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In April, two of the greatest gunfighters in hedge fund history said they were throwing in the towel. George Soros announced he had decided to turn his mighty Quantum Fund, after 30 years of spectacular growth, into an endowment fund for his charity work. His star dealer, Stanley Druckenmiller, admitted that the game was over: "We just overstayed our welcome," he was quoted as saying, "we thought it was the eighth inning, but it was the ninth." He has quit Soros to run his own fund. Julian Robertson, whose $20 billion Tiger Fund along with Quantum once scared presidents and central bankers around the world, is unwinding it, having veered off course into the shares of US takeover targets.
Although these are only two in an industry of over 5,000 hedge funds, they mark the end of an era. The global macro fund manager still exists. Louis Bacon still runs the $9 billion Moore Capital, and Paul Tudor Jones still puts his billions into currency positions, although both have given capital back to their investors. But few expect to see again those great directional plays of the 1990s when the war-cry "Hedge Fund Attack" encouraged armies of speculators to join in and punish governments that thought they could implement non-market policies.
Such funds have fallen out of favour with end-investors since the dramatic collapse of Long-Term Capital Management in 1998. Their reputation was tarnished. Investors concluded that their strategies did not incorporate hedging, or risk management, at all. Of course, the other 4,996 hedge funds aren't like that: they are almost the opposite, since they tend to pursue one of twenty-or-so diversified strategies to achieve an absolute return.
Hedge fund specialists have faced another challenge. The world has changed in ways that make big macro bets harder to place. Since the breaching of the Berlin Wall in 1989 the western and eastern economic blocs have been converging. Since the advent of the euro in 1999 the great convergence plays on European interest rates have evaporated. The sheer size of these macro funds had become an embarrassment, whereas before investment banks and wholesale currency dealers had followed the macro hedge funds into battle because size and fire power were important.
The other attrition factor on Soros, Druckenmiller, and Robertson was hubris: the feeling that they were invincible. They got into territory they didn't know. With Soros it was the new technology, which he first shunned then invested in at the wrong time. Robertson, having misread the yen (his territory), tried to recover by buying big chunks of US takeover targets, including a 25% stake in troubled USAir.
Soros in a letter to shareholders at the end of April admitted: "We have come to realize that a large hedge fund like Quantum Fund is no longer the best way to manage money. Markets have become extremely unstable and historical measures of value at risk no longer apply. Quantum Fund is far too big and its activities too closely watched by the market to be able to operate successfully in this environment."
And it's not just hedge fund managers who find today's markets perplexing. Even Warren Buffett, the great value investor whose investment vehicle Berkshire Hathaway made some spectacular calls on US stocks, admitted defeat after last year. (In his 1999 letter to shareholders chairman Buffett took it on the chin: "We had the worst absolute performance of my tenure and, compared to the S&P, the worst relative performance as well ... Even Inspector Clouseau could find last year's guilty party: your Chairman.")
It would be foolish to predict that a battlefront of speculators will never attack a vulnerable economic policy again. For example, how invincible is the fortress around European economic and monetary union? But 4,000 hedge funds won't lead the attack - they never have. It is a fragmented industry that thrives on diversity - and it tends to be micro, not macro. The average size of hedge funds has been shrinking, from around $135 million a year ago to $93 million, according to MAR/Hedge, which monitors 1,300 hedge funds.
Hedge funds, following classical hedging principles, tend to follow market neutral or arbitrage strategies rather than take directional bets. Of the 20-or-so most popular hedge fund styles only a couple are directional: global macro (betting on major international economic trends) and short-selling (betting that the equities in which it has net short positions will fall in price). Because their strongest distinguishing feature is the ability to go short, most hedge funds are designed to continue to make money in down markets as well as up. But that limits their optimum size: if they are trading cash against equity futures, for example, there is a limit to the size they can deal before the market moves against them. As established hedge funds reach or exceed optimum size there is an incentive for more hedge funds to spring up and find their own niche in the market.
