Hedge funds regularly close or return money to investors, so the decision last month by David Muschel to return capital to investors in his Jemmco fund ought to have been unexceptional. But the explanation he gave gives pause for thought. Some of the fund’s strategies, he said, simply cannot perform in today’s environment.
He singles out decimalization, low volatility and ?enormous pressure to deploy capital to hedge funds that, once modest in size, have grown to billions of dollars in assets, many competing to exploit the same inefficiencies. I can see that the history of compressed opportunities is going to continue for more time than many of us have the patience to wait.?
Could it be that there are too many hedge funds? It could be merely a function of the low volatility that has beset the market for much of this year. But even when opportunities do come along there are so many players waiting to take advantage that spreads soon dry up. Merger arbitrage is a case in point. Fewer mergers and many more players have led to any opportunities quickly disappearing when mergers are rumoured or announced, although it is one of two strategies, along with credit structure arbitrage, that Muschel still sees value in and will still run.
Other managers wonder whether the growth of hedge funds has introduced so much smart money that it actually acts as a stabilizing influence, eliminating the volatility it is seeking to exploit. And as hedge funds take on more assets and exert greater influence, more long-only managers realize that they cannot ignore them. That could mean setting up internal hedge funds, or altering the rules to allow long-only funds to go short, which would further increases the pool of short-term smart money.
Some fear that lower returns for hedge funds might have more serious implications ? for example, style drift as hedge funds search for any way of increasing returns, or of trying to increase leverage. In one or two strategies it could cause a crisis: many convert arb funds, for example, might hold similar positions in converts, so there might be margin calls, mass selling and a converts crisis.
Few expect an LTCM-style crisis, though. A more likely consequence could be a push for lower hedge fund fees. If the funds can only provide returns similar to regular money managers’, they should only get paid for that.
Saving grace for equity capital
One group that has done well out of hedge fund growth is the investment banks. It has been one of the few boons for banks’ equities departments during the triple whammy of the bear market, the research scandal and falling trading fees. According to a report last month by Smith Barney financial services analyst Ruchi Madan, hedge funds account for at least 20% of trading volumes, and about 30% of cash commissions. They also place more value on bank research, allocating 35% to 40% of commissions to research as opposed to 30% to 35% by traditional money managers.
Some banks, of course, do better than others. The top two houses, Goldman Sachs and Morgan Stanley, says Madan, earn as much as 40% of their cash commissions from hedge funds. Add in fees from their prime brokerage services, such as derivatives, stock lending and interest spread on borrowing, and hedge funds account for 35% to 40% of all equities revenues at these two firms. At Lehman, it’s 25% to 30%, and at Merrill 10% to 15%.
Hedge funds’ willingness to pay for such services has had an impact on banks’ relationships with traditional asset managers. Noting how profitable hedge funds are, banks have been re-examining their traditional customer relationships and found many to be unprofitable. Many fund managers, says Madan, seem receptive to the banks’ desire to change the economics of the relationship. The banks have the hedge funds to thank for that.
