Guide to Hedge Funds Read online

  This frenetic activity has an enormous effect on financial markets. A 2009 survey by Greenwich Associates found that hedge funds made up 90% of trading volume in distressed debt, almost 60% of trades in high-yield credit derivatives and of trades 55–60% in leverage loans.

  Diversification

  Another reason investors are willing to give money to hedge funds is that they believe they are getting something different. As already explained, they have the ability to make money from falling as well as rising prices. This absolute return means they aim to make a positive return each year. By and large, they have succeeded. The Hedge Fund Research index4 shows that, since 1990, there have been only two negative years for the average hedge fund. The first was 2002 (a terrible year for markets in general), when investors lost 1.5%. The second was 2008, when hedge funds had their worst year, losing 19%. But even that was better than the 40–50% declines suffered by stockmarkets.

  In contrast, traditional fund managers deliver a “relative return”, based on some index or benchmark. They consider they have done well if they beat the index by three percentage points. But in a year like 2008, that could still mean the clients losing 40% of their money.

  Modern financial markets are incredibly sophisticated. Investors can take a whole series of views on a wide range of assets. For example, they can bet on whether an individual company will default on its debt, without worrying about whether interest rates are rising or falling. They can bet on whether bonds that will mature in five years’ time will perform better than those that will mature in 30 years. They can take a view on whether markets will become more volatile. They can even speculate on the weather.

  As these new instruments emerge, hedge funds often have the brains and the computer power to take advantage of them. Traditional investors, such as pension funds and insurance companies, can be slow on the uptake. So for a while, the hedge funds may be able to make some easy profits before the rest of the world catches up.

  The strongest claim from hedge funds, and one that is open to considerable dispute, is that their returns are “uncorrelated” with traditional assets such as shares and bonds. What this means is that hedge funds do not always move up and down in line with other assets.

  Lack of correlation is an attractive characteristic in financial markets. It means that portfolios of uncorrelated assets can deliver the same return, with a lower level of risk, or a higher return, with the same level of risk.

  Short orders

  Another argument is that the extra tools hedge funds can use (going short, using borrowed money) give them advantages over traditional managers. To use another sporting analogy, they have a full set of golf clubs, whereas most managers are given only a driver and a putter.

  However, the ability to go short is probably the hedge fund characteristic that causes the most controversy. Short-selling is a long-established practice, with its own little rhyme: “He that sells what isn’t his’n, must buy it back or go to prison.” It has never been popular. Many people see something underhand in betting on a falling price; it is rather like wishing bad luck on a neighbour. Generally, everyone prospers to some degree when the stockmarket rises, either directly (through shares they own outright or in a pension or insurance fund) or indirectly (as rising wealth leads to higher employment). Stockmarket crashes are usually associated with economic problems.

  Companies do not like short-sellers. By driving down the price, they are perceived to be undermining the executives, who are partly motivated by share options. Politicians do not like short-sellers, often because they do not understand the role they play in markets. When a market falls sharply, you can usually find one party hack who will grumble about the manipulation of prices; it even happened after the attacks on New York and Washington in September 2001.

  Regulators stepped in to restrict the short-selling of shares in banks in the wake of the credit crunch. The fear was that depositors and creditors would see falling share prices as a signal of a bank’s poor health. Thus a determined short-selling campaign could be a self-fulfilling prophecy, forcing more banks to the wall.

  Such regulations made it seem as if short-selling was a quick, easy (and dirty) way of making money. In fact, it is a difficult business. It costs money to borrow shares; short-sellers pay the equivalent of interest. In some markets, such as the United States, there are restrictions on when short sales can be made. Other investors can indulge in “short squeezes”, trying to drive prices higher so the short-seller has to cut his position. Whereas there is no limit on how far a share price can rise, a short-seller’s gains are restricted; the price can only fall to zero. If you buy a share and the price falls, it gradually becomes a smaller and smaller part of your portfolio; if you short a share and it rises, the position becomes larger and larger. Finally, over the long run, short-selling is a bad bet, since share prices generally rise.

  But short-sellers still play a useful role in markets. Bubbles do occur, for example during the dotcom boom when companies with no profits and little in the way of sales were worth billions of pounds. Prices can develop momentum effects; as they rise, more investors want to get involved, and that pushes prices up even further. This can drive share prices a long way from fair value. It can lead to the misallocation of capital, a fancy way of saying that bad businesses get funded and good ones fail for lack of interest. Short-sellers, by taking aim at overvalued shares, can bring prices back in line.

  Gradually, traditional investors are getting the powers to go short as well, or at least to bet on falling prices. Complex instruments called derivatives allow investors to bet on a host of different factors from currencies, through changes in short-term interest rates to the riskiness (volatility) of the market itself. In Europe, a set of regulations known as UCITS III allows fund managers to use hedge fund techniques. Many big asset management companies, such as Gartmore and Goldman Sachs, have hedge fund arms of their own; some of the big hedge fund groups are launching traditional-style funds.

