Hedge-Fund Roundtable: Finding The Razor's Edge

Viewed against the Standard & Poor's 500's showing, recent hedge-fund returns
have been satisfactory -- but not stellar. The CSFB/Tremont index tracking broad
hedge-fund performance is up about 13% in the past year, compared with 16.34%
for the S&P.
Hedge-fund pros insist, however, that their portfolios aim to capture much, if
not all, of the upside in bull markets and, more important, protect against
losses in bear markets. Also, the CSFB/Tremont index has a standard deviation
that's about half that of the S&P 500's, implying lower volatility.
Thanks to those selling points, investors have bought into the hedge-fund
story in a big way, worries about blowups aside. The $1.3 trillion industry
received $44.5 billion in net new cash in the third quarter, according to Hedge
Fund Research.
For the third consecutive year, Barron's has convened a roundtable to analyze
the industry and its trends, from the rapid asset growth to a lack of volatility
in the market to the recent implosion of hedge-fund Amaranth Advisors.
This year's panelists are Peter Thiel, who runs Clarium Capital Management, a
$2.3 billion global macro hedge fund in San Francisco; John Bader, co-chairman
and managing principal of Halcyon Asset Management, a New York-based
multi-strategy firm with $5.7 billion under management; and Blaine Tomlinson,
founder of Financial Risk Management, a London-based fund of funds with $12
billion in assets.

Barron's: Let's start with your take on the financial markets in 2006.
Thiel: Two thousand six was not a terribly eventful year in some ways, but the
trend we saw was that markets started the year very far from equilibrium, and
they ended the year even further from equilibrium. So you saw some volatility
and credit spreads continue to decline. The housing bubble slowed and may be
coming to an end, though it's certainly lasted longer than people would have
thought possible. Equity markets continue to rally to even higher levels, so we
think a lot of global distortions became even more extreme.

Barron's: What's your sense of the markets, John?
Bader: Both equity and credit strategies were profitable for us in '06, merger
strategies in particular on the equity side. Activity has been strong, as
private-equity funds have on the order of $1 trillion of buying power. We've
seen bidding wars around the world, such as [gaming company] Aztar [ticker: AZT]
in the U.S. Another area we've liked is cable stocks, which were trading at
historically low multiples in the fourth quarter of last year.
On the credit side, we've made nice profits, notwithstanding a very defensive
posture. We have not wanted to have high-yield exposure at this point in the
cycle; typically, peak defaults have trailed peak issuance by about 3.7 years,
and that would place peak defaults in the fourth quarter of '07. The places
we've made money have been more event-oriented plays -- for example,
claims-resolution situations dependent upon litigation. Volatility strategies
have not been especially profitable, and we think it's a very interesting time
to be long volatility now.
Tomlinson: The best-performing liquid-asset class this year has been equities,
and, not surprisingly, the best-performing hedge-fund strategies have been
risk-seeking strategies in equities, especially emerging markets, and credit.
Event-driven and friendly activism, which is reasonably prominent in Europe, has
done really well for us. And generally our European equity strategies and credit
strategies have done well. Also, convertible [bonds] have bounced back from the
wash-out last year.

Barron's: Any parts of the market that didn't work out so well?
Tomlinson: The most disappointing strategy for us has been Japanese equity
small-cap, which really hasn't paid off. Overall, though, there has been a lot
of opportunity in equity and credit strategies. Relative-value strategies have
generally found it harder, because they require more volume and more mean
reversion.
Relative-value trades, at their most basic, involve pairing, say, a long
position in a utility stock against another utility holding that's shorted.

Barron's: What about global macro funds?
Thiel: It's definitely been a challenging year for the macro funds, ourselves
included. Part of the challenge has been that there are some of these imbalances
that, in our view, have simply not broken.
For instance, the housing bubble has gotten significantly more extreme.
Obviously, risk premiums have come down. So the various strategies that were
structurally long high-risk and short low-risk have all done very well. But many
of these strategies are correlated. So whether people are long emerging-market
stocks or long small-caps or long subprime credit, they've all been very, very
highly correlated strategies, and we think that they are likely to be correlated
quite the other way in 2007.
Tomlinson: I agree with quite a lot of that. One has to be very careful about
correlations, because what you've seen is that strategies that have paid off
have been risk-seeking strategies. And if there is some form of market shock,
you're going to get a switch to risk aversion.

