Hedge funds
Rolling in it
Nov 16th 2006
From The Economist print edition
Why investors should kick up a fuss about hedge-fund fees
THERE is an old Wall Street story that can be adapted for the modern world of hedge funds. A young hedge-fund trainee is taken to the harbour. “Here”, says his boss, “are the partners' yachts. And over there are the yachts of the bankers who lend to us.” The naive youth replies: “But where are the customers' yachts?”
Recent weeks have shown how alluring a berth on that bounteous marina is. Morgan Stanley, a big investment bank, has bought stakes in three groups, Avenue Capital, FrontPoint Partners and Lansdowne, at a total cost believed to be more than $1 billion. Two former American treasury secretaries, Larry Summers and John Snow, have discovered hedge-fund lucre, as has another former Washingtonian, Chelsea Clinton, the ex-president's daughter. In the hope of tapping new sources of capital, Fortress Investment Group, which offers both hedge funds and private equity, has announced plans to float 10% of itself on America's stockmarket. Marshall Wace, a British manager, has launched a €1.5 billion ($1.9 billion) hedge fund on the Euronext exchange in Amsterdam.
But the flurry of activity raises two big questions. First, everyone knows that hedge-fund managers are rolling in it; some made more than $1 billion last year. Investment banks also earn a big slug of their income from lending to, and trading for, hedge funds. Most new investors back the sector via funds-of-funds, which collect a second layer of fees. If industry insiders make so much from the industry, can that leave anything for the clients? Where are their yachts?
Second, if investment banks are buying or launching hedge funds, the sector itself is expanding into loan-making and private equity, and mutual funds are adopting hedge-fund techniques, is there any sense in talking of a separate hedge-fund industry any more? Asset management, once so tribal, is becoming a giant melting-pot.
The long and the short of it
Already it is fiendishly hard to define a hedge fund. At best, one can outline a few key characteristics. Hedge funds are private pools of capital that are lightly regulated, often borrow to enhance returns and are partly paid on the basis of performance. The term “hedge” (from hedging your bets) derives from the aim of making money whether a market goes up or down. This ability to bet on falling prices (“going short”) distinguishes them from traditional “long-only” funds, which profit only if prices rise.
Enthusiasts say the greater variety of tools at their disposal gives them an edge. Stanley Fink of Man Investments, one of the largest hedge-fund groups, uses the analogy of having a full range of golf clubs rather than just one.
That flexibility appeals to pension funds. In the 1990s, many pension funds made far too big a bet on equities, a gamble that went disastrously wrong in the 2000-02 bear market. As pension funds sank into deficit, they started looking for alternative sources of return.
Hence the astonishing growth of hedge funds. In 1990, according to estimates by Hedge Fund Research (HFR), a data provider, there were just 610 funds controlling some $39 billion of assets. By 2000 there were 3,873 funds with $490 billion. The latest estimate is over 9,000 funds, with $1.3 trillion at their disposal.
Moving into hedge funds has been part of a deliberate diversification into “alternative assets”, a category that includes property, commodities and private-equity investment. Mark Anson, chief executive of Hermes, a British group that manages pension assets for BT, a telecoms operator, says hedge funds offer a source of return that does not necessarily move in step with share and bond markets.
A genuinely diversified source of return is the one “free lunch” available from the investment world. If it can be found, it will improve the trade-off between risk and return. That is why investors are willing to pay the high fees (often 2% annually plus a fifth of all profits) that hedge funds charge.
And the hedge funds have done a good job of protecting investors. The worst year for the sector, according to HFR, was 2002, when the index fell 1.5%; there has been only one month since 1990 when the sector lost more than 3.5%.
But Narayan Naik of the London Business School gives warning that hedge funds might be more closely correlated with other investments then they appear to be. He says pension funds have been advised to move into hedge funds by consultants, who are impressed by hedge funds' favourable risk-return trade-offs.
The problem, says Mr Naik, is that the consultants had to rely on past data. And those were very flattering. During the 1990s, most asset prices soared. The industry was dominated by “global macro” managers such as George Soros who took big bets on currencies and stockmarkets, using borrowed money. Measured returns for the sector were boosted by survivor bias: failed funds ceased to be counted in the indices.
In recent years, returns have been much less impressive (see chart). In the 1990s, the compound annual return from HFR's composite index was 18.3%; since 2000, that return has been just 7.5%. Not surprisingly, that has disappointed some investors. A global survey by Mercer Investment Consulting found that only 23% of pension funds were satisfied with their fund-of-hedge-funds investments.
