Hedge Funds Ate My Money: Facts and Fantasies in Alternative Investments

Date: Mar 9, 2007

Hedge funds have been around for 50 years, but they're not well understood. Satyajit Das removes some of the murk from this corner of the financial universe, clarifying what you need to know about the history and the reality of hedge funds (and hedge fund managers).

"Take a speculative cocktail shaker. Add four parts public ignorance and 33 parts greed. Toss in a little perceived genius. If you don’t have any freshly ground perceived genius to hand, a little dried genius status will do. Season generously with mystique. Add apparent publicity shyness to taste. Serve in opaque tumbler of awed, ill-informed media coverage." Martin Baker [1]

Hedge funds are "in." St. James and Mayfair in London, the Helmsley building in New York and Stanford, Connecticut are home to a plenitude of hedge funds. "Plenitude" refers to too much of anything. The fund’s names inevitably include the term capital—remember Long-Term Capital Management (LTCM)?

Extreme sports are specialized sports in which participants push themselves to the limits of their physical ability and fear. Hedge funds are "extreme" money. They play adrenaline-rush, high-risk money games with potentially high returns. In his book The Bonfire of the Vanities, Tom Wolfe’s hedge fund manager "[...] considered himself as part of the new era and the new breed...a Master of the Universe who was a respecter only of performance." [2]

These Masters of the Universe, with their culture of risk and extreme money games, exert enormous power and influence in financial markets. But they remain secretive and little understood. This article looks at the facts and fantasies of hedge funds.

In Fashion?

Hedge funds are fashionable, and hedge fund managers are the new financial celebrities. Today, there are probably more than 8,000 hedge funds with over $1,500 billion in assets under management (AUM). Hedge funds have been around for 50 years, but they’re not well understood. In a recent interview, a minor Master of the Universe stated that he threw light on "fragmented information" and "opaque" track records. The statement is reminiscent of another in a company prospectus during the South Sea bubble: "A company for carrying on an undertaking of great advantage, but nobody to know what it is."

In reality, these are the key things to know about hedge funds:

They’re unregulated.
They can engage in certain strategies denied to traditional investors, primarily short selling and leverage.
They focus on generating absolute returns rather than trying to beat an index.

Investment in hedge funds is being driven by multiple factors:

Institutions. Hedge funds are the latest attempts to beat markets and generate alpha (outperformance).
Individuals. Generate higher returns than those available from traditional assets.

There are a number of issues with hedge funds:

Returns. Average hedge fund returns when properly adjusted for risk and survivorship bias (many hedge funds don’t survive) are not above those for traditional assets over longer periods. A few hedge funds outperform, but many of those don’t accept new money.
Risks. Hedge funds increasingly take "new" risks—correlation, liquidity, complexity, and event risk—that are not well understood and captured by systems, understating the real risk and overstating returns.
Transparency. More than 50% of hedge funds have been in existence for less than 2 years and are small in terms of size (less than 20 people). This increases operational risks and, combined with the lack of transparency, significantly increases risk.

Banks are the real cheerleaders of hedge funds. A large part of their revenue now comes from helping hedge funds raise capital, trading with them and settling their trades, and (most lucrative of all) funding them. Banks increasingly invest ("seed") hedge funds to ensure flow of business. Internally, banks often replicate hedge fund strategies or market them to other traders. This profit comes with risk. In a severe market correction, large losses by hedge funds may lead to large losses by banks funding and trading with them. This is precisely what happened when Long-Term Capital Management collapsed in 1998.

The fundamental business logic of hedge funds is flawed. There is too much money chasing too few opportunities. Louis Bacon (of Moore Capital), when returning capital to investors, commented: "Size matters. It is the bane of the successful money manager." Clever people can make money if there are a few clever people and lots of opportunities. In 2004, one academic argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. History will show that hedge fund returns, other than a few exceptional cases, reflect the confluence of market conditions and good luck that prevailed in the 1990s.

The large amount of capital commanded by hedge funds creates systemic risks. Increasingly, trading is centered on "big" stories—China, India, corporate actions (leveraged buyouts, mergers, bankruptcies). Traders take positions in a wide variety of instruments, all focused on the same event. The tremendous volatility created by relatively minor events points to the explosive buildup of risk concentration. Central bankers are belatedly focusing on these extreme money games.

Keeping Up with the Joneses

The idea of hedge funds is usually attributed to Alfred Winslow Jones. Jones was variously an academic, diplomat, steamboat purser, and journalist. The idea of hedge funds evolved out of his research that showed that it was impossible to forecast stock price movements accurately.

Jones wanted to generate profits while minimizing the risk of losses from unpredictable market movements. He identified undervalued stocks (these he would buy) and overvalued stocks (these he would sell). The strategy today would be called "equity long-short." The combination of longs and shorts would reduce the risk of losses from general market movements. The shorts would "hedge" the longs, giving rise to the term hedge fund. By the late 1960s, Jones had outperformed other mutual funds handsomely over long periods, even after deducting his 20% incentive fee.

