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Hedge Funds Ate Lunch!

“Hedge Funds Ate My Money”

“Take a speculative cocktail shaker. Add four parts public ignorance and 33 parts greed. Toss in a little perceived genius. If you don’t have any freshly ground perceived genius to hand, a little dried genius status will do. Season generously with mystique. Add apparent publicity shyness to taste. Serve in opaque tumbler of awes, ill informed media coverage”. Martin Baker” A Fool and His Money”

Hedge funds are fashionable. Hedge fund managers are the new Masters of the Universe – the new financial celebrities. Today, there are probably over 8,000 hedge funds with over $1,500 billion in asset under management (“AUM”).

Hedge funds have been around for 50 years but they are not well understood. In a recent interview, a minor Master of the Universe stated that he threw light on “fragmented information” and “opaque” track records. The statement is reminiscent of another in a company prospectus during the South Sea bubble: “a company for carrying on an undertaking of great advantage, but nobody to know what it is”.

In reality, the key things about hedge funds are: ? They are unregulated. ? They can engage in certain strategies denied to traditional investors, primarily short selling and leverage. ? They focus on generating absolute returns rather than trying to beat an index. Investment in hedge funds is being driven by a number of factors: ? Institutions – hedge funds are the latest attempts to beat markets and generate alpha (outperformance). ? Individuals – the potential ability to generate higher returns than those available from traditional assets.

There are a number of issues with hedge funds: ? Returns – average hedge fund returns when properly adjusted for risk and survivorship bias (many hedge funds don’t survive) are not above those for traditional assets over longer periods. A few hedge funds outperform but many of these do not accept new money. ? Risks – hedge funds increasingly take “new” risks – correlation, liquidity, complexity and event risk – that are not well understood and captured by systems understating the real risk and overstating returns. ? Transparency – over 50% of hedge funds have been in existence for less than 2 years and are small in terms of size (less than 20 people). This increases operational risks and combined with the lack of transparency significantly increases risk.

Banks are the real cheerleaders of hedge funds. A large part of their revenue now comes from helping hedge funds raise capital, trading with them and settling their trades and (most lucrative of all) funding them. Banks increasingly invest – “seed” – hedge funds to ensure flow of business. Internally, banks often replicate hedge fund strategies or market them to other traders. This profit comes with risk. In a severe market correction, large losses by hedge funds may lead to large losses by banks funding and trading with them. This is precisely what happened when LTCM collapsed in 1998.

The fundamental business logic of hedge funds is flawed. There is too much money chasing too few opportunities. Louis Bacon (of Moore Capital) when returning capital to investors commented: “Size matters. It is the bane of the successful money manager”. Clever people can make money if there are a few clever people and lots of opportunities. In 2004, one academic argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. History may show that hedge fund returns, other than a few exceptional cases, reflect the confluence of market conditions and good luck that prevailed in the 1980s and 1990s.

The large amount of capital commanded by hedge funds creates systemic risks. Increasingly, trading is centered on “big” stories – China, India, corporate actions (LBOs/ Mergers/ bankruptcies). Traders take positions in a wide variety of instruments all focused on the same event. The tremendous volatility created by relatively minor events points to the explosive build-up of risk concentration. Central bankers are belatedly focusing on these extreme money games.

As one commentator has warned: “…the risk to the stability of the world’s financial system posed by the existence of these massive vehicles has not gone away. We have chosen, in the main, not to think about it – in the same way that wives sometimes choose not to think about whether their husbands are really working late at the office. The implications of thinking about it are just too scary”.

In the attached paper I have set out a critical analysis of hedge funds and their influence on modern financial markets.

Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.

Woodstock for Hedge Funds

Hedge funds are “in”. They are the fund management industry’s most recent foray into the search for alpha. Like priests of some sacred cult, fund managers have their own distinctive liturgy. Beta is risk. Alpha is the Holy Grail. Positive alpha signals miracles, the fund has outperformed.

The areas around St. James and Mayfair in London and the Helmsley building in New York and Stanford, Connecticut are home to a plenitude of hedge funds (“plenitude” refers to when there is too much of anything). There are probably over 8,000 hedge funds with over $1,500 billion in asset under management (“AUM”). The funds names inevitably include the term “capital” - remember Long Term Capital Management (“LTCM”).

Hedge funds have been around for about 50 years. They rose to prominence in the 1990s. George Soros’ success in speculating on the £ made him the glamour boy of hedge funds, at least for a time. Many types of relative value, market neutral, event driven, multi-factor, absolute return etc investors have emerged. It is very difficult to know what any of these terms actually mean – it’s a secret.

