"Money Flows - A Contraian Indicator?"

Sydney M. Williams

Thought of the Day

“Money Flows – A Contrarian Indicator?”

March 15, 2010

The last two decades were a remarkable time for hedge funds. In 1990, there were an estimated 530 hedge funds in the United States with about $39 billion in assets under management. By 2000, assets had grown to approximately $537 billion managed by nearly 3300 hedge funds. The peak in hedge funds and assets under management occurred in late 2007 and early 2008, with assets in U.S. based hedge funds topping $1.2 trillion run by about 8-9000 funds, suggesting an average of about $130 million per fund. Like most businesses, a small number of hedge funds control the lion’s share of assets. Assets declined in 2008, but rebuilt in 2009 and now must be close to the $1 trillion level. Exact numbers are difficult to verify, as some lists include foreign based funds and others include fund-of-funds, essentially double counting assets. Others are so small that they fly beneath the radar.

The important thing for investors is that, despite all the negative publicity they have received, overall results have been substantially better than the indices. On balance, hedge funds protected their limited partners well during the credit crisis. Most equity hedge funds employ leverage rationally, and a few employ little or no leverage.

However, one should not expect much growth in the overall number of hedge funds. According to Absolute Returns + Alpha, 189 shuttered in 2009, versus 49 that closed in 2008. The rush into hedge funds in the early and mid 2000s was, in part, a function of the publicity received by David Swenson of Yale who, as early as the late 1980s and early 1990s, began investing in alternative vehicles, including hedge funds and private equity funds. Unfortunately, as is typical of markets, many institutions’ timing, in imitating his success, was not propitious. Many invested as markets were cresting. It is very possible that the next decade may prove the mirror image of the last one – a decade of reduced volatility and gradually rising prices, yet one in which hedge funds lose assets, as least those directed and managed by consultants and because of negative hype, as politicians look for scapegoats.

Nevertheless, Hewitt Associates reports that 2009 showed a doubling in terms of the number of hedge fund manager searches in 2009 compared to 2008.

For the thousands of hedge funds that began operations in the late 1990s, their timing could not have been more opportune. Money was plentiful and investors were willing. The collapse of the dot com bubble – provoking a two and a half year bear market – provided the perfect venue for hedge funds with their ability to sell short. The subsequent rally took some by surprise, but the assets were there, so modest returns, given their fee structure, provided out-sized income to the managing partners of these funds. It was a decade during which asset flows allowed hedge funds to sail before the wind, while at the same time the tide governing investment opportunities was ebbing. It was a scenario unlikely to be repeated.

The upcoming decade may provide the exact opposite environment. Despite a 23.4% return to the S&P 500 last year, money allocated to equities in both pension plans and mutual funds continues to be negative. Allocators of assets are also likely to continue to remove money from alternative investments at the precise moment that the investment environment is improving.

The moral of the tale is as old as investing. Money flows are a contrarian indicator. Money flows into strategies that are cresting and flows out in the final moments of an ebbing tide. “If that were not the case”, as my friend Walter Harrison is fond of saying, “then tops would be bottoms and bottoms would be tops.”