| Sandra Manzke | ||||||
It’s almost as if Long-Term Capital Management had never happened. Three years ago, the very mention of the term hedge fund was enough to have most investors running for cover. The spectacular collapse of LTCM caused such a furore that anyone calling themselves a hedge fund manager was liable to be held in the contempt usually reserved for politicians, lawyers or journalists.
Today the story is very different. Hedge funds are the saviours of investment, at least according to those whose job it is to sell them.
“A broadly diversified portfolio of hedge funds can provide double-digit returns at bond level risk,” says Josh Weinreich, head of hedge funds at Deutsche Asset Management.
Deutsche is setting an ambitious target to become the number one player in funds of hedge funds. These vehicles offer investors, for a fee, access to a bundled-up package of hedge funds. Initially they are aimed at medium-size pension funds that might not have the expertise or available assets to invest in individual funds. Jupiter Asset Management is the latest firm to launch its fund of funds product in London with a 7.5% performance fee, plus 1.5% administration charge.
Firms such as Deutsche and Jupiter hope that institutions will continue to pour funds into these products. At this stage, things are certainly moving in the right direction. Research by Tremont Tass in London shows that hedge funds have never been so popular. In the second quarter of 2001 net inflows were $8.4 billion – more than in the whole of 2000. Even September 11 has not stemmed the tide as $6.9 billion flowed in during the third quarter and Sandra Manzke, Tremont’s co-chairman and co-CEO, expects even higher numbers in the last quarter as fears of September 11 fallout subside. “We didn’t have any clients that lost money,” says Manzke. “Everyone who has been in hedge funds during this very volatile period is very happy that they didn’t look at their statements on September 30 and get a bad surprise.”
Nicola Meaden, recently departed CEO of Tremont Tass, says there is a clear reason for the current hedge fund mania. “Investors have finally realized that the 10- to 15-year bull market is finally over,” she says.
Meaden says investors are turning to alternative sources for returns. “They are not looking for outrageous performance,” she says. “What they want are steady returns with low risk. We expect asset flows to be positive and it really is across the board. It used to be predominantly high-net-worth individuals and now it’s institutions too.”
Transparency issues
There is still a big stumbling block to greater institutional investment in these funds: the need for more transparency in the market and the education of investors.
The original true hedge funds are ones where risk is hedged and managed. Unfortunately for the hedge fund community, it got a bad name from rogue funds taking large macro bets, or getting their hedges wrong, as did LTCM (see page 107). This has left many people wary of the whole sector.
“Hedge funds historically offered less transparency and consistency in the investment process,” says Deutsche’s Weinreich. “You don’t have as good information and in many cases they’re more complicated because they’re more opportunistic so they are long, short, they’re looking across markets and instruments so it’s more difficult for the average investor to look at the portfolio and know exactly what is happening.”
Weinreich says the industry is trying to change things. “So what we’re doing is chipping away at that by increasing transparency everywhere we can,” he says. “By improving liquidity, by being clear. If you think of all the aspects of hedge funds that make them more of an emerging asset class and the thing that institutional investors take comfort from in terms of understanding and systematic process, we think making hedge funds more systematic and more transparent will give investors greater comfort.”
He draws a comparison with traditional investing where investors are comfortable with a systematic investment process. “Because that process can be articulated, investors can scrutinize, evaluate, monitor and feel like they know what’s going on,” he says.
Meaden agrees that institutions need to be aware of what they’re getting involved with and shouldn’t just look at the returns the funds have been generating. “Investors must always understand what they are investing in,” she says. “They shouldn’t just buy performance.”
Funds of funds on the rise
Alain De Coster, managing director, alternative investments, at Credit Suisse Asset Management, says that increasingly information is available from an industry that was well known for its secrecy. “Transparency has improved a lot over the last three or four years,” he says. “People who are really in the business to stay are not afraid to explain to people what they’re doing.”
| Josh Weinreich | ||||||
Hence the rise of the fund of funds industry, which adds gatekeeping to the process and seeks to give investors a smoother ride.
The latest research by Goldman Sachs and Frank Russell into alternative investing by institutions suggests that most of those looking to make a first move into hedge funds will do it through funds of funds.
