Why you should be wary of hedge funds
By
Tim Price Apr 05, 2006
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Hedge funds are booming. But investors should beware. If you come into hedge funds now, you might be coming late to the party.
The rise of hedge funds seems unstoppable. Funds under management grew by an extraordinary 50% last year, and now account for more than $1,500bn (£860bn) in global capital, according to HedgeFund Intelligence. What are often referred to as “alternative” investments now seem to have entered the mainstream.
Last week, the UK’s Financial Services Authority finally got involved too. It announced that retail investors would be able to invest in hedge funds with regulatory protection. It widened the range of authorised retail investments to include “funds of hedge funds”, starting from next year. The FSA also hinted that, in the future, private investors might be able to invest in funds of funds based offshore with consumer protection.
The FSA also said that it would focus on asset valuation in hedge-fund portfolios and “side letters” (separate agreements made with certain fund investors), rather than impose a heavy supervisory hand as some market participants feared. Asset valuation is a complex but vitally important issue. It is complex because hedge funds often invest in illiquid, synthetic instruments where there is no exchange to check their prices. It is important because it is potentially open to abuse. Hedge fund managers’ pay is usually directly linked to the funds’ value, so at best there could be conflicts of interest and at worst it could encourage fraud. Side letters are given to some investors, providing them with special terms – for example, on fees or portfolio construction. These might invite further conflicts of interest within the asset-allocation process itself, yet other investors might not even know about those special arrangements. In future, hedge funds will need to disclose any private deals.
Many hedge funds share similar structures and characteristics, which also have a lot in common with the pioneering fund set up by Alfred Winslow Jones 57 years ago. The manager, who may well be based onshore – typically in the US or UK – manages the investment portfolio via a fund domiciled in an offshore tax haven – a Caribbean island is especially popular. Unlike conventional mutual funds (in the UK, oeics and unit trusts), which have explicit objectives and constraints spelled out in their prospectuses or trust deeds, hedge funds can normally do anything and go anywhere. There are few restrictions. One day your hedge fund might buy UK Government bonds, a week later it might see opportunities in Moldovan equities. With mutual funds, what you see on the tin is what you get, but buy into a hedge fund and, potentially, it’s a Pandora’s box.
Hedge funds do not represent a distinct asset class in the way that equity funds or bond funds do; rather, they offer access to specific types of “skills-based” investing. Hedge fund managers trade across all kinds of asset classes in pursuit of profits: currencies, commodities, equities, debt markets, even other funds. A strategy now in vogue is “merger arbitrage” – where the hedge-fund manager buys stock in the target company in the expectation of higher bids and simultaneously sells short stock in the acquirer company, who may be overpaying.
Hedge funds gained dramatic notoriety during the Exchange Rate Mechanism (ERM) crisis of September 1992. Financier George Soros, through his Quantum hedge fund, in a stand-off against the Bank of England and the then Chancellor of the Exchequer, Norman Lamont, is rumoured to have made $1.1bn in profits from betting that sterling would be forced out of the ERM, and succeeded on “Black Wednesday”. In fact, the hedge-fund industry tends to make headlines only during times of extreme market turbulence, and the highly-paid but publicity-shy managers are then forced out of the shadows.
The recent growth in hedge-fund assets has certainly been helped by the fallout from the collapse in the dotcom bubble that hit markets in 2000. Investors had become used to double-digit returns and went looking for ways to maintain them. The “absolute returns” – that is, paying positive returns regardless of whether market indices rise or fall – promised by hedge funds, with no explicit benchmark beyond beating cash-deposit rates, offered one way to do that.
But even hedge-fund practitioners themselves recognise that the industry faces problems – in part because they are victims of their own success. David Shaw, founder of DE Shaw, a hedge-fund group managing more than $20bn of client assets, recently suggested that investment returns from the sector will probably deteriorate because of the weight of capital pouring its way. This has “made it easier for people to go into business but harder to make a profit once you’re there”. And many managers swim in the shallow backwaters of the capital markets – niche sectors and thematic strategies that can only absorb so much capital before the opportunity to extract profit evaporates, perhaps permanently.
Although the barriers to entry are few, involuntary closures are a constant and unavoidable feature of this highly competitive world. Some fail at the lowest hurdle: simply the task of operating and managing a business doesn’t suit a skill-set learned as traders in an investment bank.