Jones’ strategy contains the elements that continue to be a feature of hedge funds today:

Hedging away market risk. Jones used short selling to achieve this goal. But Jones’ hedge fund was not actually fully hedged. He generally only shorted around 50% of the value of the longs. Jones was always net long stocks. The shorts reduced his risk but didn’t eliminate it entirely. He astutely figured that generally the market went up and net long was the right way to be.
Leverage. If Jones was long $1.5 million and short $1 million, then he was exposed to around $2.5 million of stock price movements on $.5 million of net risk.
Research. Success depended, primarily, on Jones’ stock-picking skills.
Incentive fee structure. Jones was paid 20% of performance.
Management investment. Jones also had his own capital invested in the fund.

Remarkably, Jones also anticipated other developments. His fund acted as an "incubator" for two employees who left to set up their own funds. Later, Jones’ fund transformed itself into a "fund-of-funds"—investing its capital in other hedge funds with different areas of expertise and investment styles.

The Rise and Rise of Hedge Funds

Jones started these efforts around 1950. In the late 1960s, Carol Loomis, a journalist with Fortune, published an article about him. The article had a huge impact. Others now copied Jones’ hitherto secret investment strategies.

Hedge funds rose to a new level of prominence in the 1990s. This was the age of "macro funds." The Loomis article actually inspired many of these funds. George Soros’ success through his Quantum fund in speculating on the British pound made him the glamour boy of hedge funds for a time. Julian Robertson, Michael Steinhardt, Stanley Druckenmiller, Nick Roditi, Bruce Kovner, Martin Zweig, Joe DiMenna, Paul Tudor Jones, Monroe Trout, Louis Moore Bacon—all came to prominence.

Traditionally, the investors in hedge funds were the rich. You had to have at least $1 million to play. Currently, around 15–20% comes from individual investors, around 60–70% comes from pension funds, insurance companies, mutual funds, foundations and endowment funds, and banks—and the rest comes from the usual suspects (money laundering, Mafia barons, drug lords, arms merchants, etc.). California Public Employees’ Retirement Scheme (CalPERS) has announced a program to invest some $12 billion in hedge funds over a number of years.

Investment interest came from the stellar returns that the better hedge funds offered. There were more practical reasons. Hedge funds prosper during periods in which traditional asset classes underperform. In the early 1990s and again in the early 2000s, the economy was mired in a deep recession, equity markets were moribund, and interest rates were at record lows. Investors chasing returns were forced to look elsewhere, prompting an increased flow of money into hedge funds.

The switch to hedge funds is also driven by a profound crisis within the investment management industry. Over a long period, few if any active managers outperform the market, especially after trading costs and fees.

Inept fund managers might be one explanation—though this is one never offered by the industry itself, of course. Market efficiency might be an explanation. There is the winner’s curse, too: If you outperform, people give you more money to invest, and the added money reduces flexibility. An orgy of mergers in the fund management industry has also created ever-larger funds. Every time you try to trade, the market moves against you—"dis-economies" of scale.

Star fund managers are prima donnas—difficult to manage and even more difficult to retain. Frequently, it’s difficult to establish whether well-performing fund managers are lucky or skillful. In selecting fund managers, investors should think about Napoleon; before battle, he asked his generals, "Are you lucky?"

Traditional fund managers also measure investment performance slavishly in relative terms. In the 1990s, I consulted to a pension fund. If fund managers are priests, then asset consultants are cardinals. Asset consultants advise investors, evaluate fund managers, allocate money between fund managers, and assess performance. The asset consultant to the pension fund took an instant dislike to me. I was a "troublemaker."

Prior to my arrival, the asset consultant had persuaded the trustees to put a small amount of the portfolio into emerging markets. This was in 1996. In 1997, the Asian crisis had sent the emerging markets plunging. Using a slick PowerPoint presentation, the asset consultant took the trustees through the performance of their portfolio. "The emerging market portfolio has outperformed its benchmark by 3%," he stated when he got to it.

"What was the absolute return?" I asked. The asset consultant turned to me. "We only deal with returns relative to benchmark." I pressed again. He didn’t answer. The chairman didn’t have a clue what I was saying. He sensed only the reluctance of the asset consultant to divulge this information. "Yes, what was our about turn?" he insisted. Emboldened, the rest of the trustees joined in. They too wanted to know what was the "about turn."

The asset consultant was furious. "Well, the portfolio was down 45%, but the benchmark fell 48%, so we were +3%."

"What, we lost half our money?" The chairman was confused.

"Not really, we outperformed our benchmark." It was not a smart answer. The chairman was apoplectic. "Son, you can’t make money when you lose money. What kind of idiot are you?"

It’s how the game is played.

The 1980s and 1990s saw the emergence of new markets such as mortgage and other asset-backed securities and derivatives (futures, options, swaps, and complex financial products) in a wide range of asset classes. Traditional institutions looked on these products with suspicion. Reduced returns available from traditional assets forced institutions to participate in these markets. Hedge funds, specialized in these "new" markets, preyed on conservative investors’ greed and fear with promises of arbitrage and sophisticated trading strategies. The "structured credit" market is merely the latest chapter in that story.

Conservative asset managers now allocate part of their funds to a new "asset class" (alternative investments). Funds that can’t short, can’t leverage, can’t use derivatives, instead gave their money to hedge funds that can.