As a result, it is logical that Deutsche and other firms from traditional fund management and investment consulting backgrounds are developing these businesses. De Coster says when he first set up his fund of funds business in 1994 he encountered quite scathing criticism but the opposition has caught on to his way of thinking.
“At the time people were looking at us and saying: ‘you’re just charging a fee on a fee, why would you buy into that?’,” says De Coster. “In fact what we were doing at the time was creating a limited access to a very talented money manager format which is now recognized by many other investment operations as the place where they want to be.”
Certainly no one would be discouraged by the progress of his business. In 1994 he started with $30 million in seed money. Today he has $3.3 billion under management.
Of course it doesn’t impress everyone. One marketing head at a traditional London investment house sneers: “Funds of funds, now that’s an easy business to be in. Take someone else’s product, box it up and sell it on for a tidy fee? Nice.”
However, as Weinreich argues, this approach does offer the sort of risk and return profile that institutions look for. Hedge funds do not simply short stocks. There are many other styles, including long/short, arbitrage and event-driven funds. Building a mixture of these into a portfolio will reduce the risk. “If you bought a broadly diversified cross-section of hedge funds, it doesn’t matter if you’re an individual or an institution, a reasonable expectation is to earn in the low teens, at 5% volatility. That’s what the market will give you,” he says.”It’s critical to have a broadly diversified cross section of hedge funds.
“If you invest in a single hedge fund, or even a single hedge fund strategy, you can have a lot of volatility. That stems from a number of things. Many strategies are cyclical, many are impacted by market dynamics. Then there is event risk, which has led some fund managers to experience dramatic under-performance. So if you’re investing in a specific hedge fund then you shouldn’t look at that as low risk or low volatility. A diversified cross section will have modest risk.”
Retail money to come
Weinreich says hedge funds are one area where the value was discovered by individuals and it is institutions that are still catching up. In 1990 institutions held only 4% of hedge funds, today they have around 25%. “As institutions get comfortable that hedge funds are a legitimate asset class, it will add many more dollars into them,” says Weinreich. “The trend is happening and it will continue.”
De Coster says that though interest is growing it has still to translate into full investment. “There is a big difference between the interest that institutional money shows for alternative investment right now and the real money invested,” he says. “Most of the institutional investments are rather new. There is enormous interest from institutions and all the people that normally cater to institutions, namely the consultants.”
However window shopping does not always lead to people putting hands in their pockets. The main obstacle to this is a certain degree of lack of understanding. “Most of them have not put their toes in the water, because people have a problem of how to evaluate most of these investment strategies because they’re outside the normal boundaries of traditional asset management,” says De Coster.
He argues that hedge funds suit the more clued-up investor and are more suitable for institutions rather than retail investors. “The more sophisticated the investor, the better the relationship. People really need a good grip on the risk involved in the investment strategy before they go into it,” he says. “The biggest problem is that a lot of these strategies are based on track record, or pro forma track record where people look at risk as a measure of given volatility of the return over the last 12 months to three years. It doesn’t tell you what risk has been taken to get these returns.
“Therefore you need to be sophisticated to understand that the volatility of returns sometimes doesn’t match the risk. You have to understand the economic and financial environment when you took these risks.”
So all is well and good when people fully understand what they’re investing in. The problem comes when people simply pile into hedge funds because they think they’re offering easy money.
Sound like a familiar story? Certainly the alarming rise and fall of the dot coms and other tech stocks was precipitated by individual investors following where other investors had already trod, believing the hype that fortunes were there to be made by all.
As one leading investment bank’s global head of equity capital markets, says: “It looks very much like another tech bubble blowing up in front of us. People really should be aware of the risks.”
As the equity head points out, more and more money piling into hedge funds creates problems: are there enough good funds around to accommodate all the new money? With ever-increasing numbers of funds in the market, can the fund managers still successfully pursue their investment strategies? And if portfolio managers continue to leave traditional investment houses to set up their own hedge funds, will the brain drain harm mainstream fund management?
Investors should be well aware of the risks. For once the institutional pension funds have blazed a trail into the market, they will inevitably be followed by retail money. These investors may be at the most risk, tempted by the idea of large returns. As the equity head says: “People really should take into account what happened with the tech bubble and be aware of the risks involved.”