The Financial Times recently reported that the top 50 hedge-fund groups now control 40% of the sector’s overall assets, and that the top 200 hedge funds manage 90% of all hedge-fund capital. Given that there are something like 9,000 hedge funds out there, there must be hundreds if not thousands of managers struggling to break even.
Hedge funds have no shortage of external critics either; and few are as high profile as Warren Buffett, America’s second-richest man. In his most recent letter to shareholders of his holding company, Berkshire Hathaway, he compared the alternative asset management community with paid advisors, or “hyper-Helpers”, to a wealthy family seeking investment advice. He wrote, “The new arrivals offer a breathtakingly simple solution: pay (us) more money. The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY.”
The typical fee structure of a hedge fund (2% annual management fee and 20% in what is euphemistically called an “incentive fee”) is expensive, particularly in comparison to (passive) low-cost exchange-traded funds, which typically charge 0.50% or less. Whether well-paid managers are worth it depends on whether they perform.
However, there are growing concerns that an increasing number of hedge funds are simply directional managers – “free-riding” on the coat-tails of bull markets – and charging higher fees for what are, in practice, index-trackers. In the jargon of the industry, the suspicion is that many hedge funds are selling “beta” (the market return) as “alpha” (the value generated above the market return). This trend has been compounded by a blurring of the boundaries between traditional fund managers and hedge funds.
After wealthy individuals came the big institutions. A Morgan Stanley (a US investment bank) study noted that funds of hedge funds saw net new money grow by 40% per year between 2002 and 2004, representing half of all flows into hedge funds. These inflows came primarily from first-time investors, including pension funds, keen to diversify their risk across a variety of strategies.
The growing involvement of institutional investors, rather than super-rich individuals, is also changing the industry in another way. Hedge funds originally pursued unconstrained mandates, investing in whatever way they felt appropriate. Institutional investors, on the other hand, tend to be risk-averse, yet demand high short-term gains – even in volatile markets. The danger is that hedge-fund managers, with sizeable institutional investors, try to avoid short-term losses at the expense of generating longer-term returns.
There is no real reason why both individual investors and institutions shouldn’t consider hedge funds or funds of hedge funds as part of a diversified portfolio, alongside more conventional assets, such as equities and bonds. Classic hedge funds should be viewed as “stay rich”, rather than “get rich” vehicles. But hedge funds do not comprise an homogenous asset class – some are good, others aren’t. Periods of market turbulence provide the acid test.
Also, there is growing evidence that many hedge-fund returns are highly correlated to equity markets (in a market crisis, different types of assets often behave in a similar way) and therefore the diversification benefits from owning hedge funds may be overstated.
Potential investors in hedge funds should conduct “full due diligence” on the underlying manager – which means check their credentials. But if you want more information than you’ll get from a Google search, then it’s not a cheap option. Exhaustive analysis of both the qualitative and quantitative aspects of hedge funds takes time and money: how many staff does the firm employ? The manager may be a talented investor, but he may lack critical technology or support staff. Does the manager use leverage? If so, how much? Who is the fund’s prime broker (the market counterparty – usually an investment bank – that settles the hedge fund’s trades, lends it money and prepares account statements)? How does the fund avoid conflicts of interest? Many investors conclude that the cost and effort involved in full due diligence is unacceptable and take the “easier” route of using a fund of hedge funds instead. It cuts out the costs of research, but then they are faced with hidden costs. A fund of funds pays fees to the hedge funds it invests in, and these might well be passed on to its own investors.
Even if you buy into a fund run by managers with impeccable credentials – either directly or through a fund of funds – you can still go badly wrong. Few funds could ever match the pedigree of Long Term Capital Management (LTCM) – packed with Nobel Laureates and traders with legendary reputations. Yet, following Russia’s debt default in 1998, LTCM had to be bailed out by a $3.6bn rescue package organised by the US Federal Reserve. Its catastrophic failure has been analysed many times over. One important conclusion is that it was the strategy of the particular fund that was at fault, rather than an inherent defect in the hedge-fund structure. LTCM was simply too highly leveraged: it was betting with $25 of debt for every $1 of its own capital and could not survive the collapse in global markets – no matter what its computer models told it – and indeed, once its exposure became known to other traders, its own trading positions actually contributed to the collapse of equity markets.