The number of hedge funds also has exploded. Every new product or instrument has resulted in the emergence of a new type of hedge fund. Disgruntled fund managers and traders, especially derivative specialists, set up hedge funds. Tired of the politics, the inflexibility of large organizations, and increasing compliance burdens, they’re attracted to the money and the power of the "buy" side. Fund managers are owner-managers. They can earn more than they ever would on the "sell" side.

The new mantra is "Hedge funds for everybody." If it was good enough for the rich, then it must be good enough for everybody. What did Groucho Marx say about not belonging to any club that would have him as a member?

Style Gurus

What defines a hedge fund? I would say the following features:

Investment style emphasizing reduction in risk by combining long and short positions
Use of leverage to increase returns
Pursuit of absolute returns
Use of techniques such as short selling and (sometimes complex) derivatives

The "what" of the definition also encompasses styles:

Equity long-short. This is little changed from what Jones practiced. One difference is how closely the longs and shorts are matched. Some funds match exactly; others take a view of the likely trend—this is known as the portion "outside the hedge." The process of stock selection also varies. Some favor fundamental analysis; others use computer models to identify over- and undervalued stocks. The degree of leverage used also varies.
Market-neutral or relative value. The idea is to exploit market inefficiencies—market-neutral hedge fund managers talk about "arb" (arbitrage) a lot. It uses a combination of purchases and sales of different instruments to reduce risk. There’s fixed-income arbitrage, convertible bond arbitrage, derivatives arbitrage, mortgage-backed securities, structured credit—each is different. They all use sophisticated, sometimes highly-quantitative analysis to identify pricing discrepancies. Relative-value funds use leverage, and plenty of it, because the returns are small and the risk is low (supposedly).
Event-driven trading. This is trading driven by corporate actions, mergers/takeovers (known as "risk arb") or bankruptcy ("vulture funds" or "distressed debt" trading). Hedge funds specializing in event-driven trading use their knowledge of regulations, legal documentation, and sometimes inside information to make profits. The investment period can be long, and serious event risk (such as a merger not proceeding) is involved.
Macro or tactical trading. Dion Friedland, chairman of Magnum Funds, described macro trading as "mammoth and quick, keen and powerful, sudden and aggressive; they go for the kill, they want it all, not content with only a mere morsel of their prey." The focus is large, speculative, leveraged bets on currencies, stocks, interest rates, and commodities. Size forces trading in large and relatively liquid-asset markets. Trades are based on fundamental analysis, computer-generated trading signals, market price action, and (most often) a certain vibration in the intestinal tract.

Originally, hedge funds were specialists. Over time, single-strategy hedge funds have found that opportunities in their area of expertise dry up, leading to "style drift." Today, most hedge funds are multi-strategy. No one is sure of what this actually means. It allows the fund to do anything that’s desired. Having bought their tickets, investors can only watch the show.

Traditional investors are keen on diversification, but diversification makes absolutely no sense in the context of alpha or hedge funds. It generally signals an abject poverty of conviction and brings average or worse returns. Institutions slavishly embrace diversification. Investors invest in a spread of hedge funds with different styles. Asset managers have also established "fund of funds" (FoF). The FoF manager selects a diverse group of hedge funds, does the screening, and monitors the funds. Ordinary investors now pay several layers of fees: the fee to the mutual fund, a fee to the FoF manager, the hedge fund manager’s fee. FoF might just stand for "Fee of Fees."

Fees for All

Jones got paid 20% of performance. He didn’t charge a management fee, and met all the funds expenses from his fee. Traditional hedge funds paid the traditional formula of 1% management fee and 20% of performance above a benchmark (known as the watermark). These funds also have a "high watermark" feature—if a fund underperforms, the fund must recoup the losses before the incentive fees resume. Funds now charge 2% and 25% or higher with no watermark. One "hot" hedge fund charges more—5% and 35% of profits—and another charges 4% and 44%. Hedge funds are the only business in which an unproven newcomer with no track record can charge more than an existing operation with a proven history. One manager explained the raison d’être of a hedge fund: "A hedge fund is just an excuse to charge 2 and 20 (base fee of 2% and 20% of performance); they don’t do anything else very different." [3]

The performance-related fees and the manager’s investment in the fund are supposed to align their interests. However, the fee structure heavily favors the manager. Assume a $100 million fund in which the manager’s fees are 1% and 20% of performance. Assume also that the manager has a $5 million (5%) interest in the fund. If the hedge fund loses $20 million (20%), the manager loses $1 million (20% of $5 million). The loss is offset by the management fee received (1% of $100 million, equaling $1 million). If the hedge fund makes $20 million (20%), the manager earns $4 million (20% of $20 million) plus the management fee ($1 million)—a 100% return. In the words of Mark Twain: "I am opposed to millionaires, but it would be dangerous to offer me the position."

The fee structure creates a "moral hazard." (Naturally, this statement assumes the existence of a moral universe in the first place.) The highly skewed payoffs for hedge funds encourage aggressive risk-taking. Bank traders and our great and good corporate leaders have similar incentive structures. Thorstein Veblen, the great American sociologist, identified this problem: "It is always sound business to take any obtainable net gain, at any cost and at any risk to the rest of the community."

