Hedge funds have become fashionable in the strangest places. For geopolitical insights, Tiger Management’s Julian Robertson now turns to a board that includes Margaret Thatcher and Bob Dole. When not rescuing wayward former Soviet republics or jousting with Asian potentates, Quantum Fund founder George Soros takes to the pages of The Atlantic Monthly and other highbrow journals to inveigh against the perils of postmodern capitalism. Paul Tudor Jones pals around with Bill Clinton, crusades on behalf of the environment and is often touted as a possible candidate for political office himself. James Cramer currently stars in a shoe commercial.
But perhaps the strangest new fans of the hedge fund are traditional institutional investors. Over the past eight months, major institutions have placed as much as $3 billion with them – a drop in the bucket by their standards (at last count, US institutions alone had $13 trillion in assets), but enough to account for almost 30% of the new money flowing into funds. College and university endowments, considered the shrewdest of the lot, are leading the charge. Last year, 87 of them – including such heavyweights as Yale, Princeton and Stanford – put some of their capital to work in hedge funds, up from 74 in 1996.
By some estimates, industry coffers have swelled to over $200 billion. Business is brisk on the supply side, too. There are now as many as 3,000 hedge funds worldwide and the list is growing as a brain drain from investment banks, brokerage houses, and mutual funds brings more funds into the fray.
And now the big money is coming. Pension schemes, like retail investors always last to spot a trend, are starting to make allocations to hedge funds. Weyerhauser, Eastern Kodak and IBM are among those known to have done so already. Their public-sector cousins are also beginning to knock on the door. The city of San Diego, for instance, placed $10 million with a hedge manager last year. Although this represents less than 0.5% of San Diego’s $3 billion in retirement assets, city officials say hedge funds could eventually comprise as much as 10% of its portfolio.
These institutions, unused to funds that don’t use benchmarks and unsophisticated in leverage and quantitative arbitrage, have sought safety in legends. For instance, 13 of the 87 endowments that made allocations to hedge funds last year turned to Tiger; nine enlisted the services of Dawson-Sandberg Capital Management. “Institutions tend to invest with a small number of big names in order to avoid trouble with their boards,” says Martin Gross, who operates a fund of funds in Livingston, New Jersey. But many market-neutral funds, which are far less volatile than the global macro players and are thus seen as a more conservative way to diversify, are also benefiting from the inflow of institutional money.
Follow that bandwagon
Traditional managers of institutional money have noticed. A growing number are adding hedge funds to their product lines. New York’s Alliance Capital leads the way: it now manages $2 billion spread over 12 funds. Several other powerhouses, including State Street Global Advisors, Montgomery Asset Management, and Wellington Management, have also set up their own funds. Putnam Investments and BEA Associates are both expected to follow suit shortly. Other firms are buying their way in: last February, for instance, Value Asset Management purchased a 70% stake in Grosvenor Capital, a Chicago-based fund of funds with $3 billion in assets.
Banks are moving just as quickly. Goldman Sachs, Daiwa Securities and Swiss Banking Corporation (SBC) are running in-house funds; Bankers Trust and Donaldson Lufkin & Jenrette (DLJ) are both managing funds of funds. For its part, Merrill Lynch is now a major player on the marketing end – it raised most of the seed money for Convergence Asset Management, the firm set up by Andrew Fischer, Salomon Smith Barney’s ace mortgage trader – and Morgan Stanley, Furman-Selz, Bear Stearns, and other prime brokers are sponsoring how-to seminars for aspiring hedge-fund operators. In the meantime, Consolidated Advisors, an arm of CIBC Wood Gundy, has taken a substantial stake in Kellner DiLeo, an arbitrage partnership with around $150 million under management.