Alpha pay for beta performance
Of course, it has been much more difficult to make money in markets since the dotcom bubble burst in 2000. But that only shows hedge-fund returns are not just dependent on skill (“alpha”, in the jargon) but on general market movements (“beta”). Mr Naik says that hedge-fund returns have been increasingly based on beta in recent years. Hedge-fund managers have every incentive to take this route, since they take a percentage of all profits, however they are derived. But beta can be obtained at very low cost via index-tracking funds. Why pay hedge-fund prices?
The smart (or big) money has already responded to these problems. ABP of the Netherlands is the largest pension fund in Europe with €200 billion of assets. Edwina Neal, its chief investment officer, says the group has around 3% of its investments in hedge funds, making it one of the industry's biggest backers. That power gives ABP the ability to place greater emphasis on performance, to control fees and to insist on hurdle rates before paying them. ABP also looks for specialist hedge funds whose returns are not closely related to the rest of its portfolio.
Such investments might seem to be an example of a “free lunch”. But can everyone dine from this table? Uncorrelated hedge funds tend to have niche strategies and there is a limit to the amount they can invest. Too much money tends to dilute returns, as happened to one sector (convertible arbitrage) in 2005. Furthermore, niche strategies tend to invest in illiquid assets, such as exotic options. Assets of this sort appear to move differently from mainstream shares and bonds because their price moves infrequently. But when bad news hits stockmarkets, illiquid assets can be hit extremely hard. Correlations increase substantially.
Hedge-fund managers are well aware of the limits of specialising in niche products. Some simply close to new investors after reaching their target for funds under management. But others want to keep growing. A number develop private-equity or banking characteristics, by providing capital directly to companies or making loans. Some are diversifying into multi-strategy funds, which invest across a range of sectors. Others have started long-only funds, thereby opening up a much bigger market. As Peter Harrison of MPC investors, a fund manager, says: “There's $1 trillion or so in hedge funds but $90 trillion of long-only money and that's the big prize.”
While hedge funds are expanding, traditional groups are moving into their territory, too. Some, like Morgan Stanley, are doing so by acquisition; others, such as Barclays Global Investors and Gartmore, have built up in-house franchises. A change in mutual-fund rules applicable across the EU, known as UCITS III, has meant that hedge-fund practices are also available to retail investors. Products known as 130/30 funds (which can go 130% long and 30% short) offer some of the flexibility of a hedge fund—albeit with some of the fees, too. So it may well be that the increasingly blurry distinction between hedge-fund managers and less racy traditional managers will become obsolete. “In three to four years' time, we may not be talking about hedge funds as an element of the portfolio but about putting money into equities and then backing good managers, however they operate,” remarks Nadja Pinnavaia of Goldman Sachs Asset Management.
As the industry matures, it is becoming more concentrated. Hedge Fund Intelligence, a data provider, reckons the top 20 funds control a third of the industry's assets. The funds of funds, such as those at Man Group and UBS, are the largest. Among the direct managers, HFI says there are four American groups with more than $20 billion of hedge-fund assets (Goldman Sachs, JPMorgan Chase, Bridgewater and D.E. Shaw) and another four with over $15 billion (Farallon Capital Management, Och-Ziff Capital, Barclays Global Investors and ESL Investments).
The growing power of the most popular hedge-fund managers means some are extending the initial lock-up and notice periods before investors can withdraw their money. This might be fine until disaster strikes. And disasters do happen—such as the recent 65% loss in one month by Amaranth Advisors, a Connecticut-based hedge fund whose top trader gambled on natural-gas prices. But the image of hedge funds as a high-stakes casino is rather unfair; most hedge funds quietly give up through lack of interest rather than collapsing spectacularly.
Hedge funds may have acted to stabilise markets by increasing liquidity and by betting on both falling and rising prices. It is surely no coincidence that the recent low volatility of equity, bond and currency markets has coincided with hedge funds' explosive growth.
Hedge funds' boosters and detractors both exaggerate. Hedge funds are not the panacea for every pension-fund deficit, nor are they the cause of every ill in the financial markets. They are like a fast-growing adolescent, sometimes boisterous, sometimes clumsy but still developing. Where skill does exist, clients will probably find that managers get the bulk of the benefits. But as long as clients blindly believe in that skill, they will pay for the hedge funds' yachts.