Loss of reputation is not a deterrent to risk-taking and loss-making. John Meriwether and his colleagues had no difficulties raising funds after the collapse of LTCM. A member of the banking consortium that bailed out LTCM was quoted in the Financial Times as saying that Meriwether’s reemergence highlighted "the ongoing vitality of the Wall Street system." I would have liked to see the offering memorandum. The closest to perfection a hedge fund manager ever comes is when he prepares an offering memorandum seeking investors. Potential investors probably were comforted by the physicist Niels Bohr’s observation: "An expert is a man who has made all the mistakes which can be made in a very narrow field."

I worked with a trader who lost several hundred million dollars. He was fired. Within a week, he had been hired by a competitor, at a higher salary. The press release announcing his appointment drew attention to his "experience with large positions, complex risk, and challenging trading conditions." Here we were trying to make money, when the secret of wealth actually lay in losing large amounts. Financial markets exemplify Mark Twain’s observation: "All you need in this life is ignorance and confidence; then success is sure."

Risk? What Risk?

Hedge fund returns are hot. Based on the fee structure, you paid for a Ferrari—not some anemic, environmentally correct hybrid!

Some hedge funds have shown high returns. There are wide divergences between the best- and worst-performing funds. Long-run returns are clouded by the "survivorship bias"—that is, many hedge funds have perished along the way. High returns require that you select the better-performing funds.

You need to consider the sustainability of returns. Macro funds were beneficiaries of the confluence of specific factors: the integration of emerging economies into global markets, the end of communism in Eastern Europe, the growth of world trade, and deregulation of financial markets such as currencies and interest rates. These epochal events were once-in-a-lifetime occurrences that created trading opportunities. For example, Soros’ triumph in breaking the pound was predicated on the collapse of a highly flawed system of currencies. In 1997-98, hedge funds made substantial returns when similarly pegged currencies fell apart. This can be seen in the varied fortunes of macro funds in recent years. Some have prospered, but many funds, included the fabled Quantum and Tiger Funds, have restructured or disappeared.

Relative-value hedge funds were beneficiaries of similar events. LTCM’s early success was linked to opportunities related to the creation of a single European currency and tax arbitrage opportunities. Relative-value funds benefited in the 1990s from the introduction of new and innovative products that few understood and fewer had the skills and systems to value. The shrinkage of opportunities has forced relative-value funds to migrate into new areas—credit being the major one.

Hedge funds may offer investors 15–20% p.a. returns with minimal risk—but such funds are far riskier than the risk statistics reveal. The systems used don’t actually capture the real risks. Investors use Sharpe or information ratios to measure performance. Assume that Treasury bills yield 5% p.a. Further assume that hedge fund A has an annualized return of 20% with a volatility of 10%, and hedge fund B has a return of 15% with a volatility of 5%. The Sharpe ratios, are, respectively:

Hedge fund A = [20% – 5%] / 10% = 1.5
Hedge fund B = [15% – 5%] / 5% = 2.0

Hedge fund B, despite its lower absolute performance, provides the investor with greater returns relative to risk than hedge fund A.

Sharpe ratios are flawed. They are ex post (based on actual risk) rather than ex ante (expected risk). Actual risk return achieved should be compared to the risk that was known to be taken at the time the position was taken. This generally shows higher risk and lower risk-adjusted returns.

There are alternative risk models. The Sortino ratio, a variation of the Sharpe ratio, focuses only on adverse price changes, using deviation below a specified level. A personal favorite is "drawdowns"—a euphemism for actual losses incurred and the cash that must be found to cover a peak-to-trough change in the fund’s position.

The real risks of hedge funds are correlation risk, liquidity risk, and complexity or model risk. Unsurprisingly, traditional systems are poor at capturing these risks. Traders, whether in hedge funds or otherwise, are extremely skilled in arbitrage—internal arbitrage. Traders arb the internal risk metrics to inflate risk-adjusted returns on which their bonuses are based. Nature abhors a vacuum.

Correlation risk. Hedge funds should show low risk—remember, they’re simultaneously long and short securities. If the prices move identically, then the gains and losses will cancel out, leaving zero return where the portfolio of long and short positions are perfectly balanced. For the fund to make money, the price relationship between the long and short securities must change—correlation has to shift. Correlation may move unfavorably—the asset where you’re long falls in value and the asset where you’re short rises in value, triggering losses. Many hedge fund strategies are effectively correlation positions, where the risks are not properly captured.
Liquidity risk. Liquidity risk is the inability to sell out of or continue to finance positions. Hedge fund trading assumes liquidity risk. The position may be large. The assets held are illiquid. The liquidity risk is compounded by leverage. Hedge funds generally trade on margin—putting up a small fraction of the value of the asset as collateral. If prices fall, the hedge fund is required to post more collateral. If losses on the leveraged position exceed the hedge fund’s ability to meet margin calls, the position is liquidated, realizing losses. This severely limits the holding power of hedge funds. Risk models assume "perfect" liquidity.
Complexity or model risk. Hedge funds now use complex securities and derivatives in their trading. They use computers and sophisticated quantitative models to value and hedge positions. The models are highly subjective. They’re sensitive to minor changes in parameters and inputs. There may be no transparent market in inputs, making them difficult to value. Mark Twain provides the definitive view on "model risk": "It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so."
A number of hedge funds have suffered terminal losses in mortgage-backed securities. Model failure was a factor in many of these losses. Currently, some funds trade CDO²—that is, a CDO of a CDO, a complex instrument. Different funds use different models. Recently, I had to get market prices for some CDO² securities. There was no market to speak of, and wide variation in prices. Masters of the Universe don’t measure model risk when quantifying risk.