  A growing industry

  This convergence reflects the extraordinary growth of the hedge fund business. Everyone wants to get in on the act. In 1990, according to Hedge Fund Research, hedge funds managed some $39 billion of assets, tiny in global terms; by the end of 2007, that figure had grown to almost $1.9 trillion (or $1,900 billion). By the first quarter of 2009, the number had dropped to $1.33 trillion, but a recovery took the figure to $1.54 trillion by the end of the third quarter. The number of funds increased from 610 in 1990 to 10,096 by the end of 2007, before dropping to just under 9,000 by the autumn of 2009.

  America is still the global centre of the industry but Europe, led by London, is catching up. A Financial Stability Forum report in May 2007 found that Europe’s share of total hedge fund assets had doubled from 12% in 2002 to 24% in 2006, while Asia’s proportion had risen from 5% to 8% over the same period.

  That is an awful lot of money and it generates an awful lot of fees. One estimate put total hedge fund fees in 2005 at $65 billion. This explains why hedge fund managers are able to buy up swanky apartments in Manhattan and commandeer the best restaurant tables in Mayfair.

  Nevertheless, the hedge fund sector is still small in terms of the rest of the fund management industry. Peter Harrison of MPC Investors, a group that manages both hedge and traditional funds, reckons there is some $90 trillion of non-hedge fund assets out there. He thinks investors, particularly pension funds, will gradually push more money into the sector.

  But might there be a limit to expansion? Hedge fund managers claim they are “smarter than the average bear”. Perhaps they can gain advantages from the techniques they use, or by specialising in small parts of the market where assets might be mispriced. However, it seems unlikely that these opportunities are endless. As more money pours into the industry, mispriced assets will be harder and harder to find; in the jargon, they will be arbitraged away.

  Average hedge fund returns certainly seem to be falling. In the 1990s, it was common for hedge funds
to earn 20% a year; in 2004/05, returns were in the high single digits. According to Dresdner Kleinwort, an investment bank, hedge returns have been trending down since 1990 at a rate of around 1.2 percentage points a year. The losses incurred in 2008 will have created cynicism among investors who were told that managers could always achieve absolute (in other words positive) returns.

  Of course, the first decade of the 21st century has been a much more difficult time for asset prices in general than the 1990s were. Returns everywhere have been falling. But lower market returns mean that the fees paid to hedge fund managers take a bigger bite out of the net return to investors. At some point, indeed, the fees may outweigh any skills the managers possess.

  Hedge fund managers market themselves on the basis of their skill, or alpha as it is known in the jargon. Pure market exposure, in contrast, is known as beta. It is agreed that investors should be willing to pay high charges for alpha since it is a rare property. But beta is a commodity, a seaside postcard relative to alpha’s Picasso.

  One of the big questions for hedge funds over the coming years is whether there is enough alpha to allow the continued expansion of the industry. Already there are attempts to produce cut-price versions of hedge funds, which offer similar returns at much lower fees. Perhaps one day even smarter, but cheaper, investment vehicles will replace the hedge fund giants.

  Investors

  Who are the people who give money to hedge funds? For tax and regulatory reasons, few small investors – the people with just a few thousand pounds or dollars in savings – have been able to gain access to the sector. Historically, the rich (high net worth individuals and family offices) were the main backers of the hedge fund titans.

  But this has slowly been changing. A survey by Greenwich Associates in 2007 found that the rich owned around 21% of hedge fund assets. But institutional investors – charitable endowments and pension funds – owned around 25%. However, another quarter of the industry was owned by funds-of-funds which could be owned by anyone, pension funds and the rich included. So it is hard to say definitively where the balance of power lies.

  The development that gets the industry most excited is the growing enthusiasm for hedge funds in the pension fund sector. With many trillions of assets under management, this is a potentially huge prize. Progress is slow but steady. A 2009 survey by Mercer, an actuarial consultancy, found that 5–9% of pension funds had invested with hedge funds, or managed futures funds, compared with 14% of pension funds in continental Europe. The proportion of portfolios devoted to hedge funds may still be quite small, however; even in the United States, it is estimated that only 2.5–5% of pension fund assets are held in hedge funds.

  Why are pension funds interested in hedge funds at all? After all, they have traditionally paid low fees for fund management – less than one percentage point with no performance fee in many instances. Backing a hedge fund would appear to be handing over their members’ money to multimillionaires.

  Indeed, pension fund trustees have traditionally been suspicious of the hedge fund industry. The reason has been partly the fee issue but more generally two other perceptions: the idea that hedge funds are risky and the lack of transparency about the way hedge fund managers generate their returns. The risk problem relates to collapses such as LTCM and a few scandals in America. But the plunge in stockmarkets during 2000–02 brought home to trustees that equities can be risky too, and that hedge funds can hold up well during market crises. In 2008, a bad year for the sector, returns still beat the American stockmarket. And the willingness of consultants to get involved in hedge fund analysis has given trustees some comfort on the transparency front.

  Chris Mansi of British actuarial consultants Watson Wyatt says:

  Pension funds have traditionally owned equities and bonds and not much else. Since bonds are a close match for their liabilities, that means the risk budget has been highly focused on the equity risk premium.

