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November 2008
Banking, Managed Funds and Investments
Short Circuit?
Before Black September the hedge fund model was both simple and seductive. Hugh Lundin looks at the sector’s future
In a few years, investing in hedge funds will be the norm, and traditional mutual funds will be seen as the risky option. And it makes sense, if you think about it.” The speaker was a senior hedge fund manager and this recently expressed sentiment was obviously self-serving. But it does make sense — if you think about it.
Hedge funds promise to make money both when markets are up and when markets are down. They do this by using aggressive strategies that are unavailable to traditional long-only funds – such as short selling, leverage, program trading, swaps, arbitrage and derivatives. Lightly regulated, they are exempt from many of the rules and regulations governing old-style mutual funds.
Trouble is, most of these activities and practices have been implicated in the market meltdown of recent months, leading to temporary restrictions on one of the hedge funds’ core activites, short selling.
Short selling is where a trader borrows shares to sell on the belief that they will fall in price, upon which he can buy them back at the lower price, pocketing the difference. This manoeuvre is thought to have made at least €1.5bn in profits for traders who shorted HBOS shares back in the summer, amid rumours that it was in trouble.
The kings of shorting include Philip Falcone, who borrowed 3.29 % of HBOS’ stock earlier this year, a bet worth almost €500m. Others include David Einhorn of New York-based Greenlight Capital, who says he shorted Lehman Brothers before it went bust; Crispin Odey at Odey Asset Management; Noam Gottesman at GLG and Paul Ruddock and Steven Heinz at Lansdowne.
The UK’s Financial Services Authority recently forced Lansdowne to reveal that it had shorted Anglo Irish Bank and Barclays to the tune of 1.63% and 0.51% respectively. In the face of threats from US securities regulators to subpoena hedge funds for their past trading records, the best managers started to hoard cash instead, begging deeper questions about the future of the industry.
In particular, the best hedge fund manager of the past two years, founder of California’s Lahde Capital, Andrew Lahde, told investors that he was closing his funds, returning monies to investors and shutting up shop. He noted that while he had made money from market volatility, the danger of losing it from a bank collapse was simply too high. One of Lahde’s funds returned 870% last year, underlying how spectacularly a top hedge fund can perform in an otherwise indifferent market.
But extreme circumstances don’t disprove the hedge fund model, and according to its disciples they may very well underscore it.
The vast majority of mutual funds, unit trusts and pension funds are generally stuck with just one option: going long. As one manager noted: “It’s like driving a car that can only make right turns.” These are the people who have done badly in 2008, when markets fell precipitously amid a general banking crisis.
If anything, wealth managers have been urging clients to put more money into the best hedge funds rather than less, to ‘hedge’ their traditionally overweight stake in equities.
A recent survey showed that wealth managers have increased their clients’ investments in hedge funds by an average of 2.5%. This change was reflected, in September, by the realignment of a growth-focused benchmark published by the Association of Private Client Investment Managers (APCIM), taking the hedge fund component from 5% to 7.5%.
According to the APCIM, the composition reflects the average allocation to the various asset classes the association’s members have actually made on behalf of their clients. It said it had seen more money going into hedge funds due to “a strategic move toward more defensive assets as portfolio managers seek to stabilise returns against the backdrop of increased volatility in equity markets.”
It’s not an insignificant shift: by increasing clients’ investments in hedge funds by 2.5%, wealth managers have, in effect, increased clients’ exposure by half. These have been largely defensive moves, designed to preserve capital in an increasingly fraught market.
The first hedge fund – or at least the first investment vehicle to be given the name – was launched by Alfred Winslow Jones in 1949. A journalist, he was writing a story about investment trends for Fortune magazine when he was inspired to try his hand at managing money. His scheme was to try to minimise the risk in holding long-term stock positions by short-selling other shares. This strategy is now referred to as long/short equity, and is still the model used by the majority of hedge funds.
