Where did all the hedge funds go? Are they coming back?

As one of the dinosaurs in the modern hedge fund world, having just turned 46, I’ve been often asked what a hedge fund is and whether one should invest in them.  So I thought given the state of the markets, and what I believe should be the resurgence of hedge funds, I would write a quick blog on the topic.

First as some background for those who don’t know me, in February 2001 we launched the first dedicated volatility arbitrage hedge fund in the world.  I left the firm in January 2009 after we had our best two years and achieved between our four different funds performance of between 20 to 35% in 2008.  At the time we had almost 700 million under management.

So anyway what’s a hedge fund? Simply put, the name itself has little meaning except to say that it refers to a group of investors, pooling their money and having a team manage the funds for them.  The stated fees are typically a 2% management fee that is supposed to cover the operating costs of managing the money (in other words what the investment manager needs to pay his overhead and salaries etc); and then there is a bonus fee (or allocation depending on which gets better tax treatment from the IRS) that represents a percentage of the gains.  Some funds have also introduced benchmarks where the performance fee only kicks in after a certain minimum performance is achieved.

So in short a hedge fund is simply a legal structure where people pool capital in order for it to be managed by another party who gets paid a fixed amount plus bonus.  Sounds a bit like a mutual fund and it basically is with the caveat that unlike the mutual fund, the activities of a hedge fund are largely not regulated because unlike the mutual fund, hedge funds are not sold to the general public. Rather, they are supposed to be marketed and sold only to accredited investors.  (which basically means people or entities that due to their wealth are deemed by the government to be sophisticated and not in need of all the protections that the general investing public does.)(I would just note that there are now a variety of “hedge fund light” mutual funds that are available to the general public but I’ll discuss them a different day.) (I’ll also touch on the notion of sophisticated investors on another day as Bernie Maidoff showed this assumption of sophistication is a myth.) Anyway, so now that we know the formal definition tells quite little, lets move on.

Lets stick with the name: hedge fund.  So a name does tell a lot in that originally hedge funds were included in a person’s portfolio (initially it was dominated by very wealthy individuals) in order to help diversify their overall portfolio and lower the portfolio’s overall risk.  For example a great hedge fund would be included in a person investment portfolio so that when the markets encountered problems and their stocks or bonds were getting hurt, the hedge fund would mitigate these loses by generating strong performance.

Conversely in strong markets the hedge fund in a perfect world would also be contributing positively to the portfolio.  As time went on different hedge fund styles emerged and categories developed so they could be compared against each other.

However lets take a step back as something important began in the 80s and going through the 90s and 2000s that was a game changer for hedge funds.  Investment banks that historically were privately owned, went public.  When these firms were private, the end game for management was maximizing profits, and if that meant volatility in their income quarter to quarter, then so be it.

However after they went public, the end game became the public end game – namely set expectations, exceed them and keep showing steady growth.  They learned fast that the public investor did not reward volatile returns so they began shedding the businesses that created the volatile performance, beginning with proprietary trading.  (proprietary trading just means the banks were trading their own money as a business line.)

Let’s take a quick detour through how an investment bank historically made money on the broker-dealer side.  Basically they had three business lines pre-public: managing their own proprietary money; having clients that paid them commissions for executing their trades; and lending money to clients against their portfolio or leverage.

So the public investment banks decided to exit proprietary trading and focus on asset management servicing where they directed (through one vehicle or another) client money to outside managers for a fee.  They also focused on the increasing commission business but failed to predict the consequences of technology and decimalization.   As hedge fund managers became larger they demanded lower and lower commission fees.  The investment banks in response didn’t mind that much because while they were getting hurt on the commission business, these same hedge funds were borrowing huge sums in the form of leverage from the banks and paying the borrow costs.  Thus prime brokerage – or being the broker to hedge funds that provided the leverage, became the driver.  And the consequence was massive growth in the number and size of independent hedge funds.

However what grew was not the type of hedge fund I described earlier, namely a manager that had a strategy that helped diversify a portfolio.  What grew were easy money strategies.  Namely hedge funds no longer focused on generating performance that would help their investors to diversify risk in a portfolio, but rather increased it.  These funds basically took a view on the market or a stock and then borrowed in the form of leverage to increase the return.  With interest rates at historical lows and the markets all moving up in tandem as real estate boomed,  money was there to be minted by these “pioneers”; and the investment banks with their new found money from the end of the Glass Steagall Act, were more than happy to lend it.

However this all came crashing down when the credit crisis occurred beginning in 2007 and the easy money wasn’t so easy anymore.  These as I call them, “leveraged beta betters” killed their clients and went home to all their shiny toys bought by their investors; or if they were big enough — they called the crisis and Act of G-d, refused to return investors money hoping for a bail out of the market that would in turn bail them out, and they got it.

So when the dust settled, the hedge fund landscape had dramatically changed with a significant amount of consolidation and the emergence of super hedge funds with 10-20 billion dollars under management.

So back to the question of whether to invest in a hedge fund.  In short, it depends.  The first question one needs to ask is what am I hoping to get from the investment.  If one knows that you want to get a diversifier for when markets are difficult, then you need to look not at the performance each year of the fund but rather the performance of the fund relative to your portfolio during different market environments.  In particular one needs to look at those situations where their core portfolio will encounter problems and then look at whether the prospective hedge fund would have generated performance during those times and been a true additive value to the portfolio. 

A hedge fund should be just that, a fund that when included in one’s portfolio, helps hedge the other positions in that portfolio.

Now in terms of today’s markets and hedge funds, I am a believer that real skill exists out there that can be extraordinarily beneficial to a portfolio.  We are entering a period never seen before – coming from near zero interest rates to increasing interest rates, a volatile political leader and potentially disintegrating global collaboration morphing into global competition.  Simply put, the equity markets have been fairly easy to trade as stocks and markets were highly correlated and thus the dispersion in returns from manager to manager have been quite close.  However, I would suggest that as globalization leads to greater competition between governments and nations, the consequence will be higher volatility however also much greater opportunity for the skilled manager to show why skill does matter.  So in a nutshell, yes true hedge funds are important for diversifying a portfolio and now we are entering a period where it pays to obtain that diversification.

However finding a true hedge fund nowadays is no easy task.

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