrive on market volatility.  Without volatility, they say, stock pickers have little opportunity to ply their trade.

Great theory.  But with the volatility of the average stock now well into in the stratosphere; shouldn’t today be a golden age for active managers?

Yes and no, according to one expert.  Steve Sapra of Analytic Investors (see related posts) told a conference audience in New York this week that volatility alone isn’t enough to give active managers their moment in the sun.  Instead, active management requires two things: high volatility and a high “cross sectional dispersion” between stock returns.  While Sapra’s remarks were targeted to a group of 130/30 managers and investors (at Terrapinn’s annual 130/30 conference), his lessons can easily be applied to active management in general (”120/20″, “110/10″ or just plain “100/0″).

As Sapra explained, cross sectional dispersion measures the extent to which stocks move in different directions at a point in time.  Active managers rely on these disparate movements as fuel for their market beating returns (a.k.a. “tracking error”).  As a result, said Sapra, cross-sectional dispersion is usually a more important predictor of active management opportunities than volatility in general.

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One of the great cosmic tragedies in the past few years was the sad demotion of Pluto from a planet to a mere “planetoid”.  After decades enjoying the exalted status of a true planet, the poor thing was summarily dumped by a vote of non-confidence from the International Astronomical Union in 2006.  Yeah, we know - everyone shed a tear for Pluto that year.  But it turns out the little ice ball was never a planet anyway, but just part of the Kuiper Belt, a ring of various flotsam and jetsam circling the solar system.

Despite being referred to as an “asset class” by the popular media for over a decade, hedge funds may someday meet the same fate.  The issue is not that they are large enough - or even that their returns are high enough.  Rather, the issue is that they simply fail to meet a number of key criteria for a “true” asset class - most notably the essential ability to coalesce around a central unifying return driver.

Alan Dorsey’s book Active Alpha (listed in our recommended books section) contains a great litmus test to determine what is and isn’t a true asset class.  Much of the book can be viewed online here.

Dorsey says that asset classes must meet 8 criteria:

The first is that it must have an “intrinsic value“.  In other words it must provide a return that is not “speculative” and must have an “implicit rate of return”.  On this basis, argues Dorsey, currency is not an asset class because currency does not provide any intrinsic value.  Instead, any returns from currency investing are purely “speculative” in nature.  Real Estate, on the other hand, does have an intrinsic value - the present value of all future cash flows produced by it.  While the strategies pursued by hedge funds (such as merger arb) may have an intrinsic value (merger insurance), hedge funds in general deliver no common and defining intrinsic value.

The second is that it must provide “adequate liquidity“.  As the media has been reporting ad nauseam recently, hedge funds don’t excel at providing investor liquidity.  And one could easily argue that making them liquid would remove their illiquidity premium and thus remove part of what defines a hedge fund.

The third test is that it should have a low correlation with other asset classes.  While many traditional asset classes have relatively high correlations (e.g. small cap US equities and large cap US equities), one of the very rationale behind demarcated asset classes is to exploit the benefits of diversification when combining them.  Hedge funds score well on this measure since they have a relatively low correlation to other asset classes.

Fourth, Dorsey says that the constituents in a true asset class are homogeneous.  Many traditional asset classes contain funds or individual securities with great similarity.  Hedge funds, alas, are the financial equivalent of that bar in Star Wars with all the weird-looking, odd-ball aliens.

He argues that the risk of a true asset class is “estimable“.  As we now know all too well, the “fat tails” in hedge fund returns make it very difficult to estimate their true risk.  In other words, their volatility is itself volatile.  (Mind you, Black Swans live in equity markets too.)

He says that in true asset classes, “structures and regulation are not impediments to investing”.  Obviously, many hedge funds fail to qualify on this measure as well.

Seventh, Dorsey says that in order for an investment category to qualify as a true asset class, there must be a “large pool of talented managers”.  There are thousands of hedge fund managers in the world.  But, by definition, only a few that can exploit each unique return driver argues Dorsey.  Hedge funds, after all, aim to exploit unique and yet-unexploited market anomalies.

Finally, Dorsey says that there must be passive benchmark available that tracks the performance of the asset class in aggregate.  This is perhaps the most contentious issue in the hedge fund industry today.  Can hedge fund returns  - themselves an active strategy - be replicated with a passive index?

If hedge funds delivered pure alpha, their aggregate return should, in theory, be zero each year.  Alpha is, after all, a zero-sum game.  But hedge funds produce positive returns in most years.  Critics say this is due to simple equity beta seeping into their returns (e.g. Q3, 2008).  So if hedge funds are really just packagers of market beta (along with other betas and perhaps some alpha), then it’s the beta, not the hedge fund itself, that should be the basic unit of analysis for portfolio construction.

In fact, most traditional asset classes don’t fit the mold either.  So why not throw out the entire concept of “asset classes” while we’re at it?

As it turns out, this is exactly what Dorsey concludes too:

“The inclusion of factor analysis in order to more accurately appraise both the independent and the interrelated attributes of all traditional and alternative investments helps to move beyond the definition of asset class and its rigidity…

“As alternative investment strategies blur and overlap, and ability to compare identical return drivers across disparate strategies is critical for an investor’s success and ability to construct an efficient portfolio of alternative investments.”

As a financial “Kuiper Belt”, hedge funds lack the gravity required to coalesce as a singular point in space.  As a result, they are spread out around the financial system.  On the other hand, traditional asset classes are big, well recognized and visible with the naked eye.  But they only exist at one point in space.  But at the end of the day, the debate over Pluto ’s status and Alan Dorsey’s minimization of traditional asset classes both go to show that traditional labels die hard.