More and more investors, perceiving that such flexibility is more promising than being stuck with long positions in bonds or equities, are being tempted to invest in hedge funds. Traditional fund managers, such as GAM (Global Asset Management), Mercury Asset Management, Gartmore, Schroders and AIG, are starting to construct funds that look and behave like hedge funds. The attraction to the managers they employ is that the fees tend to be higher. A hedge fund manager will typically charge a 1% to 2% annual management fee and take 20% of the net return above an agreed benchmark (some level above the risk-free rate of return). Some hedge fund performances justify this fee. Most don't. But traditional fund managers risk losing talented staff if they don't provide them with this outlet. "An individual doesn't need an institution any more," says a fund of funds manager, "the process of leaving big firms and setting up your own hedge fund will become institutionalized. There will be shops where you can go. You're basically a contract trader - but you have to give up a lot of the income. It's basically a skill swap."
Some prime brokers virtually offer this kind of arrangement. They do everything except take responsibility for the investment decisions. And there are the enabling agencies too. Dynamic Offerings Inc will start you off, for an upfront fee of $20,000, provided you have an initial $2 million to invest in an offshore fund. Its website advice includes the exhortation "Get FAT!" and claims: "Each year about half of the top 20 names on the Financial World list of Wall Street's highest-paid professionals are hedge fund managers."
The bad news is that hedge fund managers in general are no better than any other group of investment managers at outperforming indexes. In aggregate they are more likely to get it wrong than right, although of course there have been some spectacular performances by individual hedge funds.
A recent London Business School study with a sample of over 500 hedge funds found little persistence (consistency) of performance over more than two three-month periods. And where it does find consistency, the performance is more likely to be bad than good. That seems to reflect simple trader psychology: a winner will tend to stick to his strategy until he loses; a loser will tend to switch strategy to another one that loses. Vikas Agarwal and Narayan Naik, in their paper Multi-period performance persistence analysis of hedge funds, investigate hedge fund performance from January 1982 to December 1998 and conclude that "persistence among hedge fund managers is primarily short-term in nature [less than a year]. Whenever persistence is observed it is mainly driven by losers continuing to be losers instead of winners continuing to be winners" apart from a few good managers who "consistently outperform their peers over long periods". Selecting the right manager becomes a "very important issue", they say.
But hedge funds can produce spectacular and tax-efficient returns. It is this promise that encourages investors to seek out the best performers, or to find managers of funds of funds who can do the selection for them. It is decisions on manager and hedge fund sector and style that are crucial, along with timing, since even the best managers go through their winning and losing cycles.
All eyes on correlation
A Commerzbank study on hedge fund performance, using data from Hedge Fund Research Inc, suggests that only a few hedge fund styles show close correlation with mainstream markets such as US government bonds, the S&P500 or Dax indexes. Among the most correlated are the macro funds, the equity hedge funds, merger arbitrage and the sector funds, while those negatively correlated include the short-sellers and fixed-income funds. Van Hedge Fund Advisors, which tracks 4,600 hedge funds, shows in its figures on US hedge fund returns that hedge funds in aggregate are less volatile, with a more promising risk/reward ratio, than standard indexes such as the S&P500, the MSCI World Index, and the Morningstar Average Equity Mutual Fund Index. The hedge fund styles that are more volatile are the macro, aggressive growth, emerging markets, the opportunistic, and the short-sellers. Short-sellers have had a rough ride in 16 years of bull markets but that doesn't disqualify the strategy.
Increasingly, the measure of a hedge fund's performance includes some measure of its risk/reward ratio - the investment's return above the risk-free rate divided by the standard deviation (volatility) of the return. The most often used measure is the Sharpe ratio, but some analysts feel the measure should be asymmetric, penalizing the volatility of losses, but not the volatility of excess returns. The VanRatio developed by Van Hedge Fund Advisors calculates the probability of loss. "Risk of ruin" is also a useful concept, a calculation of the probability of a fund losing more than 50% of its value.
Even taking sometimes superior risk/reward ratios into account, few hedge fund styles have done much better than the 19.1% annual average achieved since 1988 by the S&P500 index. Given that hedge fund investing is such a jungle, and buying the S&P index is rather simple, the rewards should be higher, or investing in hedge funds should be made less hazardous.