Meanwhile Morgan Stanley’s Barton Biggs has warned against the dangers of what he terms a hedge fund mania. “The mania is worrying because the money flow is accelerating,” he wrote last year. “Several corners of the industry, particularly convertibles and long/short strategies, show signs of severe overpopulation, which means returns are narrowing. Remember Long-Term Capital Management?”
On top of that, a new report by Harry Kat and Gaurav Amin of the University of Reading says that 60% of hedge funds blow up within five years. They add the caveat that the numbers have been skewed by the Asian and Russian crises of 1998. But data on hedge fund returns is subject to survivor bias.
Poor returns
Of course what is spurring the new surge of interest in hedge funds is the recent poor returns from traditional investment managers. The bull run of the 1990s has been replaced by something that some investors had never before experienced: negative returns.
As Deutsche’s Weinreich says: “One of the reasons that it is even more frenzied is that the equity markets have stopped going straight up and they’ve moved down and people have become much more focused on absolute return investing. You’re seeing allocation out of equities and into hedge funds.”
As markets have fallen, both active managers and the passive managers that track the indices have suffered and in highly volatile markets hedge fund managers able to short stock have thrived. “So people are looking at it more and more because of what happened to traditional equity asset management strategies that have had a very difficult time over the last year and a half,” says De Coster, who adds that the situation has been magnified by the fact that other alternative investment strategies, such as private equity, which were previously gaining popularity among institutions, have also gone through a difficult period.
At Gartmore, Graham Martin, a director in the hedge fund business, says institutional investors are bound to be attracted to alternatives as their existing strategies produce negative figures. However he warns against treating them as a guaranteed solution. “The downside can vary quite considerably,” he says. “There are huge issues which need to be considered by the investors.”
But Meaden adds that investors can take an added degree of comfort from the fact that managers normally have a high degree of personal interest in the performance of their funds, beyond the obvious fact that it is how they make their living. “Most hedge fund managers are rational individuals and almost all of them have almost all of their liquid net worth invested,” she says. “So if they make a mess they feel the pain as much as clients do.”
Meaden says people should not be swayed by the certain air of mystery that surrounds the hedge fund community. “They have a medium to long term perspective,” she adds. “They are investing in totally traditional assets and securities, they are just using non-traditional methods and the biggest of those methods is going short.”
Some investors may wonder about the wisdom of hiring hedge fund managers whose investment strategy may involve shorting and possibly driving down the share price of stocks that they hold in their traditional portfolios.
Meaden concedes this point but says seemingly opposing strategies can be accommodated. “If you have a fund manager and you have a hedge fund manager as well, how do you square that with your client, since once is long only and the other is shorting?” asks Meaden. “Any business with two revenue streams has a potential conflict of interest. As long as you disclose how they operate and integrate then there should be no problem.”
Mainstream investment houses have been promoting their hedge funds because of the problems in traditional products. “If you are a marketing or sales person over the last 15 to 18 months you could have been struggling,” says De Coster. “You didn’t have much to sell. All the track records are somewhat damaged. It has been a tough time to sell anything.”
Consequently they have turned their attention to selling hedge funds instead. “All the high-fee business that you could sell in the previous seven years is not available so you see all these high-powered professionals looking for the hot thing. They look at hedge funds and funds of funds and they see it’s still working and they can still charge a good fee on it, so they go for that.”
The new mainstream
So as hedge funds become more widely accepted, Meaden argues against fears of a bubble and says instead that they will simply be another part of everyone’s portfolio. “It may be within 10 years’ time,” says Meaden. “Hedge fund techniques will develop. They will become part of the mainstream. There will be some who want long/short, some who want long only and it will become very boring.” She adds that there is also plenty more room for more funds. “This investment strategy has been around since the 1940s and 50% of assets are in long/short equity where managers are buying stocks they like and shorting stocks they don’t. As long as the equity markets continue to expand I don’t really see how long/short managers will run out of capacity.”
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Weinreich also says hedge funds will increasingly be seen as mainstream. “I don’t think it’s a fad but I do think over time there won’t be anything called hedge funds, there won’t be traditional and alternative investing,” he says. “What will happen is they will merge together and they will simply be unconstrained or efficient investing.”
