By Richard Beales
From investment choice of the rich and informed to fixture on the investing scene: What’s ahead for the fast-growing hedge fund industry?
Not long ago, the idea that hedge funds were “generally run for rich people in Geneva, Switzerland, by rich people in Greenwich, Connecticut” captured the industry neatly. The funds attracted little attention, and the relatively few managers operated under the radar. Investors were wealthy individuals and families, themselves eager for privacy.
Just over three years ago Clifford Asness, W’88, co-founder of giant hedge fund AQR Capital Management, LLC and the man who coined the Geneva-Greenwich quip, was still wondering whether hedge funds could, in part at least, be a fad. “They are generally perceived to be the investment of choice of the rich and the informed, and they are more interesting and fun to discuss than your Vanguard index fund,” he wrote in the first of a pair of 2004 papers discussing the role of hedge funds in investing.
Now, though, few would say hedge funds are anything but a fixture on the investing scene. The industry has doubled in size in the few short years since Asness wrote his papers. By last fall, the private investment vehicles managed more than $1.8 trillion of investors’ money globally, up from less than $40 billion in 1990, according to Chicago-based Hedge Fund Research, Inc. Meanwhile, the number of funds has risen from about 500 in 1990 to 7,500. Asness’s Greenwich- based fund group is one of the biggest, managing some $35 billion as of early 2007.
And hedge funds and their “alternative investment” cousins, private equity funds, are increasingly commonplace investment choices, not only for wealthy individuals and families but also for university endowments and pension plans, thus following in the footsteps of early investors, some of whom have achieved spectacular returns on alternative investments. Aside from returns, many hedge fund investments aren’t too closely related to the ups and downs of traditional markets, something especially attractive to investors still smarting from losses on stocks in 2000-2002.
“There’s been tremendous growth,” says Richard Marston, Wharton’s James R.F. Guy Professor of Finance. “I don’t see it slowing down.”
This headlong growth may prove to be an Achilles’ heel for some hedge funds. Outsized returns could be harder to come by in the future, with ever increasing amounts of hedge fund money crowding into similar trades. And even as fund groups get bigger and become more institution-like, some may find it tough to stay nimble.
At the same time, lawmakers and the media are increasingly taking notice. The chance that big market-wide dangers—known as “systemic” risks—could originate with hedge funds is one reason regulators around the world are scrutinizing the industry. More prosaically, while hedge funds’ high fees—and stories of their billionaire founders—attract talent to the industry, they also catch the attention of politicians and the press. Hedge fund managers aren’t used to dealing with the glare of publicity, in fact quite the reverse.
Last summer’s turmoil in financial markets may yet prove to have been something of a watershed. While few are blaming hedge funds directly for causing the volatility, their activities contributed to it at times, experts agree. In any event, the shock rattled regulators, investors and the funds themselves, perhaps catalyzing shifts in the industry.
Hedge Funds 101
What exactly is a hedge fund? Jack Gaine, president of the Managed Funds Association (MFA), a lobbying group for hedge funds, puts it this way: “A pragmatic definition would be a private investment pool with a limited number of high net worth individual and institutional investors on the one hand and, on the other, a manager with the utmost flexibility.”
Gaine’s definition doesn’t do much to narrow down what exactly a hedge fund actually does, and that reality is a key feature of the industry. So is a measure of secrecy, although some fund managers are realizing that their increasing influence demands more openness. Ironically, U.S. regulations sometimes discourage this, because investment funds targeted only at the wealthy aren’t allowed to advertise more broadly, and fund managers risk being accused of doing so if they say too much publicly.
Subject to the constraints agreed to with investors, hedge funds can operate in almost any market—equities, corporate credit, oil, gold, timber or insurance. As well as borrowing money, they can invest “long,” like a traditional mutual fund manager, or “short,” profiting if the value of the underlying asset falls. With rapid trading, they often punch above their weight in terms of market influence.
Then there are the famous fees hedge funds charge. “They are generally characterized by a fixed fee on the assets under management and an incentive fee,” Gaine says. The archetypal hedge fund’s annual fee structure is 2% of investors’ assets plus 20% of any gains the fund managers generate, a regime known as 2-and-20. Funds don’t usually give fees back to investors when they lose money, although most have a “high water mark” arrangement by which they have to recoup any losses before they can collect performance fees again.
With so much variety in what funds do, this type of fee structure may, in fact, be what sets hedge funds apart. “It’s probably the most accurate definition you can come up with,” says Marston. “It comes down to being able to charge an asymmetric fee.”
Asymmetric and high, hedge fund critics say—among them Warren Buffett, the legendary investor and chairman of Berkshire Hathaway, who thinks hedge funds and private equity firms take a slice of returns so large that it will hurt investors, at least in the long run.