Many hedge fund trades seek to buy or sell "mispriced" securities. The position is hedged by an offsetting trade using similar securities. The idea is that the values will converge. The market prices may correct, allowing the trader to unwind his trades at a profit. If the market prices don’t correct, the trader must hold the position through to maturity to realize the profit. The holding period can be long, very long—on the order of 30 years. Hedge funds have short risk horizons—no longer than 6–12 months. Changes in mark-to-market values, the resulting margin calls, and the investor’s right to redeem capital periodically make it difficult to manage this risk. Leverage, liquidity risk, and complexity are lethal companions.

LTCM liked to arbitrage small value differences between similar securities. The returns were small, so LTCM typically leveraged the trades to increase returns. After the Asian crisis, credit spreads (the margin above government bonds for additional risk) blew out well above what was needed to cover the actual risk of people not paying up. LTCM wanted to lock this in and leverage the position.

LTCM entered into interest-rate swaps where they received fixed rates, getting government bond rates plus a margin (credit spread). Then they went short government bonds on the other side, paying the government rate. LTCM effectively locked in the credit spread. They leveraged the position massively. The game depended on the spread getting smaller (convergence) or holding the position to maturity (10 years). Unfortunately, the spread kept getting wider. Interest rate swaps rose, and government rates fell. LTCM now had losses on both legs of the trade. They had to find cash to cover their losses, and they ran out of money. The LTCM principals witnessed firsthand the truth of John Maynard Keynes’ observation: "There is nothing so disastrous as a rational investment policy in an irrational world."

In 2006, emerging markets took a hit. Market-neutral hedge funds losses mirrored the fall in the market. A short memory and a rising market generally passes for investment genius. One hedge fund manager explained: "Everything in the market was a compelling buy. We could find nothing to short."

Over 50% of the hedge funds that fund-of-funds managers invest in have been in existence for less than 2 years. The majority of hedge funds are small—less than 10 staff. The operational risk and key personnel dependency is high.

In 2006, Amaranth, a multi-strategy hedge fund with around $9 billion under management, lost $6 billion in natural gas trading. [4] In 2005, Brian Hunter, a 32-year-old Canadian, made a bet that natural gas futures would rise. Surging gas prices following Hurricane Katrina made large trading gains for the fund, and Hunter was named head of Amaranth’s energy trading operations.

He placed a similar bet in 2006, but natural gas prices fell sharply, triggering losses. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. Amaranth ultimately discontinued operations. A spokesman for the hedge fund made the following observation regarding the losses: "We did not expect that the market would move so aggressively against our positions!"

"Embedded"

In his book Hedge Funds: The Courtesans of Capitalism, [5] Peter Temple compares hedge funds to courtesans—high-class prostitutes whose clients are drawn from the wealthy or upper classes. If hedge funds are the prostitutes (the girls), then the banks are clearly the pimps and bordello keepers.

Creating hedge funds to house trading activities "off balance sheet" solves many problems for banks. The introduction of capital controls on trading in 1994 made it punishable for banks to hold trading positions on balance sheet. Hedge funds also alleviate the problem of attracting and remunerating "gun" traders. Bank shareholders, regulators, the public at large, and bank CEOs react negatively to large payments to traders, especially when it exceeds their own salaries. The hedge funds are also able to leverage more than the banks themselves.

Banks help set them up hedge funds, invest in them, and trade with them. A whole new service, "prime brokerage," combines settling and clearing hedge fund trades, execution services, and financing hedge funds. Investment banks have set up "incubators" to help budding traders create hedge funds. The services include training in etiquette and investor relations to communicate properly with investors.

Banks also design products around hedge funds, such as capital-guaranteed hedge fund investments for risk-averse investors—you can’t lose your principal, although you may end up earning nothing on your investment for 10 years. This type of investment helps explain why, in the words of Groucho Marx, many investors in hedge funds "work [themselves] up from nothing to a state of extreme poverty."

Dealers love hedge funds. Dealers earn from hedge funds at around 30–40% plus of their total earnings. The bulk of earning is from lending money to hedge funds. No bank, at least I think, would lend to hedge funds. Lending is made possible through repurchase agreements (repos) and derivative trades.

In a repo, the bank lends money against the value securities held or sold short by the hedge fund. The value of the security (collateral) secures repayment. Derivatives don’t require initial investment, just a promise to perform in the future. The promise is secured by the hedge fund’s lodging cash or securities. The collateral is increased or reduced as market prices change to ensure adequate coverage. This is no-risk lending—regulators don’t require banks to hold capital against these transactions.

If a position moves adversely, the bank will require the hedge fund to lodge more collateral—a margin call. What happens if they can’t come up with it? In order to reduce risk, banks use a "haircut"—over-collateralization to ensure that it has a buffer if the hedge fund cannot meet a margin call. Banks are under competitive pressure to reduce the haircut. LTCM didn’t require any haircut at all; it was "special." Writing in the Wall Street Journal, Holman Jenkins observed, "Would hedge funds even exist without a fatty dollop of moral hazard somewhere along the great protein chain of lending?" [6]

The setting of the haircut is flawed. To cover their risk, banks must estimate the worst-case daily change in value of the positions. This is art, not science. Hedge fund strategies have "event" risk when the value of the position could change a lot.