Despite begin caught with their hands in the beta cookie jar last quarter, hedge funds had one of the best relative performances ever in Q3 - beating equity indices by a country mile.  Most industry participants acknowledge that various “alternative betas” and even, as we have recently seen, traditional betas have found their way into hedge fund returns.  And some now attribute hedge funds’ returns since 2003 as simply repackaging beta and selling it at alpha prices.  While countless reports of abysmal hedge fund performance have included the caveat that they have still beaten the S&P 500 handily this year, the industry remains in the cross hairs of the mainstream media for what it alleges was “promising absolute returns in good times and bad”.

Despite the marketing power of the “absolute return” moniker, its adoption by the hedge fund industry is now coming back to haunt it.  Although we know very few hedge funds naive enough to make such promises, the tacit endorsement of the term by the industry at large has obscured the benefits of old-fashioned relative performance.

Institutional investors have largely adopted hedge funds not because of their performance, but because of their diversification properties - as indicated by their low market correlation.

A survey conducted last year by French business school Edhec shows that virtually all performance measures used by European institutional investors are essentially relative, not absolute.

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According to the latest research on fund flows, $43 billion fled long-only mutual funds from October 1 to October 7.  The formerly high-flying industry is experiencing its worst month ever in October with returns topping out in the -10% range.  Rather than putting their money into less volatile investments such as hedge funds or other alternative investments, they are mainly moving into cash, according to research firm TrimTabs.  The firm also finds that a small segment of self-flagellating masochists can’t get enough market risk with roughly $4 billion flowing into US equity ETFs.

Meanwhile, Greenwich Alternative Investments, a hedge fund database and research firm reported on Thursday:

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Ever seen a fund offering memorandum or prospectus that read something like this?:

“The manager uses a bottom-up research process supported by technical and quantitative analysis.  Top-down research is also used in conjunction with computer screening to identify investment theses.  The manager then uses fundamental analysis to select specific investments.”

If you think this sounds pretty typical you’re not alone.  Rarely, it often seems, are managers willing to pin their hopes on only one investment style.

Generic descriptions that amount to a grab-bag of every  approach imaginable are more common that we think according to a recent study by Russell Gregory-Allen and Jeffrey Stangl of Massey University in New Zealand and Hany Shawky of SUNY Albany.  Their paper “Quantitative vs. Fundamental Analysis in Institutional Money Management: Where’s the Beef?” aims to put to rest what they call the “quiet controversy over who does a better job, Fundamental Managers or Quantitative Managers”.

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Nearly two years ago, we wondered if 2007 would be the “year of convergence between hedge funds and mutual funds”.  Then last February, we told you about a report that concluded the market turmoil of January 2008 had “sharpened the argument for the convergence of traditional and alternative asset management”.

Well, the more things change, the more they stay the same.  Freeman & Co., a boutique M&A advisory firm specializing in the asset management industry, said in a press release last week that “The ongoing credit crisis has hit banks and other financial institutions hard, forcing some to divest asset managers and creating opportunity for aggressive buyers.”

Unlike the mega-hedge-fund-deals of the past, however, the first half of 2008 was marked by more mid-market transactions (up 57% vs. the same period last year).  The biggest growth was in the traditional asset management space (+23%) and ”other” financial institutions such as private banks (+85%), not hedge funds.

Here’s what Freeman & Co. had to say about the next year.  As you read these predictions, bear in mind that they were issued just days before Lehman showed up at the Pearly gates.

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Barbells have been around a long time.  According to historian Jan Todd, a Boston area strong man named George Barker Windship was the first to patent the now ubiquitous variable-weight barbells found in most gyms.  That was 1865.  But the first use of the term “barbell” was in an obscure 1870 British book called “Madame Brennar’s Gymnastics for Ladies, A Treatise on the Science and Art of Calisthenics and Gymnastic Exercises.”

Today, the term “barbell” is routinely applied to anything that maintains its balance even though its bulk is distributed mainly at two ends.  Take, for example, the asset management industry.  As the Financial Times reports this week:

“Things are looking good for the asset management barbell thesis Morgan Stanley (AMEX:MWD) first put forward five years ago. This suggested traditional asset managers would lose out as money increasingly shifted to cheap passive strategies on the one hand and alternative investments and high return specialists on the other.”

As we’ve reported extensively on these pages, the big winners in the asset management industry have been alternative investments and ETFs - both of which represent the constituent elements of any traditional active fund - the variable weights at each end of the proverbial barbell.  The Morgan Stanley report covers the European asset management industry and clearly illustrates this trend.

The chart below from the report shows that passive (ETFs) and high-alpha (short-extensions, funds of hedge funds etc.) are growing the fastest.

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One sport that is still seeking Olympic recognition is musical chairs - the sport where competitors dance around in a circle until the music stops.  Then, in the ensuing melee, they grab a seat anywhere they possibly can.

Well, let the asset management musical chairs begin.  Managers of both the long-only and hedge fund persuasion seem to be uncommonly receptive to recent overtures from potential acquirers.  Investment News reports that the “time may be right for big-name asset manager acquisitions”.   They cite industry observers who suggest Lehman’s Neuberger Berman and Wachovia’s Evergreen Investment Management are making their way around the circle as we speak.

Apparently, the first half of 2008 saw a dearth of asset management M&A with stakes in 104 fund managers selling for a little over $10 billion - one third of the action seen in the first half of last year).  So there is a backlog of managers who may be interested in cashing in a few chips - like, for example, Lehman and Wachovia.

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