Hedge Funds Reexamined

Hedge funds have taken a lot of criticism over the last 2 years for pumping up markets and/or leveraging their capital to make big momentum bets. Naturally when the markets corrected, which took a lot of hedge funds down with it, many of the critics were rubbing their hands with glee - sometimes, we just love to see tall poppies being hacked, or misery happen to the rich and successful ... Hedge funds took the blame for much of last year's financial havoc, but the fact is that they have played a much more benign role than is commonly thought.

Plenty of funds went under with the market plunge: a record 1,471 in 2008 out of a total of 6,845, according to the Chicago tracking firm Hedge Fund Research. But the government didn't bail out a single one. That's the way capitalism is supposed to work: incompetents go out of business, smart guys clean up. How about that, hedge funds NEVER GOT ONE CENT from any government. You fail, you close shop. you lose money, you take it on the chin and walk away to do something else.

The hedge-fund industry has shown remarkable resiliency, turning in a gain of more than 12 percent for the first seven months of 2009. The firms that caused most of the trouble on Wall Street were not hedge funds but big investment banks and insurance companies trying to act like hedge funds. They did a lot of risky proprietary trading with other people's money, and they failed. The key is betting using "other people's money" or your own capital. Funnily, firms that bet using their own capital have generally performed a lot, lot, lot better. This is the one big lesson all regulators, investors and senior management need to know by now.

Wall Street's most successful long-term model has been companies like Brown Brothers Harriman or Goldman Sachs, where firms bet the owners' own capital. Such a structure ensures careful risk assessment. Similarly, many hedge-fund managers have a lot of net worth invested in their own funds. Former Fed chairman Paul Volcker has proposed that federally insured banks be barred from proprietary trading. Maybe only hedge funds have earned the right to be the big risk takers of the future.

While many will continue to sneer and hope that more hedge funds will find troubled waters in the future ... much of it is envy and the inability to accept their compensation schemes. Most hedge funds charge an annual 1%-2% fee, plus a 20% cut of any positive returns. Some funds may have a minimum hurdle return rate (e.g. 5%) before the 20% share kicks in. All you need is a couple of good years before one can retire comfortably. Say a team of 3 runs a US$100m hedge fund. They have US$1.5m in fees to cover costs. If their fund gets a return of 18% for the year, technically they will get US$3.6m in performance profit share. You can do the math if one person manages US$100m or more. You can also do the math if you can leverage that capital 100% and double your return to 36%, thus doubling your profit share to US$7.2m. In a good run, not many investors will care about the leverage or risk that you took to get the returns as long as they were spectacular. In a down market, only then will investors and fund of funds start asking hard questions about leverage, reporting frequency, the ability to take money out at regular intervals without penalty, the amount a fund pays in commission, the percentage of portfolio that was turned over in a year, the alpha and beta and the gamma (no, we are not talking about radioactive rays).

My view is that hedge funds are here to stay. I would want to pay somebody a 20% bonus if they make me more money. I am sure the managers' interest is aligned with mine. What an investor has to be careful is that the compensation structure encourages big bets. The structure also encourages to bet aggressively to notch super normal returns as losses are not the end of the world - many dubious players will close the funds when they have one or two years of negative returns (you would then have to make up the deficit before getting the 20% profit share again)... only to reemerge somewhere else again with a new fund and new partners. Thus investing in hedge funds mean you have to know a bit about the people running the funds. You also have to know their strategy and leverage, and if you are rich enough to invest in hedge funds, spread it among a few funds, with differing investing strategies, and a decent track record.

There are many who will be starting afresh hedge funds, calling for subscribers. They are not as dangerous as one might think. They offer a fresh start, always judge them on what they had done before and what they want to achieve. New funds are more agreeable with "anytime withdrawals" and lower fees. Bear in mind that there is a danger when funds get too big. It gets that much harder to perform when its starts getting close to the US1bn mark, unless the hedge funds is based solely on quant models and program trades.


p/s photos: Chrissie Chau

Are Hedge Funds Investors Gullible?

The Economist came out with a scathing article on May 14, 2009 basically saying that hedge funds investors were naive and were gluttons for punishment. Their points were:

Hedge fund investors are gluttons for punishment.

1. That hedge funds spectacularly failed to achieve the absolute returns that were supposed to justify their high fees.

2. That hedge funds ran liquidity mismatches between the assets in their portfolios and their volatile funding and investor terms.

3. That hedge funds suspended redemptions or gated investors attempting to redeem.

4. That funds of hedge funds were only marginally less useless than Madoff's auditor.

5. Yet, says the Economist, a recent survey of most of the world's big hedge fund investors conducted by Goldman Sachs, suggest that investors remain surprisingly happy. Also there is anecdotal evidence that redemptions are slowing and that money is actually flowing back into the industry.

6. The Economist also finds that there does not appear to be much appetite to reform the structure of hedge funds. They also point out that there is scepticism or at least a tepid take up of managed account structures.