However, no firm is more bullish about hedge funds than New York’s Asset Alliance. In recent years, it has purchased 50% stakes in six market-neutral funds with a total of $1.3 billion under management. Earlier this summer, in a move that would have been truly revolutionary, Asset Alliance was due to launch an IPO of its stock. Casting aside concerns about just how to value a business that relies on ever-volatile hedge funds for its revenues, the firm was expected to sell 7.7 million shares in order to raise capital to buy still more funds. But the deal, led by Bear Stearns, was pulled at the last minute, in part because June was a brutal month for hedge funds across the board. Asset Alliance has not said when it plans to try again.
All this institutional interest is a sign to some of dangerous exuberance. “There is a buying panic at the moment,” says John Griswold of the Common Fund, a Connecticut fund of funds that parcels out over $20 billion on behalf of university endowments. “The evidence is mostly anecdotal, but there are some clear signs of stress in the industry.” A case in point, perhaps: two investment officers say they came away from meetings with Fisher’s new firm, Convergence, with no clear idea of its strategy, always a troubling sign. Yet earlier this year Convergence was able to raise $700 million in just three weeks.
Fisher does bring an impeccable pedigree to the business. Even in less buoyant times, he would have no difficulty finding clients. “Whenever a superstar comes out, things fill up quickly,” says Robert Schulman, president of Tremont Advisers, a New York company that advises hedge-fund investors. More troubling to Schulman is the fact that a lot of money is finding its way to relative unknowns. “We have seen an enormous expansion of the industry,” he says. “There are people setting up hedge funds these days who simply are not qualified to manage them. It has become much too easy to run money.” Peltz agrees: “Some of these young guys can now go out and collect $500 million without having any track records to speak of.”
Drifting into unfamiliar territory
Money is also being thrown at many mid-size hedge funds ($100 billion to $500 billion) that are very successful but have little capacity to spare. Some know their limits and are resisting the urge to grab every available dollar. “When we started out, I thought $250 million was probably about as much as we could handle,” says the head of a $200 million convertible arbitrage fund. “Sure, the money is tempting, and our market has grown to where I believe we could probably handle $400 million, but no more than that.” Others are not showing quite so much restraint. “Style drift” – managers changing their strategies and entering unfamiliar markets simply in order to take on board new clients and more capital – has blurred the distinction between true hedge funds and investment pools that take unsophisticated, leveraged directional bets. Alfred Jones, creator of the world’s first hedge fund in 1949, would certainly not recognize his strategy in most of today’s funds.
A highly regarded stock picker, Jones wanted to devise an investment vehicle that would isolate alpha – managerial skill. By balancing his long and short positions, Jones sought to remove market volatility from the equation; his so-called “market-neutral” fund would sink or swim solely on his ability to piece together a strong basket of stocks. He aimed to produce outsized returns without taking on more risk than was embedded in the market, or to match the market while actually reducing risk.
The industry has since become a hodgepodge of strategies. The 60 or so global macro players – among them Robertson (see box above) and Soros – together have around $30 billion at their disposal and make wagers based on shifting economic currents. They are anything but timid when it comes to risk. One notch below them are the global funds; they mainly focus on world equity markets. Then there is a vast collection of market-neutrals: included are a variety of Jones-style funds, fixed-income arbitrageurs and convertible bond specialists. Further down are the event-driven funds, which deal in distressed securities and mergers and acquisitions. The hedge fund universe also includes a number of long-suffering short sellers. As well, there are a growing number of hybrid products that defy categorization.
Several of those who track the industry do not believe many of these vehicles should call themselves hedge funds. By one definition, a hedge-fund operator must do one of the following: invest in multiple asset classes; use leverage; or employ hedging techniques. Some argue for a stricter definition. Ted Caldwell, who runs a Chattanooga, Tennessee, investment advisory service, contends that a true hedge fund should have at least 25% of its portfolio held in a hedged structure at all times. In his view, investment pools that do anything less are hedge funds in name only.