The relationship between dealers and hedge funds is littered with moral hazards. Senior executives at many banks were personal investors in LTCM. Some were involved in negotiating the bailout. It’s all part of the "special" relationship." [7]

Banks love dealing with successful hedge funds so they can copy from the "best and brightest." Banks have internal hedge funds that work closely with special sales desks that service hedge funds. Some had been created specifically to serve LTCM. They worked out LTCM’s trading strategies and then did the trades for their own account. When risk limits were full, they marketed the same strategies to other banks and hedge funds.

When the storm hit in mid-1998, all the traders found that they had put on the same trades. LTCM were perhaps the only ones who were not aware of this. Louis Bacon, the principal of Moore Capital, once remarked, "There are those who know that they are in the game; there are those who don’t know they are in the game; and there are those who don’t know they are in the game and have become the game." [8] In the end, LTCM was the game.

Under stress conditions, prices are affected by illiquidity. Sometimes, prices are unavailable. The valuation of positions are often very conservative, triggering larger mark-to-market losses, necessitating more collateral. Mark Twain observed, "A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain." To this day, LTCM swears that the banks manipulated the prices to force them out of business.

Even if the hedge fund goes under, banks can make money by buying the positions at an "undisclosed" (read: "distressed") price. They make money from unwinding the position. Banks provide a true cradle-to-grave service for hedge funds.

More Money Than You Know What Do With?

Hedge fund managers are the new elite. Brian Hunter, responsible for energy trading at Amaranth before it imploded, earned $75–$100 million in 2005. This, by the by, only ranked him a middling 29th-highest paid in his profession, according to Trader Monthly. [9] One hedge fund manager earned $1 billion in 2005! [10] Apparently money isn’t important; it’s just a scorecard of success.

Having more money than you can possibly spend creates new challenges for the Masters of the Universe. Billionaire hedge fund managers bid up the price of luxury apartments and modern art. Michael Steinhardt owns a large estate containing exotic wildlife. He was seeking to collect every duck and swan variety in the world.

Hedge funds managers are often generous donors to charities—tax deductible, of course. There is the paradox of charity—how enrichment by a variety of means paves the way for conspicuous generosity. George Soros supports free markets and democratic initiatives in Eastern Europe. Detractors question whether it has anything do with the fact that hedge funds are beneficiaries of the opening up of these economies. Some "donations" are also "involuntary," to settle antitrust and securities charges.

Hedge fund managers are generally secretive. Paradoxically, some hedge fund managers brazenly seek acceptance as "thought leaders." George Soros has written many books—The Alchemy of Finance: Reading the Mind of the Market, Staying Ahead of the Curve, The Crisis of Global Capitalism: Open Society Endangered. He thinks of himself as a "financial and philosophical speculator," says Peter Temple. [11]

The centerpiece of Soros’ musings is "reflexivity." Markets don’t tend toward equilibrium; markets feed on their own misconceptions to produce exaggerated price changes until they reach an "inflexion point" when it changes. Soros suggests following the trend and selling as it reaches the peak. This advice takes about 400 pages. In the December 1998 issue of The Economist, the following review of The Crisis of Global Capitalism appeared. [12]

Because of who he is there will always be buyers for his books, publishers for his books, and cash-strapped academics to say flattering things about his books. None of this alters the fact that his books are no good.... A remarkable thing happens to money when it passes through Mr. Soros; it emerges multiplied, but otherwise unchanged. With other inputs the results are more disappointing—to be blunt, more in line with biology. Mr. Soros gorged on chopped philosophy, mashed economics, and fact and figures swimming in grease. It was too much. Before he knew what was happening out rushed this book.

Woodstock for Hedge Funds

The hedge fund industry’s search for acceptance has reached new realms. In 2006, the industry staged "Hedgestock." [13] The title paid homage to Woodstock—the historic three days of peace, love, promiscuity, music, drugs, and shockingly bad dancing. Hedgestock was to be two days (nobody could afford three days in this time-challenged age) of networking and finance. Adam Smith understood networking: "People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in conspiracy against the public, or in some contrivance to raise prices." [14]

The hippies had celebrated their counterculture movement at Woodstock. Hedge fund managers are keen to advertise that they were the vanguards of the "alternative" movement—"alternative investments," that is! It was the dawning of the age of hedge funds, not the age of Aquarius.

The Fall of Hedge Funds?

Hedge funds have underperformed more traditional asset classes such as equities in recent years. Investors always chase yesterday’s returns. Adjusted properly for risk and the absence of liquidity, hedge funds return at best no more than—and frequently less than—traditional assets.

A recent study found that hedge fund performance doesn’t appear to deliver alpha consistently. [15] There are exceptions, but they’re few and far between. Many of the really good hedge funds are closed to investors. Even where you can invest, the flow of funds into better-performing funds rapidly erodes returns. Too much money is chasing too few opportunities. Clever people can make money if there are only a few clever people and lots of opportunities. This is scalability—what works on a small scale cannot work on a larger scale. In 2004, Hilary Till argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. [16] There are other constraints. Some hedge fund strategies need liquid markets and a complete set of instruments. There are few such markets.