7. The Economist finally suggests that hedge funds will slowly but surely become more like the old-fashioned asset managers they once threatened to usurp.

To hear the other side, Bryan Goh of First Avenue Partners in London, a hedge fund, has drawn up a rebuttal:

Let's deal with the charges.

1. Hedge funds did indeed fail to generate absolute returns in 2008. But was the playing field a level one? From Dec 2007 to June 2008, hedge funds were almost flat, the HFRI Index returning -1.6%. Once Lehman collapsed and bans on shortselling were established, once FNMA and FRE were bailed out arbitrarily within their capital structures, hedge funds' losses accelerated resulting in a return of -19% for 2008. Long only equity indices, credit indices, commodity indices, real estate indices would have lost between 30 - 45% for the year.

2. Some hedge funds did indeed run liquidity mismatches between their assets, their funding and their equity bases. Macro hedge funds and equity strategy managers did not have this problem. However, barriers to entry were low in the last few years leading to a proliferation of mediocrity, to a contamination from long only mindsets and expertise and thus correlation of industry aggregate indices to long only indices. A good hedge fund manages the downside as much as the upside. Examples abound of managers who have protected capital in the turmoil suggesting again the importance of due diligence and manager selection. As for downside from illiquid positions, this afflicted mostly the special situations, mezzanine finance, quasi private equity strategies which while historically at the fringe of hedge funds had gained popularity in the last few years.

3. Suspensions and gating. Guilty as charged. Some strategies cannot be run in open ended hedge fund format. They require lock ups and in some cases they just need a closed end fixed term self liquidating vehicle. However, once an ill structured investment vehicle has been hit in the crisis of 2008, there are basically 2 choices to be made.

a) Liquidate to meet redemptions, liquidate at all cost, even at firesale prices, and

b) Suspend redemptions and undergo an orderly liquidation. The devil is in the details and the behavior of the manager in such a liquidation. It is hard to swallow that a manager continues to charge fees of any kind during a suspension or liquidation. Open and frank communications are also in order in a liquidation. And next time, if there is a next time, if you want to stick illiquid assets into a portfolio, let investors know before hand and structure the investor vehicle to lock in the equity capital and the financing. Otherwise, get ready for some misrepresentation suits.

4. Funds of funds are of varying quality. One broken down car doesn't mean that all automobiles are unreliable. More importantly, funds of funds serve specific purposes. They provide a service not only to the investor but to the hedge funds as well.

5. Why do investors remain relatively happy with hedge funds? Look at the numbers. Sure, hedge funds didn't exactly do what they said they would do in terms of protecting capital in the midst of one of the worst financial crises in recent history. But they would have lost only half of what they would have lost had they been long only. Investors are only reacting rationally.

6. That there does not appear to be appetite to reform the hedge fund industry is disturbing because for all the outperformance of hedge funds versus traditional and other alternative investments, the hedge fund industry is in need of reform. Hedge funds terms and structure are not always optimal for the strategy; often they are driven by what sells, in other words, what investors want. How ironic is that. Investors have always wanted more liquidity than the portfolio could bear. Hedge fund managers pandering to investors gave them what they wanted. Standards of transparency and clarity and alignment of interest need to be addressed. While there has not been much visible activism in terms of reforming hedge fund terms and manager behavior, witness CalPers new policies for investing with hedge funds. Also, the near halving of assets under management in the industry from some 2 trillion USD to 1 trillion USD over the last 2 quarters is evidence of investors policing the market.

7. Will hedge fund managers come to resemble old-fashioned asset management companies? I hope that hedge funds become more accessible to investors of all types. Including retail. More choice can only be better. Of course intermediaries will be required to manage the added complexity of hedge fund strategies, and here funds of funds are challenged to step up to the plate. I hope that hedge fund techniques of investment become more mainstream and widespread. Leverage and short selling can only improve market efficiency. I hope that hedge funds find traction among retail investors as much as sophisticated ones. Hedge funds have proven their worth in 2008 relative to other investments. And retail investors by reason of their size and numbers represent a more predictable and stable asset base and are therefore good for the stability of hedge funds.

The hedge fund industry has come under considerable fire since the financial crisis of 2008. The reasons, however, are many, and complex, and in some instances are justified and in some, not. For those of us who have invested in hedge funds, we have been encouraged by some and disappointed by others, but by no means have we lost faith in the industry as a whole. Most of us would like to help the industry grow and develop to be stronger and more investor and market friendly. Some of the blame does fall on the hedge fund manager, where they have been arrogant, stubborn or self serving, some of the blame must go to the regulators for legislating before understanding, but some of the blame is the investors' as well, where they have been ignorant, negligent, lazy, or behaving blindly as a herd. Most of all, the hedge fund industry suffers from a PR problem, as will any industry which is inherently complex. Unfortunately, so many features of this industry cannot be overly simplified, try though the mainstream press might.

p/s photos:Dhini Aminarti