The one thing most so-called hedge funds do have in common these days is the way they get paid: nearly all of them take a 1%, 2% or 3% management fee and a 15% to 25% cut of profits, usually paid quarterly. Most contracts also include a lock-up period during which investors cannot withdraw their money, additional allocation or sales fees and – in a concession to the ultimate investors – a “high-water-mark” provision that denies the manager his incentive fee until he makes up any previous losses. So, take a one-man operator in Ketchum, Idaho, with a few rich contacts. In a bull market he raises $10 million, immediately generating $300,000 in fees. He leverages the fund a modest six times and puts all $60 million into a fund of funds that rises 20% in the year, the fund more than doubles to $22 million, and the manager gets 25% of the $12 million in profits.
Wall Street stampede
It is with such dazzling prospects in mind that traders and analysts are quitting Wall Street to go it alone. Recent notable defections include Salomon Smith Barney’s Fischer; Steven Mobbs, managing director of arbitrage trading for Deutsche Morgan Grenfell; David Slaine, co-head of Nasdaq trading at Morgan Stanley Dean Witter; Roger Gordon, head of high-yield research for Donaldson, Lufkin and Jenrette; and Marc Weinberg, head of CMO trading at Nomura. Europe, too, is seeing investment-bank talent scurrying for the exits. Last autumn, the asset-management arm of Goldman Sachs in London lost two top stock-pickers, Roderick Jack and Marcel Jongen, to the hedge-fund side.
Mutual funds are bleeding even more personnel. In the past two years, Fidelity has bid farewell to Jeffrey Vinik, Mary English, Michael Gordon, Larry Greenberg, Mark Kaufman, Remy Trafelet, John Hickling and John Hurley, all of whom left to start hedge funds or join existing ones. Andrew St Pierre, who some believe was being groomed for the top job at John Hancock Funds, Charles Glovsky of State Street Research and Management and George Wyper of Warburg Pincus have done likewise. Just last month, William Newman and Thomas Gilbert, senior executives at Phoenix Investment Partners, both resigned to go it alone.
Institutions putting money into this mêlée should consider three things. First, the hedge-fund industry does not guarantee yield enhancement for those with traditional benchmarks. On average, hedge funds returned 13.36% annually between 1989 and 1995. The S&P500 yielded 16.47% during the same period, but hedge-fund gains came with less risk. Even allowing for survival bias (funds that do poorly or fold often don’t report results), it is an impressive showing.
In a recent study, Leah Modigliani, US investment strategist for Morgan Stanley Dean Witter, found that combining almost any type of hedge fund with the S&P500 produced better risk-adjusted returns than either the fund or the index-yield alone.
But the statistics mask some other, more sobering findings, brought to light in several recent studies led by William Goetzmann of Yale University School of Management.
Surveying the performance of offshore hedge funds between 1989 and 1995, Goetzmann looked for evidence of persistence – funds registering gains in consecutive years. Just 22.5% of the funds included in his study managed to do that – distressingly close to the 25% that would be expected to repeat as winners if returns were simply random. True, a handful of stars have delivered astonishing results over the course of their careers, but even they suffer down the years. Robertson and Soros can be regarded as anomalies. Consider the industry attrition rate: more than one in every five funds goes bust within its first seven years.
Second, while several managers may defy the law of averages, all are subject to the law of diminishing returns. True, Robertson keeps taking new money and winning big, but Bruce Kovner, Louis Bacon and Paul Tudor Jones have all returned substantial amounts of capital to their investors in recent years. Last winter, John Merriwether divested Long Term Capital Management of $3 billion, half its capital.
In addition, with many mispricings now remedied within seconds, arbitrage opportunities are harder to come by than ever (witness the demise of Salomon’s bond desk). This has particular implications for market-neutral funds. In theory, they don’t make directional bets. In reality, many do. For instance, David Askin’s $600 million mortgage-backed securities fund was billed as market-neutral; only after it was wiped out during the 1994 bond market slide did it become clear that it was something other than advertised. As finance is made ever more precise, other market-neutral managers are being forced to do the same. “Many of these guys, if you put a drink or two into them, will admit that they are making directional bets,” says one consultant.