That leads to one perennial question over the future of hedge funds: whether the 2-and-20 fee structure can survive. In some ways, that’s a question in its own right. But industry insiders see it as related to whether hedge funds can deliver good returns, after fees. For funds that perform well for investors, “if anything fees are going up, not down,” says the manager of a prominent multibillion-dollar fund.
Some funds charge well above the average. Take, for example, SAC Capital Advisors, the Greenwich hedge fund firm founded by Steven Cohen, W’77. The firm manages about $15 billion, and charges fees closer to 3-and-40 than 2-and-20. But few investors are complaining—the fund has reported returns, net of fees, averaging more than 30% annually since it started in 1992. In fact, the fund rarely accepts new money, so investors are waiting to get in.
A key question, however, is whether past returns can be sustained. The average hedge fund’s performance, as measured by HFR’s fund-weighted composite index, seems to have declined while becoming more consistent. In the last five years, returns have been 20%, 9%, 9%, 13% and 9% (the last through September last year). Through the 1990s, annual returns above 20% and even better than 30% were more common, interspersed with the occasional low single- digit return.
The question is whether what hedge fund managers call “alpha”—returns over and above those on the broad market in which they operate, presumably due to skill exploiting inefficiencies in that market—is becoming harder to come by with so many funds chasing similar strategies. Asness of AQR and others have observed that some hedge funds may even be achieving only market returns, or “beta,” albeit in non-traditional investment areas.
(There is a nascent but as yet unproven spin-off industry in which academics, Wall Street banks and fund groups are trying to replicate what some call “hedge fund beta” at lower cost using carefully designed portfolios of readily available financial instruments—potentially the exchange-traded funds of the hedge fund world. So-called 130/30 funds are also a step from a long-only approach towards a hedge fund model, with managers allowed to sell some stocks short within a primarily long portfolio.)
Industry insiders agree that hedge funds are the victims of their own success, with good opportunities likely to be spotted by more funds and exhausted more quickly. “It’s harder; it’s more competitive,” says Karen Finerman, W’87, president of Metropolitan Capital Advisors in New York City.
Michael Steinhardt, W’60, managing member of Steinhardt Management LLC and a hedge fund manager from the early days of such enterprises in 1967 until 1995, agrees that this is probably the case. But he also doesn’t think today’s investors push their fund managers hard enough.
“[Some funds] could not exist without the softness, the weak nature, of so many of their institutional clients,” he says. “I say that because they are sheep-like in their choices. They are not demanding enough in terms of return expectations, particularly [with] hedge funds and private equity.”
His comment goes partly to what investors, and fund managers, have come to see as normal. “In those days, when the egregious 1-and-20 I was making was truly a rarity, I felt this extraordinary compulsion to be the best performing person in the world,” he says. But he feels it’s a different business now. “I think it’s now a superior method of compensation for anyone who can do it—without much pretense even of achieving rates of return that remotely, in my mind, justify the kind of compensation that hedge funds charge.”
If returns do come under pressure across the board, investors may eventually force fees down. But average hedge fund fees have been remarkably stable for years. Some observers suggest this is partly because better performing funds keep charging their 2-and-20 or more, while those that don’t deliver good enough net returns quietly close up shop.
Investor be Wary
With so many funds to choose from, picking the winners is becoming all the more challenging. Aside from achieving good enough returns, avoiding fund blow-ups—the inevitable occasional consequence of risk-taking by hedge funds—is a key objective of many investors, especially as more endowments and pension funds with responsibilities to their beneficiaries move into hedge fund investing.
In the mutual fund world, a single percentage point divergence from a benchmark annual return—say the S&P 500 stock index—is considered relatively large. In hedge funds, and even among funds that claim to pursue a similar strategy, the return difference between a fund that does well and one that does poorly can be 10 or 15 percentage points or even more.
That’s why investors queue up to get into funds with track records like Steven Cohen’s at SAC. But it’s also why Marston says hedge fund investments are not for everybody. “Somebody with one or two million dollars ought to think twice before they get into this business,” he says.
Gaine at the MFA also emphasizes that investors should be wary. His organization doesn’t view hedge funds as a retail product. He cautions that smaller institutional investors, too, need to do plenty of research to assess hedge funds before they invest.
One way to do so is by entrusting money to funds of funds, through which HFR reckons more than 40% of hedge fund investments have been made. In exchange for more fees— themselves sometimes a target of criticism—these groups screen individual funds and help investors select and gain access to a portfolio of funds that suits them.