Barron's: Let's look ahead.
Bader: No. 1, we believe that M&A activity is very much going to continue
until credit dries up. As I've noted, peak credit defaults trail peak issuance
by about 3.7 years, which would have credit defaults peaking at the end of next
year. However, I suspect that liquidity in the marketplace will postpone that
day of reckoning, although it's difficult to say.

Barron's: John, you've indicated that as a way to hedge against potential
credit and geopolitical risks, you are "long" volatility. What's a very basic
example of how to play that trade?
Bader: Maybe the simplest way to get long volatility is to buy options on the
VIX index, although there are typically more efficient ways to do that.

Barron's: Where are your credit investments?
Bader: Our credit book largely consists of floating-rate, secured bank debt.
We also believe some of the biggest opportunities are going to be within the M&A
space.

Barron's: There's been a lot of discussion about how low volatility has been
in recent years, and how that's made it tough for some hedge-fund strategies.
What's your read on the volatility situation?
Thiel: Generally speaking, if you have low volatility, it's safe to take on
lots of leverage. If you have high volatility, you can't put on nearly as much
leverage, and you're forced to de-lever. As the world has gotten smoother the
last two years, the markets have become very uneventful. That has encouraged
people to put on more and more leverage in all sorts of markets, whether it's
going long equities or buying houses. Owning a house is a leveraged bet on low
volatility, because you will be fine as long as house prices don't go down.

Barron's: What are some of the other scenarios should volatility increase?
Thiel: You would expect equity markets to sell off. You would expect spreads
to widen on all sorts of subprime markets. I would expect the dollar to get
dramatically stronger, especially against the euro, the pound and
emerging-market currencies.

Barron's: What other factors do you see impacting volatility?
Thiel: Our view is that volatility has been suppressed across all global
markets as a result of the flow of petrodollars into the world economy.
Basically, there was a $1 trillion dollar tax increase on oil, and while that's
bad for consumers, it's actually been very good for financial markets because
the money has basically been this regressive tax that's been reinvested in
financial markets: gold, real estate, tech stocks, emerging markets and
equities.

Barron's: John, what's your view of the credit cycle, which does appear to be
getting a little long in the tooth?
Bader: Right now, there is a relatively low default rate, but it's definitely
heading up. The question is how quickly it's going to happen. Is it going to
happen in '07? Is it going to happen in '08? Will it go beyond '08? That's a
function of liquidity and market psychology. In the high-yield market,
underlying fundamentals are sometimes much less important to changing market
psychology than the blowup of a big deal.
In 1989, it was United Airlines, and the credit spreads blew out dramatically.
The underlying fundamentals were weak before that, and bad deals were getting
done, but it needed that big bust to kill market psychology. I'm not certain how
quickly we will see that bust, but you're clearly on the upswing in terms of
default rates and, hence, my reason for wanting to be long volatility as a hedge
to reduce the risk associated with the equity and credit positions we have.

Barron's: So you are betting, in terms of the credit cycle going bust, that
there's a 50% chance of that happening next year, and it increases with time?
Bader: That's correct. My gut tells me I don't want to be unhedged. It also
tells me we are not talking about an '07 event for credit spreads to really blow
out, because of the liquidity created by these structured products, such as
adjustable-rate mortgages. The day of reckoning probably gets postponed beyond
2007, but I wouldn't stake my life on it and I am going to be very hedged.
The second and third quarters were very strong for hedge-fund flows. How well
is the industry digesting all of this money? Tomlinson: Clearly, there has been
an issue and a continuing issue that some of the managers who have done well are
taking too much money and their returns are going to come down, there is no
question about it. And it is a real problem for expectations and for clients;
that's the nature of the beast.
But looking at strategies and the current market environment, you've got many
pools of capital competing for different opportunities. In equities, for
example, what hedge funds do and what long-only managers do are often quite
different. They are often fishing in different ponds. Certainly their risk
objectives are very, very different.