Traditionally, hedge funds were for the very rich. Now, most of the money comes from traditional investors - insurance companies, fund managers and private banks. Some of the money comes from individuals directly – namely, you. The new mantra - hedge funds are for everybody. At least, if you fit into the private bankers definition of the “mass affluent”. This is the new democracy of money. If it was good enough for the rich then it must be good enough for everybody. What did Groucho Marx say about not belonging to any club that would have him as a member?

The truth - investment managers have given up trying to beat the market. Weary of under-performance, they have switched to index funds just buying the entire market. These days some fund managers invest say 90% in indexes to match the market (their beta). They give the remaining 10% to hedge funds to try to beat the market (the elusive alpha).

Disgruntled fund managers and traders from dealers, especially derivative specialists, have set up hedge funds. Fund managers and traders are tired of the politics and inflexibility of large organisations and increasing compliance burdens. Traders are attracted to the money and the power of the “buy” side. Hedge funds charge a fee of 1% on AUM plus around 20% of profits, sometimes above an agreed benchmark. Sought after funds charge more. One “hot” hedge fund charges more - 5% and 35% of profits. Most hedge funds are small and fund managers are owner managers. Performance related fees mean that they get paid more than they ever would on the sell side.

Edward Thorp and Sheen Kassouf were pioneers of convertible arbitrage, a sometime popular hedge fund trading gambit. They were the authors of a famous book published in 1967 - Beat the Market – which set out the principles of convertible arbitrage. Interestingly, Thorp was already well known for another book - Beat the Dealer - which set out the process of card counting in blackjack. That more than anything provides an insight into the world of hedge funds.

Hedge funds are not actually hedged. They can do certain things that traditional investors can’t. Hedge funds can short allowing them to make money when prices fell. They can also leverage to enhance returns in stable markets. They also chase absolute return. Traditional investors have become obsessed with performance relative to a benchmark like the broad market index. Investors have finally figured out that beating the index by 2% when the index falls 10% means that you still lost 8%. Hedge fund manager’s fees are also linked to performance. Hedge fund managers also have their own money in the fund. Investors like all that.

All this means that traditional investors have joined the rush. Conservative asset managers now allocate part of their funds to a new “asset class” – AI (alternative investments). Funds that can’t short, can’t leverage, can’t use derivatives instead gave their money to hedge funds who can.

AI has gained traction. Some asset managers have established FoF (fund of funds). The FoF manager selects a diverse group of hedge funds. They do the screening and monitor the hedge funds. Ordinary investors are now paying several layers of fees. There is the fee to their mutual fund. There is a fee to the FoF manager. Then there is the hedge fund manager’s fee. FoF might just stand for Fee of Fees.

There are capital guaranteed hedge fund investments – you can’t lose your principal although you may end up earning nothing on your investment for 10 years. This type of investment helps explain why many investors in hedge funds in the words of Groucho Marx - “work [themselves] up from nothing to a state of extreme poverty.”

Dealers love hedge funds. Investment banks help set them up, invest in them and trade with them. A whole new service has developed – “prime brokerage”. This combines settling and clearing hedge fund trades, execution services and (the most lucrative) lending money to hedge funds. Investment banks set up “incubators” to help budding traders create hedge funds. Some estimates put the dealers earning from hedge funds at around 20% plus of their total earnings. The rise and collapse of LTCM has long been relegated to history.

Hedge fund managers are the new elite. They have taken over from the Internet barons. Talented newcomers all head for hedge funds. A freshly minted MBA announced his intention to establish a $500 million plus hedge fund. The secrecy of hedge funds provides additional mystique.

Old hedge funds paid the traditional formula of 1% management fee and 20% of performance above a benchmark (known as the watermark). New funds were charging 2% and 25% or higher with no watermark. Hedge funds are the only business where an unproven newcomer with no track record can charge more than an existing operation with a proven history.

Hedge fund mangers are the nouveau rich. Their tastes are distinctly retro. Their work places feature swimming pools, basketball courts and other perks. They are a direct lift from the dot com Internet 1990s. Billionaire hedge fund managers bid up the price of luxury apartments and art. Others buy modern art. The extravagant, ersatz, retro chic of hedge fund managers and traders reached new heights in 2006.

In June 2006, the hedge fund industry staged “Hedgestock” (see Stephen Schurr “Hedge Funds Jump on Hippie Bandwagon” (Financial Times (3/4 June 2006); Penny Wark “Selling Themselves Short” (Times (9 June 2006)). The title paid homage to Woodstock – the historic 3 days of peace, love, promiscuity, music, drugs and shockingly bad dancing on Max Yasgur’s farm in Bethel, New York. Hedgestock was to be 2 days (nobody could afford 3 days in this “time challenged” age) of “networking and finance” in Knebworth House, just North of London. The stately location has seen many rock concerts though it is doubtful whether it has ever seen anything like Hedgestock.