Nevertheless even proponents of hedge funds are concerned about the increasing demands on existing players. CSAM’s De Coster says the demand for access to hedge funds necessarily means money will be spread more thinly. “Take the private banking networks. The large private investors want to have a certain percentage of their assets in hedge funds. The head CIOs for private banks say they want 5% or even 10% in alternative investments,” he says. “That magnitude of assets is going to have a negative effect on the industry. Meaning by that, that as you search for talent, talent is not a commodity: money is a commodity and there you have a mismatch.” He warns that this will mean lower returns for all with the overall quality of fund managers down from three years ago.
Gartmore’s Martin says a parallel can be drawn with the large sums of institutional money that started to pour out of active management into index tracking at the end of the 1990s. Questions were raised then too about whether the flow could be coped with. “There are always concerns about how much money can be invested in a sector and these things tend to reach a saturation point,” he says.
Missing the boat
But the concern for those people trying to get in on the act is that they may already be too late. It’s often true that once an investment trend becomes very popular, it’s probably past the best time to be involved, since the best opportunities will be gone.
This seems true of hedge funds. “There is definitely a huge capacity issue,” says De Coster. “A lot of the good funds are closed.”
Added to this he says that those people monitoring funds have less time to do so because they close faster with the increasing sums of money flowing into the sector. “You’re not sure if they’re good or not because you can’t evaluate them. People have six months of good performance and they’re closed so you don’t know if they’re still going to be good in a year or two from now.”
If someone is setting up a new fund, says De Coster, and has a good business plan, a good résumé and approaches the investor base intelligently they will raise money faster than they would have done five years ago. “It doesn’t mean that they’re up to doing the job,” he warns.
Indeed, as the Reading University report says, there is an increase in hedge fund failures now as the sector expands and more fund managers try their hand at it. It may be that this is yet to impact on analysis and performance of hedge funds over three to five years. There is criticism from some quarters that analysis of performance and returns for hedge funds may sometimes conveniently concentrate only on the survivors and ignore the failures.
New investors should be aware of these issues, says De Coster. “In a way they have already missed the boat,” he says, adding that there is another issue to consider. Previously when there were increased flows to traditional asset management vehicles and index funds, hedge funds took advantage by arbitraging mutual funds flows and looking at opportunities stemming from the huge increase in money going into equities or technology.
“That was great for them because they were more flexible and could use the opportunities better,” he says. “Now these flows have gone in the opposite direction because so many funds have lost money by attrition and redemptions that these natural flows are not there any more. There is less liquidity in the market. So you see more that hedge funds are trading against each other, making it more difficult to manoeuvre than it was a year ago.”
De Coster says he is more concerned with looking after return for his existing clients than expanding the business. “I want to keep the integrity of my investment process and maintain the highest quality possible. We try to make money in good environments and we tell clients in difficult environments not to expect us to make a lot of money,” he says. “It’s more important to protect the asset base to be ready for the next good environment. That’s always the concept.”
With that in mind he has been able to refuse mandates during the recent rush despite requests from CSAM’s marketing team. Now the boot is very much on the other foot. “I remember at the end of 1998 I was screaming for money thinking there was a huge amount of fantastic people that we could give money to and I was not getting any response,” he recalls with a wry laugh. “Then after a good 1999 and a great 2000 suddenly people don’t raise any questions, they just say ‘here is the money’ and I say ‘I don’t want it any more’.”
Deutsche’s Weinreich says that investors should still look at hedge funds, though not simply as a source of extra returns but because they can help to diversify a portfolio. “They are tremendous in terms of their portfolio impact because of their relatively low correlation to major market indices,” he says. “Once institutional investors have locked into that and then done the maths they will want to allocate 10% to 15%.”
However, he also warns that funds must be prepared to move quickly. “The first movers will be able to allocate that 10% to 15%. But the best fund managers, many of them are closed, many will close when they feel they have taken an appropriate number of assets relative to the opportunities in their strategy. The folks who are late to the party will be chasing managers and chasing returns.”
This lends an element of urgency to institutional managers that are still deciding whether to get involved. So the ones that have decided are really trying to move quickly because they want to go ahead and lock in investments with good managers who currently have capacity.
Then as the most popular funds close, more managers will open new funds but it will take time for them to build a track record and prove themselves, says Weinreich before Deutsche will be prepared to put them forward. Above all, he says, demand is going to exceed supply very shortly.