Barron's: So, save for certain pockets of the market, you see plenty of room
for this new money to work. What about you, John?
Bader: Money flooding in simply means that strategies get commoditized faster.

But let me be very clear: Every good investment strategy I have ever seen gets
commoditized sooner or later. What we have tried to do is identify and monitor
strategies and understand when they are creating alpha and to exit strategies
when they aren't working.

Barron's: How do you go about managing investors' return expectations?
Tomlinson: What funds need to do is customize portfolios to achieve specific
return objectives. If a client says he wants cash plus 5%, you can structure a
portfolio that gets pretty close to that in terms of expected returns. If a
client is looking for a smarter way of taking equity exposures in Europe through
long/short managers and they want an alpha, or excess return above the market,
of about 5% to European equities, that's what we do.

Barron's: What's your sense of the blurring of the lines between hedge funds
and private- equity funds?
Bader: You are certainly seeing more of it. We are longtime investors in
private debt and private equity. We have been very, very mindful of liquidity
issues. In certain instances there can be -- and there doesn't have to be -- a
mismatch between the horizons that some of these private-equity investments
require and the relatively shorter lockups that a lot of hedge funds have. I
don't think this is a problem for great multitudes of hedge funds. But for some,
it certainly is an issue.

Barron's: What is the biggest danger that you see as hedge funds and
private-equity funds become similar investment vehicles?
Thiel: There is obviously something very strange about enormous amounts of
money that has gone into private equity. Is this justified or not? It comes back
to the volatility. What does a private-equity investor do? They buy a company.
They pay themselves a very large dividend where they take all the company's
cash. Then they borrow money from a bank, and they leverage things up even more.

If you have a low-volatility world where nothing happens, that investment
strategy works and you will make money. The bet that people are making who are
going into private equity is there is going to be no meaningful bump in the road
and that the low volatility will continue.
Bader: I'm not sure that's true, because a lot of people are looking at it the
other way around and positioning themselves for the bump in the road.
The other thing to note is the reason hedge funds are looking at this area --
particularly as institutional money flows in -- is that you typically get paid a
premium for illiquidity. You have many investors, typically offshore, who really
want as much liquidity as possibly in hedge funds. And then many of the U.S.
institutions recognize the premium you often get paid for illiquidity and they
actually sometimes like less-liquid strategies. You really have to look at it on
a case-by-case basis.

Barron's: One of the biggest headlines of the year involved Amaranth Advisors,
a hedge fund that lost about $6 billion last summer on bad energy trades. What's
your sense of what happened there and how it's impacted the industry?
Tomlinson: When the fund's NAV [net asset value] lost 25%, the creditors were
in there and basically looking after their own interest. The other issue for me
was the fact that it was against the interest of the equity investors. There
were two groups, reportedly two groups -- over-the-weekend-type negotiations --
they wanted to survive and probably there wasn't time for equity interests to be
represented in there. But clearly in that situation, equity interests weren't
represented and some of the prime brokers basically looked after themselves
rather than the interest of the hedge-fund manager or in the interest of equity
investors.

Barron's: What about Amaranth as an event within the hedge-fund industry?
Bader: It was a big event. There is no question it made some institutions
nervous. But hedge funds are sometimes misunderstood. There are some hedge funds
that try to be very defensive and have low volatility, and others that want to
bet the ranch.
A hedge fund is just a vehicle. There are mutual-fund managers who try to bet
the ranch. There are mutual-fund managers who try to be defensive. There is no
great secret that Amaranth was making a massively leveraged directional bet on
commodities.
Tomlinson: They had moved away from a multi-strategy system.
Bader: They had other strategies, but they had a massive, aggressive bet on
commodities and I think that was fairly well recognized. But this has made
investors focus more on risk controls and "tail risk."

Barron's: Which means?
Bader: Disaster scenarios. When we look at the risk of our portfolios, we look
at the potential shock and drawdown, or negative returns.
What happens if you have an '87 Crash? What happens if credit spreads blow out
to 2002 levels? The return relative to what happens in the tail-risk context is
a very important point. A lot of investors in the hedge funds are more focused
on the return relative to the monthly volatility. There is a danger in that --
that's important too -- but the danger is, I can devise lots of strategies where
you make money every single month with very low volatility until disaster
happens.