One manager who runs a fund of funds questions whether market-neutral funds can be found. “These days, without employing leverage, a true market-neutral manager will get the riskless rate of return, plus or minus, because the markets are so reasonably efficient,” he says. “The only way you can enhance that is by adding leverage or directionality, and once you do that, you are no longer market-neutral. There are all sorts of things you can do to find pricing disparities, but none is market-neutral.” For his part, Goetzmann believes there are many bona fide market-neutral funds, with near-zero betas – correlations to the overall market movement – still to be found, but agrees that opportunities are fewer and far between.
“When the tide goes out, we’ll know who’s swimming naked,” says Griswold. Every recent market downturn has claimed at least one major scalp from the hedge-fund world and there is no reason to believe the next time will be any different. Indeed, it could be considerably worse if the decline is particularly violent or protracted. Managers who have taken too much money or become too bold will inevitably be punished. So will the many long-only managers who have slapped “hedge fund” on the letterhead to take advantage of the fee structure.
Third, conservative institutions, like retail investors, tend to be last onto the bandwagon. Ultimately, the influx of traditional investors’ cash may defeat its own purpose. Too much money is flowing in, and the requirements of these investors are too different from those of the early hedge-fund buyers to be accommodated without either large losses for the traditional investors in the coming downturn or the dilution of the hedge-fund ethic to nothing more than traditional money management.
Rich man’s game
Hedge funds have thrived as a private game for wealthy individuals. The previous decade’s bull market had created vast new wealth and, with it, a need for alternative investments that could diversify portfolios. Real estate was assigned that task and failed miserably. As the good times carried over into the 1990s, and other non-traditional assets lost their lustre, it was going to fall to hedge funds, proven winners, to take up the slack.
Now, institutional investors want a seat at the table. Yet they tend to demand things that are antithetical to the nature of hedge funds. They require benchmarks and lots of transparency. They seek lower fees and less risk.
Competition will prompt many hedge-fund managers to make these concessions – some already are. Over time, that may well change the rules for everyone, or at least those who hope to run money for institutions.
“Institutions equate low price with value,” says the head of one fund of funds. “They think we are commodity providers. However, there are certain parts of the financial business that really cannot be commoditized.” Yet he believes many of the companies that are now starting hedge funds or buying them will be happy to cater to this new breed of client, offering sharply lower fees and customized products with features that are anathema to most hedge-fund managers.
Take the issue of transparency. Funds that trade in illiquid securities will never be especially forthcoming, but others seem willing to keep clients well informed regarding both performance and risk. On the other hand, disclosure only provides so much protection. No manager is going to give his investors daily updates, and without that there are limits to what they can actually know. But will pension-fund directors, who hitch their fates to the funds they hire, truly permit fund managers the kind of latitude to which they are accustomed? More likely, those who wish to run money for institutions will end up surrendering some of their freedom. “They will force these guys into a style box, just like they do to the traditional managers,” predicts one analyst.
Institutions also favour benchmarking. Hedge funds, by contrast, pursue absolute returns and “inherently defy benchmarks”, says Hunt Taylor of consultancy TASS Management. Schulman expects the industry to bend on this issue, too: “There is a handful of top managers who will give institutions what they want, and if they are willing to do it, so will the also-rans.” In fact, it is already happening. One hedge-fund operator, Barr Rosenberg Institutional Equity Management, is offering clients a “portable alpha” product: a market-neutral hedge fund with a futures-overlay benchmark – usually an S&P500 contract. Barr-Rosenberg has reportedly provided one such fund to General Motors Investment Management and at a fee lower than the norm.
One fund-of-funds manager doubts this type of arrangement will leave anyone satisfied. In his view, institutional investors are generally too conservative to be comfortable with hedge funds: “They want benchmarks, but will then ensure that they almost never get beaten. Institutions are frightened by people who beat benchmarks. If a guy is 400 basis points above one, they will demand to know why he is taking so much risk.” Thus, both sides stand to lose: the manager is forced to be mediocre and the investor pays for mediocre results. As more money comes into hedge funds, and more institution-friendly products emerge, performance for the industry as a whole will inevitably decline.