Ultimately, if you make money from inefficiency, someone—other investors—must supply the inefficiency. We cannot all exploit inefficiencies, as nobody would be supplying the market inefficiency in the first place. To be "alternative," there has to be a majority; the alternative cannot be the majority.

Hedge funds with certain areas of expertise began to trade in other markets as opportunities became limited, creating "style drift." LTCM had drifted from their métier—relative-value trading in fixed income—into volatility trading, credit-spread trading, and merger arbitrage. Lack of disclosure meant that you didn’t know how far the ship was off course until it was on the rocks. Cases of fraud and other common crimes had also begun to surface.

Smart investors know that there’s no money to be made from investing in hedge funds. In investing, the majority is always wrong. The focus is now "incubators"—venture capital for hedge funds. They identify traders, seed startups, and allow them to establish a track record. Once established, the hedge fund seeks third-party funding, allowing the original investors to exit. They retain the real money—a free carry or shareholding in the general partner or fund manager. Incubators are only open to the really rich and connected.

The hedge fund universe is overheated. At the suggestion of a "bubble," one hedge manager bristled that hedge funds weren’t an "asset class," and therefore there was no "bubble" to burst—only asset classes experienced bubbles. Another hedge fund apologist argued that all funds managers in the future would be hedge funds. The semantics aren’t reassuring.

Hedge funds are also under attack from clones. Hedge fund performance doesn’t depend significantly on skill, nor is it as distinctive as the Masters of the Universe claim. In fact, hedge fund returns can be replicated using readily available instruments such as equity index futures and corporate bonds. [17] Banks are starting to clone hedge funds using precisely these instruments. [18] The advantage for investors is lower fees, with the risk of blowups like Amaranth or LTCM. The clones are not the real thing—they’re cheap reproductions. Some analysts argue that the replication models are flawed, though they have their own version that works.

Who’s in Charge?

As John Kenneth Galbraith observed, "In central banking as in diplomacy, style, conservative tailoring, and an easy association with the affluent count greatly and results far much less." Regulators see hedge funds as providing essential liquidity and distributing risk more efficiently, reducing risks of a major financial shock. There is also a ideological element. In the aftermath of the Asian crisis, economist Robert Wade wrote, "[Greenspan] and other U.S. officials see it as imperative to make sure that the troubles in Asia are blamed on the Asians and that free capital markets are seen as key to world economic recovery and advance; the idea that international capital markets are themselves the source of speculative disequilibria and retrogression must not be allowed to take root." [20] Bailouts of troubled banks in developed countries are naturally not contrary to free market principles.

In theory, hedge funds remove risk from regulated banks. But banks are deeply embedded in the hedge fund industry. The only significant control is on lending to or entering into derivative trades with hedge funds using collateralization to manage risk. Writing in the Motley Fool Internet Bulletin Board, Lou Corrigan noted, "Alan Greenspan was mistaken in believing that the largely unregulated hedge fund industry can be effectively controlled by regulating creditors. [...]Creditors can be just as prone to greed as the latest wizard of Wall Street, but they are often the last to understand the risks that would ordinarily help fear counterbalance greed." [21]

Benign neglect is giving way to concern. Timothy Geithner, president of the Federal Reserve Bank of New York, has warned that the changes in markets may make financial crises less common but more severe. Australia’s Reserve Bank governor Glenn Stevens has speculated that, in crises, hedge funds are users rather than providers of liquidity. The UK’s Financial Services Authority has identified conflicts of interest as well as operational risks in the relationship between banks and hedge funds.

Hedge Funds Ate My Lunch?

There is a temptation to dismiss the Masters of the Universe, their culture of risk, the hedge funds, and the extreme money games as peripheral to "real life." After all, fast and foolish money will always find a way to play extreme sports. Isn’t it just a case of a few rich investors playing around with their courtesans and getting more excitement than they bargained for?

Not really. Hedge funds affect all of us—directly and indirectly. Your money—your savings, your retirement funds, the money you invest in banks—increasingly finds it way into the hands of hedge funds. Corporate or government pensions and defined-benefit schemes are a thing of the past. The investment performance of hedge funds—preservation of capital and returns—will shape your senior years and the ability of your company pension funds to meet their liabilities.

Hedge funds also affect us indirectly. In 1997, attacks on the overvalued currencies of Asian countries helped bring about deep recessions, resulting in the collapse of companies, massive unemployment, and social unrest. Malaysia’s prime minister Mahathir blamed hedge funds. "It was greed; a kind of greed that cares nothing for the destruction caused for the collapse of perfectly healthy and prosperous economies, greed that thrives on the misery of others." [22]

Mahathir did not refer to the poor government, crony capitalism, and corruption that created the conditions for the problems. But the activities of hedge funds undoubtedly exacerbated the severity of these problems. Hedge funds may have colluded in manipulating markets to maximize their returns. In the event of a major shock, hedge funds will sharply increase volatility and the severity of any adjustment.

Any major problems in the hedge fund industry will ultimately affect the stability of the banks and the financial system itself. Hedge funds trade with banks. Banks provide the leverage that hedge funds use. Hedge funds don’t really disperse risks. They increase and concentrate them.