Watch out for the cowboys
So as more and more fund managers enter the market looking to scoop up a piece of the action, inevitably the overall quality of funds is likely to suffer. Again Morgan Stanley’s Biggs has some cautionary words.
“Unfortunately, the successful hedge funds with records are mostly closed because their managers have become very rich and also know that their strategies are not scaleable,” he says. “A lot of money is therefore going to the apprentices who worked for the old masters. A young person with a decent résumé can raise $300 million and, if he hits in the first year, he will have $1 billion in a flash.” He does not have a great deal of faith in some of the fledgling managers. “A lot of small hedge funds are being opened by incompetents – fortunately most of the money they will lose is their own.”
Another warning worth taking seriously comes from one of the leading lights of the hedge fund industry, Clifford Asness, who runs AQR Capital Management in New York. He has also argued against raising expectations on hedge funds. “Hedge funds have been oversold as an asset class that’s a miracle,” he said.
His argument is based on looking at seven years of returns from the CSFB/Tremont hedge fund index. He contends that the industry has severely underestimated the correlation of its returns to the overall stock market and therefore has overestimated the value of those funds. If you take away the cost of the more glamorous but far more expensive hedge funds, the average investor would have fared better, taking risk adjustment into account, with a standard equity index than the index of hedge funds.
Having seen the mother of all bull markets in recent years, there is a view that hedge funds may not have added all that much value through their own skill and simply hitched a ride, inflating returns through illiquid securities. If a stock is not trading then it will make a portfolio seem less volatile and correlated.
The AQR study adjusted returns allowing for illiquid securities and the correlation of the hedge fund index rose while its relative risk-adjusted performance fell to somewhere around the level of passive index funds. Those arguing against the theory say AQR makes too much of the effect of these illiquid securities.
While Asness’s theories unsurprisingly drew criticism from the hedge fund world, suggesting they were designed to raise the profile of AQR, there is a common view that more industry-wide comparison and research is essential for the future health of hedge funds.
Some funds are exceptional, says Asness but most are merely average, reiterating Biggs’s point of view that anyone launching Joe Bloggs’s hedge fund will be able to attract interest in the current market.
A role for the regulators?
Meaden concedes that there are some bad funds out there. “In the universe, some funds are very good, a huge majority are average and some are awful, though they don’t tend to last long,” she says, though she adds: “It is rare to see a fund completely blown out of the water.” It’s important to get good advice to separate the good from the bad, she says. “A rising tide lifts all boats. That is why they pay specialist advisers to keep them out of trouble.”
She also takes issue with those who say that hedge funds should be better regulated and more like mainstream fund management. “There is a lot of regulation, depending on jurisdiction,” she says. “You can’t do it in the UK unless you’re registered with Imro, or the SFA. As a result you’re bound by the same rules as any other asset management company. In the US, if you want to pursue Erisa money, you have to be SEC-registered.”
As long as the industry does a good job of regulating itself, it won’t become necessary, she argues, adding there are more risky investments to be found in the mainstream market place. “How can it be more risky than investing in an emerging market fund?” she asks.
Despite this there are still concerns among many market players that unwary investors will simply buy into the hedge fund story, believing they will get rich quick. Anyone failing to heed the lessons of previous bubbles could get a nasty shock.
As one market player says: “When I first got involved with hedge funds seven or eight years ago, I spent my whole life trying to explain to people that hedge funds were going to grow and they weren’t all bad guys. In fact they were probably the brightest and most diligent fund managers I spoke to. Now I almost feel like I’ve got to argue the other case, that they’re not all good guys. We probably haven’t got to that point yet but the industry will continue to grow and you’ve got to be pretty sceptical about some of them.”
Keeping the troops happy
No sooner had he been released from the recent court case between Unilever’s pension fund and Merrill Lynch Investment Managers than Alistair Lennard was revealed to be setting up his own business.
Little is yet known about Magna Investments but it is expected to be a hedge fund and that would surprise no-one.
Barely a week goes by without some name from the traditional fund management world setting up a hedge fund. Other names to follow this path include Tony Dye, the former head of Phillips&Drew. There are many others, on both sides of the Atlantic.
As one senior director in a traditional investment house in the City says: “I think there’s a bit in all of us which likes the idea of setting up and going it alone. Look at the returns you can make. Of course it’s tempting.”