Jones also introduced a number of other innovations: the use of leverage to increase returns, the imposition of a 20% incentive fee to the manager (Jones, in this case) and the classic limited partnership structure. For all this he is now known as the father of the hedge fund. As for performance, he out-paced every mutual fund on the market, often by double-digit figures.
The hedge fund industry has grown enormously since then. Presently there are said to be between 7,500 to 8,000 hedge funds handling €1.7 trillion to €2 trillion in assets between them. There are now 14 distinct investment strategies used by hedge funds, some of them fairly exotic. Distressed Debt funds, for instance, buy deeply discounted debt or trade claims of companies facing bankruptcy or reorganisation; Emerging Market funds invest in the new economies of eastern Europe, central Asia and areas where growth is volatile and market conditions are less than perfect; and Special Situations funds look for incidents such as mergers, hostile takeovers or leveraged buyouts to profit from.
The advantage for investors is that the various strategies are – or are meant to be – non-correlated, meaning that if one strategy crashes, the others won’t necessarily be affected.
The big question now, of course, is how are hedge funds doing? Given market conditions over the past year, and particularly in September, they should, by all accounts, be delivering above-average, non-correlated returns to happy investors. After all, that’s their selling point: the ability to deliver an absolute return when markets are tanking as well as when they are up.
The answer is decidedly mixed. According to Chicago-based Hedge Fund Research, the average fund lost 4.83% in the first eight months of the year (to the end of August) – their worst returns in a decade. Previously the worst year was 1998, when funds were down by 5.5%, the giant fund Long Term Capital Management collapsed, and the world’s financial system almost went down with it.
On the other hand, hedge funds have out-performed long-only funds – US mutuals tumbled by 13.28% through 4 September. But that ‘outperformance’ was still much worse than simply hoarding cash.
“I think we’re seeing what these hedge fund managers really, truly are,” says one asset manager. “And some of them really can’t make money in a difficult environment.” The proof will be in the coming months, when strategies will have either been proven or disproven by the markets. Hedge funds are meant to deliver over the medium term – a year, say – not each and every month.
Though shorting has recently had a bad press – being blamed, somewhat absurdly, for causing the collapse of tapped-out financial institutions – it’s notable that the suspension of shorting, in both the US and the UK, is temporary. This should be a relief to investors: shorting is a perfectly legitimate way of making money in a declining market.
The other strategy that has produced above-average returns this year is macro – appropriately, perhaps, because it tends to benefit from turmoil. According to data from Credit Suisse Tremont, macro funds returned on average 18.8% in the year ended in June.
Macro funds have enjoyed some major themes to boost their returns, among them seven Federal Reserve interest rate cuts since September 2007, the surge (and subsequent decline) of oil and other commodity prices, the plunge by financial stocks and the weakness of the dollar. For macro funds it doesn’t matter whether the economy and markets are weak or strong, as long as there’s a trend.
Hedge funds have been called many things. One well-known hedge fund manager said they were “highly speculative vehicles for unwitting financial fat cats and careless financial institutions to lose their shirts.” Some regulators have said they posed “systemic risks”. This view has been reinforced by the periodic, well-publicised blow-ups of large hedge funds, from Long Term Capital in 1998, through the meltdown of the Tiger Funds in 2000, to the collapse of Amaranth and Peloton within the last three years. To the general public, there always seems to be a hedge fund disaster about to happen.
But what’s been notable in 2008 is the dog that didn’t bark – at least not yet. The collapse was instead among highly regulated investment banks, mortgage companies and insurance conglomerates. One reason for this, perhaps, is that these institutions played with other’s money, receiving huge bonuses if they succeeded and little sanction if they failed.
In hedge funds, things are different. Most often hedge fund managers invest their own money in the fund and take key decisions themselves, or at least closely watch those who do. Their incentives to take huge risks have been smaller. So these have at least survived. In markets where ‘flat is the new up’, as the current City witticism has it, surviving is the ultimate defensive position. 
