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Hedge Fund roles


Jekyll & Hyde Hedge Fund Roles

NEW YORK --Many say hedge funds will cause the next market meltdown. Strange, other folks say the funds provide the market with greater efficiency and lower volatility. One thing's certain: Hedge funds have become an integral part of financial markets. So are they good, evil, or a bit of both? And is their explosive growth just a fad or a permanent shift? To answer both questions, it is worthwhile to look at the reasons why hedge funds appear to have come so forcefully to the fore, having grown their assets to a little over $1.11 trillion from just $40 billion a decade ago.

There is both a supply and a demand component.
The demand comes from pension funds and other institutional investors. Earlier
this year I spoke at the annual conference for Commonfund, a not-for-profit company that manages about $30 billion in mostly small-to-midsize university
endowment money. The sessions on hedge funds and alternative investments were
standing-room only. The talk at the tables over lunch concerned the terrific
returns earned by the Yale and Harvard endowments through skillful use of
alternative investments.
To understand the reason for the heightened interest, you have only to look at
stock-market returns over the past several years. You'll see a lot of negatives.
Many of these endowments and pension funds are required to distribute some of
their funds each year, to be used for scholarships or sports or endowed chairs.
Negative returns on their investments mean they are cutting into principal. That
just couldn't last long.
They went searching not so much for higher returns as more even returns. "One
of the reasons that pension funds are moving money toward hedge funds, is
because they've now sort of changed their objective to producing a more
consistent return year after year," says Bob Prince, co-chief investment officer
for Bridgewater Associates, which has $115 billion under management and is one
of the nation's biggest hedge funds.
So what was attractive about hedge funds, then, was both higher returns and
investments in alternatives that weren't correlated to the stock market.
The demand for these hedge-fund services hit at just about the same time that
there was an increase in supply for those who would offer them. Recall the two
critical investment mantras from the 1990s: that markets were instantly
efficient and couldn't be beaten and, therefore, the best way to invest was to
buy and hold. Along came "benchmarking" which acted like a ball and chain around
the necks of investment managers. Beating the benchmark became the be all and
end all. The best way to beat or at least match the benchmark was to hold a
preponderance of the securities in that benchmark index.
"What happens is that we as an industry have tended to force kind of good
investment managers into a smaller and smaller boxes," said Verne Sedlacek,
chief executive of Commonfund. "The investment managers tend to look at that and say, 'Well, that doesn't make any sense. I can go out and I can invest in growth stocks, I can invest in value stocks, I can invest in emerging markets. I can see a great opportunity here. And as a result, I can add value for my client by
being much less constrained.'"
Changes on Wall Street have also driven the move of top investment managers
from the big firms to hedge funds. The shift from partner to public ownership
has made many big investment banks more concerned about quarterly earnings and less willing to accept the kind of volatility that can accompany hedge-fund-like trading.
Says Sedlacek, "A lot of what the hedge funds are doing today are things that
were formerly done by proprietary desks at the large investment banks when you
go back to the heyday of partner-based Wall Street, that's a lot of what they
These managers are not, strictly speaking, trying to beat any benchmark
(although they are more than happy to tell you when they do.) They market their
ability to provide investors with what they call "absolute return" - a profit year after year that isn't related to the vicissitudes of the stock and bond market.
It is no small part of the motivation that the fees in the hedge-fund world often equal 2% of the assets under management - and then 20% of the gains.
Finance professor William Goetzmann says the fee structure is significantly different from how mutual funds are organized.
"Mutual-fund managers are really compensated if they are able to attract assets under management," Goetzman said. "Now if you're a really hot manager and
your performance increased 25% year, then the money will flock into the fund and
you'll get some payoff for that. But it's not a direct one-for-one relationship.
The mutual-fund industry is often called an asset-gathering industry rather than
an industry dedicated to making high rates of return."
But for hedge funds, "You have to be able to deliver the goods if you're going to make the big bucks."
So we arrive at an answer to one of the questions: Will hedge funds stick
around? As long as the investors are willing to pay the fee structure, as long
as big institutional money has reason to seek returns that aren't correlated
with the stock market and as long as big investment banks shy away from some of
this business, hedge funds will be here to stay.
As to the second question, there is more debate. Former New York Federal
Reserve Bank President Gerald Corrigan told me in an interview that he doesn't
believe another meltdown like Long Term Capital Management is likely. Corrigan
is now at Goldman Sachs (GS) and heads a private-sector group, The Counter-Party Risk Management Group II, set up to offer guidelines for assessing risk in the
derivatives market that is often the playing field for hedge funds. He believes
the finance world has learned much from the LTCM meltdown and that leverage in
the hedge-fund industry is not as great as it was.
Yet he acknowledges that there is simply no way for any individual banker or
regulatory agency to know and he wouldn't rule out a significant shock from a
hedge-fund blowup. The best regulators can do is try to limit both the
concentration of a single banks' lending to a single fund and into a single
asset class or trade.
By using leverage and trading spreads between asset classes, hedge funds tend
to make our market more efficient. This can show up in everything from low
interest rates to lower volatility in the stock market such as we've had during
the past several years.
Which brings us to our next answer. The dominant principle of this column has
always been the idea that there is no free lunch. We must understand what we pay in economic terms for some benefit we receive, as well as understand the benefits we receive from what we have paid.
When it comes to hedge funds, we accept the lower volatility and the tighter
spreads - between such things as the interest rate on corporate bonds and
Treasurys that can lower borrowing costs for companies - that come from their
investments. To enjoy that benefit, we pay a price in uncertainty that comes
from the opacity of hedge funds.


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