Even after careful selection, investors shouldn’t expect too much, Marston says. He notes that with about $20 billion in assets, Yale’s endowment—headed by chief investment officer David Swensen, who has pioneered alternative investments with great success—has the scale and experience to have a reasonable chance of picking winners. Yet according to its 2006 update, the Yale endowment expects just a 6% annual return after inflation on hedge fund investments, or less than 10% in absolute terms.
“That ought to be an eye-opener for investors,” says Marston. “They’re going to earn something between fixed income and domestic equity … [with returns] not correlated with domestic long-only equity.” In other words, that non- correlation, which applies most of the time, should be as much of an attraction as the size of the expected returns.
Scale versus Agility
Among the most powerful trends in the industry is a developing bifurcation, with the largest funds accumulating assets and the smaller ones becoming niche players. As the industry matures and the nature of its investors changes, some hedge funds are becoming at least as interested in size as in returns. Finerman at Metropolitan Capital says that, for some, “the business model has changed from the goal being superior returns to the goal being an asset-gathering machine.”
If anything, hedge fund data groups say, this has accelerated since last summer’s market turbulence, with bigger funds seen by some investors as better positioned to weather such periods.
The trend partly reflects the increasing significance of relatively risk-averse endowment and pension fund investors in hedge funds. With their own fiduciary responsibilities to worry about, they often demand scale, stability, comprehensive computer systems, increased transparency and other features that can be difficult for smaller funds to manage, or even afford.
It also owes something to the natural accumulation of assets by bigger funds, both through returns on investment and new money coming in. After all, they are large partly because of strong historical returns.
With many funds now managing billions after only a decade or so in business, there’s also the question of turning what in some cases began as a business based on one person’s reputation into an enduring institution—a process that also calls for giving the original principals a chance to partially cash out. Hence the public sale of shares in some hedge fund and private equity firms, including Fortress Investment Group LLC and Blackstone Group. At the time of writing, Och-Ziff Capital Management Group LLC, a big hedge fund manager, was readying an initial public offering. Reports have also surfaced in recent months suggesting that funds such as AQR and SAC have considered IPOs or sales of stakes to other, larger financial institutions. Neither fund would comment for this article.
This “institutionalization” can suit both the founders of funds and many of today’s investors. IPOs tend to open a window into the often-secretive world of hedge fund investing, another source of comfort to some investors and even to regulators. Another outward sign of this shift is the long-term debt some funds, including Chicago-based Citadel Investment Group, have put in place to reduce their dependence on collateral-based loans from Wall Street.
But where does this trend leave the smaller funds? Steinhardt says that when he ran his hedge fund, “there was a clear diseconomy of scale.” He says fund managers in the 1970s or 1980s would not have wanted to manage more than $100 million or $250 million, because the scale would make it harder to find opportunities with big enough return prospects.
Growing and more accessible global markets have made big bets easier to make, and large funds can and do make good returns. But Finerman, who manages about $500 million of investor money, still believes smaller funds have some advantages. “For us, the advantage of our size is our nimbleness and the ability to be in so many names that for us have adequate liquidity—we can be in and out without really moving the price,” she says. Larger funds need to put more money into trades and that may close some options to them, she adds.
Finerman says providing an adequate operational infrastructure for her fund is not a problem, but concedes that in the hunt for talented people it can be hard to win against big fund groups with deep pockets.
Gaine adds a personal concern about this trend. If you’re “the little guy in the garage with the dog and the neighbor” and a great investing idea, how do you get started when many investors want scale, carefully monitored processes and hefty disclosure from day one?
Tougher Talk about Regulation?
Regulators are increasingly keen on similarly institution-like behavior. The MFA and other hedge fund alliances recognize the need for consistent standards and practices. Generally, funds see this as helpful provided it is voluntary—although many funds are, in fact, regulated by the SEC in the U.S. or the Financial Services Authority in the UK, sometimes to a greater extent than is realized, in some cases under laws that are decades old. Even back in the early 1990s, former fund manager Steinhardt and others had a brush with U.S. regulators over Treasury bond trading.
Regulators tend to champion high levels of disclosure to protect investors, although this applies primarily in the retail arena, where most hedge funds don’t operate. “In general, as long as you can be sure it’s only big guys playing with big guys, there’s not an awful lot of reason to have the range of regulation we often see,” says Richard Herring, the Jacob Safra Professor of International Banking at Wharton. “It starts to get tricky when retail investors are involved.”
That’s not yet happening in the U.S. Indeed the MFA wants to raise the minimum net worth threshold for investment in hedge funds—but this is more of an issue in parts of Europe. Finerman thinks retail investors will eventually want to invest in U.S. hedge funds, too.
Meanwhile, Herring says hedge funds need to be alert to what he calls “back door retailization.”