Barron's: What's an example of that?
Bader: If I go out every month and I short puts on the S&P 500 10% out of the
money, unless the S&P 500 goes down 10%, I am going to make money on this. I
will pocket that money every month like clockwork, and it will have low
volatility, most likely. That is, until S&P does go down 10%, in which case I
will probably be carried out. Now that's an example of a put-selling strategy
masquerading as an alpha engine. The Amaranth blowup will force people to
understand what the tail risk associated with some of these strategies is. Many
people have their heads in the sand.
Tomlinson: I agree with that. I'd like to see standardized risk-reporting by
strategy type or by instrument. Some hedge-fund managers have pretty
sophisticated risk reports, but it really varies a hell of a lot. Another
takeaway from Amaranth -- and this deals with multi-strategy managers -- is that
successful traders increase their power and influence in these funds. That's a
potential structural issue for multi-strategy funds.
Nevertheless, the best hedge funds really do have independent risk controls.
The best hedge funds really do have independent valuations. The best hedge funds
are run by real businesses, and the fact is that, like in any real business, you
can get some kind of flaws. But I wouldn't say that's a structural issue across
the entire industry.

Barron's: There's been a lot of criticism that Amaranth, as a multi-strategy
hedge fund, lost its way and put on too much leverage.
Bader: It's important to recognize there are a lot of hedge funds that don't
use a lot of leverage. There are others that use massive amounts of leverage.
Everybody connects the dots. In asking your question, one of the things you are
doing is connecting the dots between Amaranth and multistrategy.
I frankly never thought of Amaranth as a multi-strategy fund. This was a fund
that had morphed into making a massive leveraged directional bet on energy. Most
investors recognized that, but wanted to make the bet. In the trenches of the
hedge-fund world, it wasn't any great secret that Amaranth had a massive
directional bet on energy, which by the way everybody knew also had made them a
huge amount of money, until it didn't.

Barron's: Shifting gears to funds of funds versus multi-strategy hedge funds.
What are the pros and cons of each?
Bader: There is a place for both. For smaller institutions and individuals who
can't do the work of identifying, doing due diligence and monitoring managers or
cannot commit minimums that certain managers require, funds of funds that
generate alpha are well worth the fees.
But with many funds having longer lockups today, there is a greater challenge
for the fund-of-funds manager, in as much as he is less nimble. Also, that
fund-of-funds manager may have to understand that the writing is on the wall two
years ahead of time for many strategies. The multi-strategy fund manager has the
benefit of being able to look out the window to see if it's raining. If it's
raining, he can decide whether to take an umbrella. He doesn't have to forecast
two years ahead of time that it's raining.

Barron's: But what makes it harder for a multistrategy manager to be
effective?
Bader: The disadvantage is that he or she doesn't have the whole world to
choose strategies from that the fund-of- funds manager has. For the
multi-strategy manager, the issue is recruiting the talent, and the question is
whether they can dynamically switch between strategies. But longer term, because
of the nimbleness multi-strategy funds have, many institutions will choose
multi-strategy hedge funds rather than funds of funds. Both models are valid and
both will continue to prosper.
Tomlinson: I agree with a lot of the sentiments, not all of the statements.
There is a role for single-manager funds and multi-strategy funds. But there are
more than 6,000 hedge funds. Looking forward, at least 50% will be outside of
the U.S. Also, as John points out, there will be more niche strategies. Funds of
funds are in a much, much better position to not only cover the world in terms
of existing strategies, but also in terms of developing strategies.
As hedge funds develop new, innovative strategies, due diligence is a huge
issue and not a trivial problem, even if it's a very experienced analyst. I'm
talking about somebody who understands markets and who has traded, himself. You
are making judgments on people and processes that can take two, three, sometimes
four years for them to get really good at it. Due diligence and monitoring is
not about box ticking.

Barron's: But what about the extra layer of fees that funds of funds charge?

Tomlinson: This causes a concern. But it comes back to: Where is the industry
going? Your ability to be able to stretch a product to certain clients' needs is
huge -- a customized portfolio, for example. So there is that flexibility with
funds of funds and the ability to find innovative and niche strategies.

Thanks, gentlemen.