  The premium to which Mansi is referring is the excess return equities have to offer to compensate investors for the extra risks involved in owning them. However, Mansi says there are other types of risk, including credit risk (in the bond market), illiquidity risk (some investors cannot own illiquid assets, which means that those who can earn excess returns) and skill. Hedge funds represent an exposure to this skill factor.

  But a lot depends on whether you can find the right managers. Mansi says:

  It is hard to take the view that the average hedge fund investor is going to be successful going forward. Either there is an unlimited number of talented people or there have to be new sources of return for hedge fund managers to exploit.

  Hedge funds are only one of the “alternative assets” that pension funds have been pursuing. Other asset classes include private equity, real estate and commodities. Many funds have been trying to follow the Yale example – the American university’s endowment fund enjoyed remarkably successful returns for 20 years (until a big plunge in 2008) thanks to a highly diversified portfolio.

  Fees

  Hedge fund managers charge a lot more than conventional managers, although their fees are similar to those charged in the private equity industry (firms that buy up companies, restructure the businesses and sell them again). The fee structure can vary but the standard model is “2 and 20”, that is an annual fee of 2% of the assets under management and 20% of the returns that the portfolio produces. So if the portfolio returns 10%, the hedge fund manager would take four percentage points of that return.

  Successful fund managers can charge more; one of the best-known high chargers was Renaissance Technologies, which charged an astonishing 5 plus 44 on its Medallion fund. However, the fund in question no longer looks after money for outsiders, even though they would have been more than happy to pay; before the fund was closed to outsiders, its annual average return was more than 35%, even after fees.

  There are some protections for investors, notably a high water mark system that allows performance fees to be charged only if the previous peak has been reached. Say a fund was launched at $100 and rose to $122 in its first year. A 2 and 20 manager could take 6 percentage points of fees (2 annual and 4 performance). But if the fund then dropped in value to 110, the 122 mark would have to be passed before performance fees could be charged again.

  Even with that safeguard, hedge fund fees mean that managers really do need some skill (or a lot of luck) to deliver decent returns to investors. Furthermore, many hedge funds trade frantically, turning over their portfolios several times in the course of a year. This incurs considerable costs. When you buy and sell a share, there is a spread between the prices a marketmaker will offer you (that is how marketmakers earn the bulk of their profits). Then there are brokers’ commissions (hedge funds often get their ideas from stockbrokers), borrowing costs when taking a short position, custody fees (someone has to keep safe hold of the assets in the fund) and so on. According to Dresdner Kleinwort, all these costs add up to 4–5% a year.

  If the hedge fund client wants a net return of 10% a year, the hedge fund portfolio may need to generate 18–19% a year before costs and fees. This is a tall order in a world where cash and government bonds pay 4–5%. In a good year, the stockmarket can return 20%, but as already explained hedge funds are not supposed to be offering simple exposure to the stockmarket.

  Costs can be even higher for those clients who use a fund-of-funds manager to invest in the sector. It is understandable that so many choose to do so. These intermediaries can sort through the several thousand managers on offer, attempt to understand their complex strategies and, most importantly, check that their backgrounds and systems are above board. In addition, because the best hedge funds are often closed to new investors, getting access to those managers may require the services of a fund-of-funds, which will have a long-established relationship with the industry’s elite. But fund-of-funds managers take an annual fee (normally 1%) plus a performance fee for their trouble.

  These high fees are attracting m
any traditional fund management groups to open hedge funds and encouraging investment banks to buy, or take stakes in, hedge fund managers. The industry is gradually becoming mainstream. But this is still a weird and wonderful world, with lots of different creatures being dubbed hedge funds, even though they have strikingly different characteristics. The taxonomy of that world is the subject of the next chapter.

  1 Hedge fund taxonomy

  It is hard to make sweeping statements about hedge funds. Some take extravagant risks; others control risks carefully. Some love to be in the public eye; others would be mortified by a mention in the Wall Street Journal or Financial Times. Some deal in exotic instruments such as credit derivatives; others simply buy and sell shares like an ordinary fund manager.

  That is why commentators have to be careful before pronouncing that hedge funds are buying oil, or that hedge funds have lost a bundle in the Japanese stockmarket. For every hedge fund on one side of the trade, there is likely to be another that is betting in the opposite direction. It is at once a source of strength and of weakness for the sector. The strength is that a market fall is highly unlikely to ruin all hedge funds. In August 2007, when everyone was concerned about a financial crisis, the average hedge fund lost just 1.3%, according to Hedge Fund Research. But the weakness is that, if hedge funds are on both sides of the table, their activities sound increasingly like a zero sum game – a game for which investors are paying extremely high fees.

  The sheer variety of hedge funds means that investors need to be careful about what they are buying. The freewheeling style of George Soros or Julian Robertson (who ran the Tiger funds) is far less common these days. The institutional clients of the industry (pension funds, university endowments and private banks) like funds that do “what it says on the tin”.