To some extent this is happening. Since the fallout of Long-Term Capital Management (LTCM) in September 1998, and one or two other well-publicized hedge fund crashes, regulatory authorities and multilateral bodies have demanded more transparency from the hedge fund industry, and from the prime brokers that finance it.
Some hedge funds hate the idea of transparency, since they fear their positions will be punished by the market. Bacon of Moore Capital in April berated excessive transparency as one of the tell-tale signs that a fund might be in trouble. He also feared that funds whose trades were known were vulnerable to "copycat" investment, and front-running. That may be true of some macro funds with big currency or bond positions, but it is less of a danger for the average-size hedge fund.
Hedge fund managers have traditionally been secretive. However, since LTCM, investors and prime brokers have been asking more questions, and getting more answers, about a fund's aggregate risk position, its leverage, liquidity and the overall extent of its portfolio.
The prime broker relationship is crucial to most hedge funds, because hedge funds raise money to borrow securities and leverage their positions, by posting cash or securities as collateral with the broker.
In the past some brokers were so keen to see this business that they would lend hedge funds money without security. No longer. Prime brokers will seldom take credit risk on hedge funds now - they require collateral to cover all market and credit contingencies. Moreover, leverage is not what it used to be. Although some prime brokers are saying leverage is back, equity funds are typically leveraged no more than 1.6 times their capital and bond arbitrage funds around three to five times. LTCM, with the help of the interest rate swap market and zero initial margin, was leveraged around 300 times.
Hedge funds are keener to protect themselves against a prime broker pulling the plug in volatile markets. The most prudent have put medium-term financing lines in place, in case the value of their collateral is hit by the market, or more investors than expected call for cash redemptions. Says one prime broker: "Whereas before LTCM a manager would have almost blindly walked in, now they ask 'how will you treat us in volatile situations?' while as providers of cash we're asking 'can we see the whole portfolio?'"
Prime brokers are seeking to know more about the hedge funds' end investors, to judge how likely such redemptions are. And investors are more interested in the hedge fund/prime broker relationship as a guide to the durability of the hedge fund.
Since Manhattan Capital Management was exposed in January as a hedge fund with a hugely overvalued portfolio, the relationship between the fund manager, prime broker and the fund administrator has come under closer scrutiny. Bear Stearns apparently did not know that it had the distinction of being Manhattan Capital's only prime broker. If it had known, it would have been more alarmed at the losing positions it was financing, although they were covered by the appropriate margin.
According to SEC charges, Austrian-born Michael Berger, who ran Manhattan Investment Fund, was sending false reports to his auditor and the fund administrator in Bermuda. A number of Austrian banks were among those who suffered losses as the fund, officially valued at over $420 million, was revealed to have assets worth less than $30 million. Various investors, including Bank Austria, are suing Berger for their money.
A hedge fund usually tells a prime broker if it is the fund's only source of financing. The prime broker then has more right to know everything about the fund's portfolio.
But the quest for more transparency from hedge funds, and more liquidity to trade in and out of them, may ultimately be self-defeating. Hedge funds are naturally secretive. One reason is that many of them are looking for a trading edge. If competitors find out too much about their positions, the market inefficiency they have found will be arbitraged out more quickly.
However, last year the US Congress was threatening to regulate hedge funds. This year, with the heat somewhat diminished, there seems more readiness among regulators to press for what has been called "benign transparency" in which prime brokers' big non-bank counterparties are expected to disclose risk information, such as value at risk, concentration risk and hypothetical stress tests, without having to reveal their trading strategy. Five major hedge funds published a paper in February, Sound practices for hedge fund managers, making recommendations for risk measurement, stabilizing portfolios and helping to ensure liquidity in volatile markets.
It seems inevitable that more risk information will be required of hedge funds. This may take some of the mystique out of the industry, but there are still many obstacles to getting full performance and portfolio information.
Comparison of hedge fund performance is fraught with difficulty. Performance can be measured quarterly, annually or across any other time period. It is sometimes quoted pre-tax, sometimes after, sometimes net of fees, sometimes gross. Funds sometimes don't report performance until they've built up a track record, and they sometimes stop reporting if they have some bad periods. For funds invested in illiquid assets it may be impossible to obtain a market value, yet performance is measured on quarterly or annual net asset value.