In recent years, there have been warnings: the turmoil in the credit market in 2005 when General Motors and Ford were downgraded; the emerging market correction in mid 2006; the collapse of Amaranth in 2006. Commentators have seized these situations to illustrate the robustness of the system. Banks and financial systems emerged seemingly unaffected.

But banks and hedge funds sustained significant losses in each episode, which were absorbed by profits or gains in other activities. Low cost of money allowed the problems to be handled without a meltdown. The markets also recovered, helped by traders’ increasing positions, assuming the correction was a "buying" opportunity at "better price levels." Banks sometimes merely bought the portfolio from the distressed hedge fund to avoid potential losses from a forced liquidation of the position. The bank was getting the positions at attractive price levels and hoped they could trade their way out of it.

The greatest concern is concentration of risk. Shortage of trading opportunities means that traders—both in hedge funds and banks—focus on "events"—the emergence of the BRIC economies; commodity prices; corporate actions (mergers, leveraged buyouts, and bankruptcy). There are innovations—volatility swaps (bets on the level of volatility), correlation swaps (bets on correlation), and gamma/dispersion swaps (bets on both volatility and correlation). Hedge funds use them to further leverage up their bets on the "big" stories. The tremendous volatility created by relatively minor events points to the explosive buildup of risk concentration.

Matthew Lynn, writing in UK’s Sunday Business, warned, "[T]he risk to the stability of the world’s financial system posed by the existence of these massive vehicles has not gone away. We have chosen, in the main, not to think about it—in the same way that wives sometimes choose not to think about whether their husbands are really working late at the office. The implications of thinking about it are just too scary." [23]

Courtesans have played pivotal roles in the rise and fall of empires. Hedge funds may yet play such a role. If a major event occurs, the effect on the Masters of the Universe and the extreme money games may seriously damage financial systems and economies, and taxpayers will bear the losses. Australian economist Ian Macfarlane commented, "Hedge funds have become the privileged children of the international financial scene, being entitled to the benefits of free markets without any of the responsibilities." [24] Yet the popular investment consensus is that hedge funds, alternative investments, should be a part—indeed, a growing part—of your investment strategy.

Huge structural imbalances in the world, an excess of investment capital chasing returns, and the gradual withdrawal by central banks of the liquidity that has fed recent growth are capable of triggering the problem. How far off is that event? Economists only exist to make climatologists look good. I’ll tell you after the event.

In any major global city today, you can find homeless people sleeping rough. They are the dark underbelly of capitalism. If you look into their eyes, you see resignation, hopelessness, despair, and occasionally defiance. Why are they there? Substance abuse, mental illness, just sheer bad luck. But I fear a future when many us will be on the streets. Etched into the tattered piece of cardboard will be our story: "Please help. Hedge funds ate my money!"

References

[1] Martin Baker, A Fool and His Money: How to Understand the Money Markets and Those Who Work in Them (Orion Publishing, 1995).

[2] Tom Wolfe, The Bonfire of the Vanities (Bantam, 1987).

[3] Alan Kohler, "Hedging Your Bets for a Life Less Ordinary," Weekend Edition Sydney Morning Herald, 5–6 August 2006.

[4] See "Flare-up," The Economist, 21 September 2006.

[5] Peter Temple, Hedge Funds: The Courtesans of Capitalism (John Wiley & Sons, 2001).

[6] Holman W. Jenkins, "How a Cat Becomes a Dog," Wall Street Journal, 5 April 2000.

[7] Merrill Lynch, Bear Stearns, and Paine Webber senior executives are understood to have invested in LTCM. See Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Random House, 2001).

[8] Quoted in [5].

[9] See [4].

[10] The manager is reputed to be Jim Simons of Renaissance Technologies; see [3].

[11] See [5].

[12] Quoted in [5].

[13] See Stephen Schurr, "Hedge Funds Jump on Hippie Bandwagon," Financial Times, 3–4 June 2006; Penny Wark, "Selling Themselves Short," The Times, 9 June 2006; The Economist, "Tune On, Tune In, Meet Clients," 10 June 2006.

[14] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (Methuen and Co., Ltd., 1776).

[15] William Fung, et al., "Hedge Funds: Performance, Risk, and Capital Formation," 19 July 2006.

[16] Hilary Till, "On the Role of Hedge Funds in Institutional Portfolios," Journal of Alternative Investments, Spring 2004.

[17] See Jasmina Hasanhodzic and Andrew W. Lo, "Can Hedge-Fund Returns Be Replicated? The Linear Case," 16 August 2006.

[18] See H. Kat and H. Palaro, "Who Needs Hedge Funds? A Copula-Based Approach to Hedge Fund Return Replication," "Replication and Evaluation of Fund of Hedge Fund Returns," "Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds," "Tell Me What You Want, What You Really, Really Want! An Exercise In Tailor-Made Synthetic Fund Creation Alternative," all working papers of the Investment Research Centre, Cass Business School, City University, London.

[20] Robert Wade, "The Asian Economic Crisis and the Global Economy," quoted in [5].

[21] Quoted in [5].

[22] Quoted in [5].

[23] Matthew Lynn, "Financiers Play with Fire Again," Sunday Business, 9 April 2000.

[24] Quoted in [5].