The hedge fund community thinks of themselves as “alternative”. The hippies had celebrated their counterculture movement at Woodstock. Hedge fund managers are keen to advertise that they were the vanguards of the “alternative” movement – “alternative investments” that is! It was the “dawning of the age of hedge funds” not the “age of Aquarius”.

Hedgestock was unashamedly nostalgic. The Who (at least, it two surviving members – Pete Townshend and Roger Daltrey) appeared reviving the memory of their legendary performance at the original Woodstock, some 37 years ago. The Who’s impressive backlist was filled with songs which had a peculiar resonance for hedge funds and their investors:

“Won’t Get Fooled Again” (…Meet the new boss same as the old boss…)

“Can’t Explain” (…Got a feeling inside, Can't explain, It's a certain kind …)

“My Generation” (…People try to put us d-down… I hope I die before I get old …)

The organisers and attendees spared no expense. Some even laid on vintage Woodstock era VW camper vans for transport. Some promised to revive the costumes and dress codes of the psychedelic 1960s. Despite the promise, on the day, Porsches, BMWs, Mercs, Ferraris and the odd Bentley were predictably the attendees chosen mode of conveyance. The dress code was straight out of “The Great Gatsby” and “The Graduate” – preppy cool. Blackberries and mobile phones were conspicuous.

One press report of Hedgestock had Pete Townshend shouting at the audience to “turn yer mobiles off!” Pete obviously had calmed down. In younger more energetic day, he was famed for smashing guitars as part of the act. The audience, apparently, did not pay much attention. “Hey, Pete, it’s a 24/7 business, man! Don’t you get it.”

There were many differences between Woodstock and Hedgestock. Most of the attendees had not even been born at the time of the original Woodstock. Entry to Hedgestock was a cool £500 plus VAT and limited to 4,000 “guests”. The original Woodstock was attended by around half a million, most of whom simply turned up and didn’t pay anything. They broke through a specially constructed fence to get to Woodstock. Hedgestock’s house rules were new “age” – 1030 pm curfew; drugs were “verbotten”; there would even be raincoats to counter the vagaries of the UK’s fickle weather. As for promiscuity, there was a debate “Esoterica – New Risk and New Returns for Consenting Adults”.

The original Woodstock is mostly associated with rain, mud and “bad” acid (LSD) by the few people who were there and can actually remember it. Hedgestock in contrast promised “alternative entertainment” – poker tournaments and other forms of betting to allow the hedge fund managers to exercise their natural “animal instincts”, “testosterone” and considerable “egos”. Hedgestock was even discretely sponsored by a number of investment banks that made large amounts of money from hedge funds. It was their way of “putting something back”.

The hedge fund industry’s self conscious bravura and social awareness (the event was going to support charities) as well as it’s attempt at being “hip” were tepid. The contrived link to Woodstock – the seminal moment of the counterculture movement – was vapid. If Woodstock’s anthem was “make love not war”, Hedgestock’s less catchy mantra is “make money not war”. As the late John Kenneth Galbraith, the American economist noted: “Nothing so gives the illusion of intelligence as personal association with large sums of money. It is also alas an illusion”.

Hedge fund performance is already starting to falter. There is simply too much money chasing too few opportunities. The idea that clever people can make money is true only if there are a few clever people and lots of opportunities. The markets now have too many clever people and few opportunities. Returns have slid. Astute investors have noticed that after you adjusted for risk (at least properly) and the absence of liquidity, hedge funds return at best no more than and frequently less than traditional assets. There are exceptions. They are few and far between. Many of the really good hedge funds are closed to investors.

The absence of opportunities creates “style drift”. Hedge funds with certain areas of expertise begin to trade in other markets. LTCM too had drifted from their metier - relative value trading in fixed income – into volatility trading, credit spread trading and merger arbitrage. Hedge funds are not noted for their transparency. Lack of disclosure means that you don’t know how far the ship is of course until it was on the rocks. Cases of fraud and other common crimes have also begun to surface.

There is every sign that the hedge fund universe is overheated. At the suggestion that there was a “bubble”, one hedge manager bristled that hedge funds weren’t an “asset class”, therefore there was no “bubble” to burst. Only asset classes experienced bubbles. The semantics aren’t reassuring.

© Satyajit Das 2006; All rights reserved. ____________________________________________________________

The above is adapted from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at www.pearson-ed.com.

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Satyajit Das works in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (a 4 volume 4,200 page reference work for practitioners on derivatives) and Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall), an insider's account of derivatives trading and the financial products business filled with black humour and satire. The book has been described by the Financial Times, London as " fascinating reading … explaining not only the high-minded theory behind the business and its various products but the sometimes sordid reality of the industry". He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.