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& 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
did."
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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