Managers of several funds understandably tend to lionize the ones that do well. The bad performers don't get the same coverage, so there is a natural selection process at work - sometimes called survivorship bias - which makes the sector look better than it is.
Hedge fund managers often have their own capital at risk in the fund. But it must still be borne in mind that their incentives are slightly different. If they are rewarded quarterly or annually on the fund's performance above a high watermark there is an incentive to push returns over that mark, to the detriment of a longer-term growth strategy. As one fund of funds manager notes: "The fee structure of many funds encourages people to maximize profits at a certain time. The manager should in some way be at equal risk." As it is, he concludes: "He's like the doctor who gets paid in the middle of the operation."
If a manager runs several funds, how can you be sure he isn't allocating the good trades to one fund - cherry picking - to the detriment of another? "You can't be 100% sure about cherry picking," says the fund of funds manager. "You can talk to the fund administrator. You have to make a judgement call on the person." The best source of information on a fund's performance, he says, is the investor who is no longer with it. "If he's still there it means he likes the position."
That's assuming the investor can get out when he likes. This is another dilemma for the hedge fund manager and investor. The manager's worst fear is a flood of redemptions. He may have to sell his liquid positions, and be left with the least liquid assets.
Yet the investor feels he is safer if the fund can offer him liquidity monthly, weekly, even daily. For certain investment strategies that could be wrong. If the fund is invested in distressed securities or asset-backed instruments it could be sacrificing value by offering investors liquidity. Some managers insist on a lock-up of one year. John Meriwether's LTCM insisted on three years. "There's a lack of tolerance of one-year lock-up, especially in Europe," says a prime broker. "But if you're investing in distressed securities or event-driven stuff you shouldn't be demanding monthly liquidity."
There is a move among traditional fund managers to offer a hedge fund lookalike with daily or weekly liquidity. But, points out a prime broker: "If the liquidity of the underlying fund has at best monthly liquidity, and you want daily liquidity - that smacks of wanting to create a retail product."
UK fund of fund managers Momentum Asset Management and insurer Royal & Sun Alliance are planning just that. Says Momentum managing director Michael Goldman: "We're doing a unit-linked fund for Royal & Sun Alliance which offers weekly liquidity."
Then there is a drive to create another kind of liquidity: in the fund shareholdings themselves, by making them tradable, and by listing a tradable index so that investors and traders can protect their cash fund positions.
There are several competing indexes, including the Zurich HFR Hedge Fund Indexes created by a joint venture of Zurich Capital Markets and Hedge Fund Research; CSFB/Tremont indexes; Van Global Hedge Fund Index; and Morgan Stanley's MSCI Hedge Fund Indices developed with UK-based Financial Risk Management. Zurich/HFR, CSFB/Tremont and Morgan Stanley are developing investable products.
In the meantime there are two initiatives to get hedge funds traded on the Bermuda Stock Exchange. PlusFunds.com is aiming to encourage purpose-built and transparent hedge funds to list on the exchange. It will monitor each trade that the fund does (in strictest confidence) and produce a daily independent mark-to-market and risk profile. HedgeTrust Exchange, set up by HedgeWorld is offering tradability of existing hedge funds.
But fund of funds managers are sceptical that these funds will be tradable, for several reasons. First, one asks: "How wide would the bid-offer spread be, especially on the day you want to dump?" Second, most fund managers want to know who their investors are and to have an idea how they will react if the fund hits adversity. Some hedge fund managers have fired investors they weren't comfortable with, says Morgan Stanley's Shook. On the other hand hedge funds accept unnamed nominee investors via private banks.
Hedge funds will lose some of their mystique if they are successfully imitated or tracked by retail products. Yet the growth of online distribution of sophisticated financial investments makes that an almost inevitable outcome. It may be that regulation saves hedge funds from this fate, by keeping them just out of reach of the average punter.