“What do you do when a group of state policemen invest the life savings of the troop and the thing crashes?” He says managers need to think carefully about ensuring that investors are suitable for their funds, or they may find regulation “will be thrust upon them.”
Regulators also want hedge funds to be more transparent about what they do, especially over matters such as the valuation of illiquid securities—one of the issues at the root of last summer’s credit crunch.
Various industry groups have proposed ways to improve and standardize practices. But many managers agree with Herring’s view that it’s not clear what kind of prescriptive approach would actually be helpful to investors. For example, he says, “The intensity with which they trade means a balance sheet disclosure is temporarily meaningful at best.” He adds that some hedge fund strategies are proprietary and won’t work if they become publicly known.
It’s unclear whether regulators will push this agenda, especially since funds, egged on by investors, are already largely disclosing more and following better-defined processes than they used to.
And regulators are likely most interested in potential systemic risks. The New York Federal Reserve, for instance, engineered a bailout of the Long-Term Capital Management (LTCM) fund in 1998 because its losses threatened banks and other lenders, an event regulators are keen to avoid looking ahead.
Herring says that, on the one hand, hedge funds can have the flexibility and often the courage to take the other side of markets when traditional investors are selling. “That’s a very good thing” for the health of the system, he says. The danger is another LTCM—in the form of trouble at a big fund or a group of funds all with similar market bets.
This could have happened last summer when credit briefly all but dried up—something that could have triggered major problems for hedge funds, because many of them rely heavily on borrowed money. But as it turned out, the bigger losses appear to have been taken by banks and Wall Street brokers.
For now, that tends to vindicate the U.S. regulators’ strategy to date, which is to scrutinize regulated banks and brokers that lend to hedge funds, indirectly controlling the funds’ borrowing and risk-taking capacity.
Nonetheless, “If we have another blow-up that has the systemic implications of LTCM, I think there’s going to be tougher talk about regulation,” Herring says.
An Alluring Career Option
For those within it, the hedge fund industry can be a pot of gold. In 2006, three top fund managers each took home more than $1 billion, according to Alpha magazine. The top 25 earners garnered more than $14 billion among them.
Indeed, for those who enjoy money and investing, working for a fund is an alluring option. Finerman, for instance, always knew she wanted a career in investing; thus, Wharton was the only school she applied to. “For someone with laser-like focus on being in capital markets there was no other alternative.”
Finerman is one of just a few women heading hedge funds. “It’s really only a handful,” she says, adding that she believes the balance will change over time. “It’s a very male-dominated world, but I’m comfortable in it. I can be a little different, and that can sometimes work to my benefit.”
For some, the thrill of making money for investors and themselves and the belief that they fuel the capitalist engines of growth and prosperity are satisfying enough. Steinhardt says he persuaded himself he was doing something of economic importance. Now, with the benefit of hindsight, he isn’t so sure. “I would grudgingly think hedge funds are not in any way ennobled in their effort to get rich.”
Even so, there’s no denying that his hedge fund days have made him wealthy enough to devote plenty of money and much of his time to philanthropy from his office overlooking New York’s Central Park.
Of course, there’s a danger that the recent accumulations of wealth in hedge funds and private equity provoke a backlash—something Gaine of the MFA says he has so far seen mostly in the form of calls for higher taxation on alternative investment managers, whose compensation, particularly in the case of private equity, is often taxed at the capital gain rate rather than the higher income tax rate.
But even if higher taxes come to pass, they aren’t likely to dent the attractiveness of the industry much, whether for budding hedge fund managers or for investors, experts say.
A Bumpy Road Ahead
Back in 2004, Asness pointed out that in considering then novel-seeming hedge funds, investors should consider that at one time, they might have asked: “Why mutual funds now? Why money market funds now? Why index funds now?”
“Why hedge funds now?” is a question that isn’t asked much any more, but the industry is still maturing and shifting. Investor expectations may need to adjust, as may fund managers’ hopes of collecting generous fees without having to divulge much about their methods, industry observers say.
“The road will not be short, and certainly not free of bumps,” Asness says. He added that “bump” was a euphemism for “some people losing a lot of money at some point.” But investors shouldn’t be surprised by the occasional hedge fund blow-up, provided they were told about the kind of risks being taken.
Herring has another view of the future, with some big funds diversifying into other financial services as Citadel, for example, is doing. “We may see some of them reinventing themselves as other kinds of institutions,” he says. Does that mean even high-flying Goldman Sachs bankers need watch their backs? Herring puts it this way: “It’s not just commercial banks that may need to worry about disintermediation.”
Richard Beales is associate editor at Breakingviews, an online financial comment site. Breakingviews articles are available at www.breakingviews.com and also appear in the Wall Street Journal and a range of European newspapers.