Hedge funds: When everyone's is in the game
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Hedge funds: When everyone's is in the game

The hedge fund mantra of making absolute returns regardless of market conditions is questionable. When everyone is in the game, the game is over.

Mystique is magic. At least that’s what I, like Greta Garbo, believe. I might be in a minority because we seem to be living in an era of information overload. The evidence is everywhere: sizzling circulation figures for celebrity magazines such as Hello, entrail-churning reality television programmes and the trend for people dying of cancer to write columns or blogs “sharing” their suffering with us.

The hedge fund industry is glamorous precisely because it is opaque for most of us but packaged with a glittering bow of alleged excess returns for everyone involved. It’s now second rate to be an investment banker. It’s the hedgies who swagger down the street. Last year, according to Institutional Investor’s Alpha magazine, George Soros earnt $840 million, while Steven Cohen of SAC Capital made $550 million.

I lunched recently with one of my wealthier acquaintances at Daphne’s in Chelsea. The acquaintance runs his own private equity fund and is irritatingly arriviste. His conversation is peppered with references to his richness – the jet, the country estate, the Belgravia townhouse. I long to take a pin and prick his pomposity, (AA enjoys his food and in middle age has become rather Reubenesque.) Instead, though, I asked him how the market dislocation was affecting his personal share portfolio. “I’m not concerned,” Arriviste Acquaintance said airily, waving a fork laden with beetroot risotto dangerously near his pale Pucci silk tie. “I’m only in hedge funds, so I’m not really exposed to market fluctuations.”

Sometimes intelligent men utter foolish things. To say you’re in hedge funds is like saying you’re in computers. There are so many variations, the phrase is meaningless. One cynic recalls laughing aloud when a hedgehog revealed that he ran a long-only hedge fund. “The sole common strand,” a friend snorted, “is the 2 and 20 fee structure” (2% management fee and 20% performance fee). A weighty Morgan Stanley research report, published this spring, states: “In our view, hedge funds describe an organizational form, or possibly a compensation model, not an asset class.” Increasingly, connoisseurs talk about style drift or multiple personalities as hedgies stray into new space (private equity, loans, reinsurance, for example) searching for the nirvana of higher returns. To win, as an investor, you either have to place money with a fund of funds (and incur the higher fees inherent in this structure) or accept that you are highly dependent on strategy and manager. If you are not with one of the best hogs (and often their funds are closed to mere mortals), you might end up weeping into your whiskey sour.

Many pundits (including Arriviste Acquaintance) argue that hedge fund performance is weakly correlated with traditional cash markets. That is why hedge funds are dubbed alternative investments. However, according to Merrill Lynch, hedge funds are now more than 90% correlated with the S&P500, compared with 35% correlation in 2000. And, equally corrosive, recent Standard and Poor’s data claims that indices outperformed active funds across most asset classes during the first half of 2006. So the hedge fund mantra of making absolute returns regardless of market conditions is questionable.

Another worry is that returns will diminish as the industry bloats. The Credit Suisse/Tremont Hedge Fund Index sank 1.3% in May and 0.11% in June, but was up 6.29% at 30 June 2006 (the S&P500 index increased 1.76% during the same period). Last year, the Tremont Hedge Fund Index rose 7.61 % (and the S&P500 3%). But would these returns cause a financial rottweiler to salivate or would they even quicken the pulse of a demanding manager of a prestigious family office? I am tempted to ask why one should bother. Remember that today you can place $1 million on one-month deposit with a solid commercial bank and receive 5.125% interest. And this way, you pay no fees and risk no capital.

Yet hedgehog coffers continue to swell. Hedge Fund Research estimates that $1.3 trillion was invested in approximately 8,900 hedge funds as of 30 June 2006. It seems that there is a bifurcation: a few weighty beasts and a lot of wannabes. Morgan Stanley claims that the top 50 hedge funds now control 40% of all assets under management, with a super-league of the top 200 managing more than 80%. That leaves another 8,700 tadpole hedgies chasing ephemeral dewdrops of arbitrage. And the failure rate is high. According to Hedge Fund Research, 2,073 funds were launched in 2005 but 848 went out of business. Moreover, most average industry statistics are skewed because they only count survivors. So lousy funds that lose their investors’ money don’t figure. In his amusing book Hedgehogging, Barton Biggs, founder of hedge fund Traxis Partners, insists his industry “has become a grossly overpopulated loser’s game”.

Alarming silence from the Costas camp. “He’s disappeared in to the dark blue yonder,” one former colleague snapped

Investment banks, always eager to rush lemming-like to a party, have also piled in. Their proprietary desks are essentially in-house hedge funds and their asset management divisions offer various hedge fund products. Then there are the prime brokerage operations as well as the baby hedgehogs that bank chiefs love to seed (when ex-employees waltz off to set up Big Bollocks Capital in London’s West End or Greenwich, Connecticut). For years, competitors have been whingeing that “Goldman Sachs is a hedge fund”, referring to the firm’s significant trading activities. For example, last year Goldman’s pre-tax earnings from trading and principal investments were more than $6 billion. This June, Alpha magazine reported that Goldies was indeed the world’s largest hedge fund manager, with $21 billion in assets (as of December 31 2005).

UBS is perhaps the most extreme example of this investment banking love affair with hedgies. Last July, John Costas, head of UBS’s investment bank, announced that he was off to form a hedge fund but was staying within the firm. He snaffled 120 of the best traders and set up Dillon Read Capital Management. In a press release, Costas enthused: “I am terrifically excited to have this entrepreneurial opportunity to build a new business within UBS.” Sorry? Entrepreneurial? Swiss? Some mistake surely? Since then, alarming silence from the Costas camp. “He’s disappeared in to the dark blue yonder,” one former colleague snapped. “But then as far as I’m concerned, that was always the case.” Oh dear! Bitter and twisted or what? But I wonder whether hedge fund hyperbole might wane as smart investors start to realize that, when everyone is in the game, the game is over. On reflection, perhaps Arriviste Acquaintance was slightly too smug about his investment portfolio. What do you think?

Hank loved voicemail. But some ruffians are wondering how he will fare at the US Treasury, where e-mail is said to be de rigueur

And talking of Goldman Sachs, a tasty morsel crossed my desk recently. A mole insinuated that Hank Paulson, former Goldman CEO and chairman, had been in a foul mood during the sultry days of early July. As US Treasury secretary nominee, Paulson was forced to sell his Goldman shares (some $470 million-worth). Apparently, the great man sunk in to a crabby decline and took to accosting interns in the lift to complain about the ridiculously low price he had achieved for his stock. And another thing... Hank Paulson’s preferred method of communication with underlings is voicemail. This is easy to understand. Voicemail leaves no trace. Once listened to, it normally vanishes, unlike e-mail. E-mails are a minefield for investment banks: complete deletion is prohibited and storage can ricochet back to bite you on the buttocks many years later. So Hank loved voicemail. But some ruffians are wondering how he will fare at the US Treasury, where e-mail is said to be de rigueur. Suggestion to Hank: why not modernize the Treasury and pay for an efficient voicemail system yourself? After all, isn’t that what your appointment’s about – importing the mores of the lean, mean private sector to the creakingly arcane public sector?

How was your week? Please send news and views to abigail@euromoney.com.


Next time, the hedgie on holiday and summer sartorial sandpits.

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