The sector has achieved something close to legitimacy in the eyes of many investors, but recent returns have also disappointed some. So if you do decide to invest in hedge funds, you have to wonder if you are more or less likely to make money than if you just bought units in a mutual fund – or even threw darts at the share pages of the FT. In any case, you will be arriving late to the party. Even Nobel Prize winners wash up in the hedge-fund business. And as Warren Buffett points out, it’s unlikely there are 9,000 geniuses to run the 9,000 hedge funds. The danger is that you get into a fund run by a half-wit, not George Soros.
Tim Price is chief investment officer at Ansbacher
How do hedge funds work?
A hedge fund invests its own capital in a range of assets, including derivatives and exotic markets, using various trading techniques, to earn high returns. In the UK, hedge funds are regulated by the FSA, but most are based offshore and are unregulated. They often have high charges – 2% a year and a 20% performance fee is typical.
“Funds of hedge funds” hold portfolios of hedge funds, and are viewed as safer for small investors: they spread your risk and the due diligence on individual fund managers is done by professionals, but can add additional layers of charges.
Hedge funds can “go short” (sell stock they don’t own) of stocks they don’t like, often “matched” by the purchase of a stock they do; they can take on a lot of leverage or gearing (borrow heavily) to buy assets they like, which is good if they go up, but bad if they fall; they often use “dynamic” trading strategies deploying derivatives and other complex financial instruments; they try to pay high (“absolute”) returns to their investors even when markets fall. They use a “prime broker”, usually an investment bank, that settles their trades, lends money and prepares account statements.
Inventing hedge funds
American journalist and investor Alfred Winslow Jones is widely credited with starting the first hedge fund back in 1949. Researching an article on fashions in investment for Fortune magazine, he concluded that he could do better himself. So he set up an investment partnership that came to embrace four classic hedge-fund characteristics.
First, he ‘hedged’ the stock positions he owned by ‘selling short’ stocks he believed were less attractive, thus achieving a degree of market neutrality. It was a prototype of the “long-short” strategy still popular today: more important than stockmarket direction is that the stocks he liked performed better than the ones he didn’t.
Second was the limited partnership structure of the fund, which gave it a degree of exclusivity, and meant it had less onerous reporting requirements to the regulatory authorities.
Third, in 1952 he introduced a “profits incentive fee” of 20% on funds under management, so significant outperformance was rewarded by a payout to the fund’s manager. Finally, he used leverage – borrowed money – to enhance prospective returns, but at the risk of raising the fund’s volatility of returns, since leverage magnifies losses as well as profits.
Hedges for everyman?
The development of “funds of hedge funds” has made the industry more accessible to smaller (retail) investors in the US. Investors in a typical hedge fund usually need to earn over $200,000 a year or have a net worth of more than $1,000,000 (“accredited investors”), or have at least $5,000,000 in qualified investments (“qualified purchasers”). But a fund of hedge funds is available to people with assets to invest from as little as $10,000.
Several funds of hedge funds are now listed on the London Stock Exchange, which makes them eligible for inclusion into tax-favourable wrappers such as Isas (individual savings accounts) and Sipps (self-invested personal pensions). They include Close Man Hedge (CMNp.L), a product of Man Group, the UK’s largest listed hedge-fund provider; Dexion Absolute (DAB.L), a closed-end fund incorporated in Guernsey; and Thames River Hedge+ (TRM_pa.L). Hedge fund-watchers looking to piggy-back on the growth of the industry can also make direct purchases of shares in Man Group (EMG.L), or its rival, RAB Capital (RAB.L). RAB last week reported a 38% gain in profits for the second half of 2005, as client assets soared.
Fast-growing hedges
Hedge-fund assets worldwide are around $1,500bn (compared to $30,000bn-$40,000bn invested in mutual funds), with the US making up $1,000bn alone; European hedge-fund assets are c.$325bn (up 25% from 2004), with London hedge-fund managers running $255.5bn (78% of the European total); Asian funds are now $115bn, according to Hedge Fund Intelligence. Hedge funds with assets of $1bn plus – the US “Billion Dollar Club” – account for $850bn in assets. The total number of hedge funds worldwide is reckoned to be nearly 9,000. They account for up to half the daily turnovers of the London and New York stock exchanges.
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