It’s a worry to anyone running a fund management business that all their bright young things with a few years of success under their belts think about going it alone. After all, if you lose all your best fund managers, you lose all your intellectual capital – the very essence of any financial services firm.
It is a logical move then for firms to launch their own hedge fund divisions in-house and give high-flying fund managers an incentive to stay.
A clear example of the success of these systems can be seen at Gartmore where Roger Guy set up the firm’s first hedge fund, the AlphaGen Capella in late 1999. Since then the fund has produced an impressive track record and with $1 billion of assets, it is now closed to any new investors. It has added further funds to its stable, including AlphaGen Avior, a UK equity long-short fund run by Ashley Willing and Simon King. It has around $2 billion across 16 funds.
Gartmore has about $50 billion of assets under management today. It’s hedge fund business forms only $2 billion of that but is seen both inside and outside the firm as increasingly important.
“The firm would hardly deny that it has slipped some way from its position as one of the big five UK fund managers,” says a London rival. “They’ve been caught and overtaken by others but Roger Guy and the rest of the hedge funds business is certainly making waves for them and gaining them a certain amount of kudos. Any firm would welcome that.”
Graham Martin, a director at Gartmore, says the business is growing steadily but the firm is keen to preserve returns for existing clients. “It’s important to maintain credibility and not just take on money for the sake of it,” he says.
Nicola Meaden, recently departed from Tass Tremont, says it makes sense to keep staff happy. “If you have talent and you want to keep it then the best way is to set up hedge funds divisions within your organisation,” says Meaden. “Because if the fund managers are good then you can bet your bottom dollar there will be people who are out there looking.”
However, she adds that looking after egos and different levels of compensation is always a tricky balancing act. “Looking at some of the institutions who have done this, there isn’t a standard model,” she says. “I can see quite a lot of jealousy and resentment if you don’t get it right, given the incentives and different pay structures.”
LTCM: a cautionary tale
In 1998 around 5,000 hedge funds had some $200 billion to $300 billion in investment capital. Today hedge funds are estimated by some sources, including Tremont Tass, to total $650 billion. The market estimates that this will double in the next three to five years.
| Paddy Dear | ||||||
Before its fall from grace in 1998 Long-Term Capital Management was almost ridiculously highly leveraged and though it was producing returns of 40% a year at its height, living at such high risk levels was always going to leave it vulnerable to any downturn in fortunes.
LTCM’s collapse was spectacular and coloured many people’s views on hedge funds for some time. Indeed some of that antipathy towards the asset class still remains today. However it is worth remembering that most funds do not seek to occupy such dizzy heights, preferring to take much lower risk and aim for more conservative returns.
Ultimately what did for LTCM was leverage. On an asset base of $4 billion it was trading $125 billion. “When LTCM blew up, many feared that it was the tip of the iceberg,” says Paddy Dear, global head of hedge funds at UBS Warburg. “Even before the sharp decline in their assets, their leverage was about 200 times.” By comparison most fixed income arbitrage funds use 30-40 times leverage while convertible bond arbitrageurs use five to 10 times and long/short equity funds use one to three times.
“So in terms of leverage, and therefore total assets on the table, they were such an outlier that they didn’t represent the hedge fund industry in the slightest,” says Dear. “They represented a very bizarre trading entity and that’s still not very widely recognised or understood.”
In today’s market the gatekeepers, funds of funds managers and investment consultants, who will push the most money towards these funds in the future are looking for managers to show real skill, not simply produce returns on hefty borrowing.
Alan Brown, chief investment officer of State Street Global Advisors, argues that the new era will give fund managers the opportunity to show their skills. “What hedge funds managers need to be able to convince their clients of is that when you take the restrictions off them and give them less fettered mandates, that they really are able to demonstrate skill and not just the effects of leverage,” he says.
Deutsche Asset Management’s Josh Weinreich, who is leading the firm’s push to be the number one fund of funds provider, argues that a diversified portfolio, across several funds, each following different strategies can provide steady outperformance while still avoiding any of the traumas associated with LTCM.
“Pick a year that you think is the most bloody ever for hedge funds. You’ll probably pick 1998,” he says. “A broadly diversified portfolio of hedge funds came in at plus or minus 5% that year.”