But don't bet on it. Hedge funds have never been a sharply definable group. It is difficult to regulate them as an asset class. They are already being fitted into the broader category of "alternative investment". It seems only a matter of time before insurance companies, pension funds and other prescribed investment vehicles are able to benefit from the alternative investment universe. CalPERS, the California Public Employees' Retirement System, last August approved an investment of up to $300 million in hedge fund Pivotal Partners. "In the next 10 to 15 years the hedge fund industry will have been absorbed into mainstream fund management," predicts Nicola Meaden, director of Tremont Advisers. That allows plenty of time for more hedge funds to be born, flourish and die.
Leslie Rahl, principal of Capital Market Risk Advisors (CMRA) in New York, predicts convergence on a new investment model: risk allocation rather than asset allocation. "Enter risk budgeting," she wrote in a recent CMRA newsletter, "an asset allocation tool that works by defining an institution's risk appetite, identifying the risks associated with each investment, and then allocating a dollar amount at risk to each investment." This approach could fundamentally change how investments are selected, she says. It fits the noticeable trend among traditional investment institutions: that they are becoming less interested in beating indexes, more interested in absolute return.
HFRI - macro funds index - monthly performance %
HFRI - technology funds index - monthly performance %
HFRI - short selling funds index - monthly performance %
The main hedge fund styles
Global macro
Taking a directional view on major international economic trends
Equity market neutral
Exploiting anomalies between cash and futures positions in equity markets
Fixed-income arbitrage
Spotting pricing anomalies between bonds and other fixed-income instruments anticipating that their value should converge over time.
Emerging markets
Equity and fixed-income investment in developing markets
Long/short equity
Equity trading, using shorts, but with a net long position
Short-selling
Maintaining a net short position in equities and derivatives
Event-driven
Anticipating a corporate event, such as a merger or acquisition. Typically going long the stock of a takeover target and short the predator and the target
Distressed securities
Investing in the deeply discounted debt or equity of companies in financial distress, anticipating recovery
Convertible arbitrage
Investing in the convertible securities of a company, typically being long the convertible bond and short the common stock of the same company
Managed futures
Trading commodity and financial futures, often using computerized trading models
Literature and links
* www.plusfunds.com funds tradable on the Bermuda Stock Exchange
* www.hedgefund.net access to 1,400 hedge funds if you sign on, but no free information despite what it says
* www.hedgindex.com CSFB/Tremont Hedge Fund Index
* www.hennesseegroup.com advisory group founded by market veteran Ms Lee Hennessee
* www.hfr.com Hedge Fund Research, including indexes
* www.marhedge.com MAR/Hedge online newsletter and indexes
* www.hedgeworld.com Hedge fund community includes news, Tremont/TASS database and link with the HedgeTrust Exchange, an initiative to make funds tradable on the Bermuda Stock Exchange
* www.magnum.com fund of funds website, some good articles among the hype from Magnum chief Dion ("Neon Dion")Friedland
* www.thehfa.org Hedge Fund Association sponsored by a handful of members including Magnum and Van Hedge Advisors
* www.hedgefunds.org Dynamic Offerings encourages you to set up your own hedge fund and "Get FAT!"
* www.vanhedge.com Van Hedge Fund Advisors, includes good background material on hedge funds and their risk and reward
* www.hfmsoundpractices.com Caxton Corporation, Kingdon Capital Management, Moore Capital Management, Soros Fund Management and Tudor Investment Corporation pen their response, Sound practices for hedge fund managers, to the US president's working group's Hedge Funds, Leverage and the Lessons of Long-Term Capital Management
* www.hedgefund247.com new site promising to cover hedge funds 24 hours a day 7 days a week. Should we settle for anything less?
* Multi-period performance persistence analysis of hedge funds, by Vikas Agarwal and Narayan Naik, London Business School, working paper no 298, downloadable at www.london.edu/ifa/research/working_papers/working_papers.html
* Background note on the hedge fund industry, prepared by the IMF for the Financial Stability Forum highly-leveraged institutions group. www.fsforum.org/Reports/RepHLI.html
* Starting a hedge fund - a European perspective, chapters written by various experts. ISI publications, Hong Kong
* Hedge funds, an overview, December 1999. Commerzbank alternative investment strategies group, New York 212 703 4090
* Hedge fund risk management and practices, May 2000, a survey by Capital Market Risk Advisors, New York. www.cmra.com/html/publications.html
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