FINANCE: Hedge Funds

I admittingly do not know a lot about "hedge funds". It is included in the CFA curriculum under the sub topic of "Alternative Investments" (together with "real estate investments" and "commodity investments" among others). Other than that, I do have some friends who work for "hedge funds" and regularly read "Institutional Investor" magazine, a monthly magazine on hedge funds, investments and corporate finance.

I do know that "hedge funds" have been increasingly popular the last couple years and the regulations in the industry - if any - are still minimum at best. With this limited knowledge, I actually made a call couple months ago - OK, I'm officially making this on public record now - wildly guessing that "hedge funds" would be the next "big exploding thing" here in the US (as far as I know, "hedge funds" is much more popular here than in any other developed countries) based on the very premise of the lack of regulations and disclosure requirements.

Here is an excerpt from one great article from Bill Gross of PIMCO from his Investment Outlook column in August 2004 on what he thinks about "hedge funds":

http://www.pimco.com/LeftNav/Late+Breaking+Commentary/IO/2004/IO_August_2004.htm
Lemonade for Sale

Horatio Alger stories which allude to finding the proverbial toy at the bottom of the manure pile or turning lemons into lemonade are a reflection of the American dream – rags to riches, something from nothing, a pot of gold at the end of your own personal rainbow. Still while dreams and wishes upon a star do come true for some of us in this Jiminy Cricket world, there can be a cost to fantasies ungrounded in reality and everyday common sense. In the world of money we have our oft-cited historical examples: tulips, portfolio insurance, NASDAQ 5000. Pop went these bubbles and the savings for that matter of investors lured in at or near the top. It’s a story of the ages, an endless ticking of the human metronome setting a cadence swinging from fear to greed then back again. What isn’t always obvious, however, and what makes the game go on and on is that the lure morphs into a different shape, sometimes during the same generation of investors. A good fisherman knows that if the fish aren’t biting you change the bait and a good salesman knows that if you can’t sell lemons, push the lemonade.

So it is with today’s craze for hedge funds. Longer term returns for both stocks and bonds are sinking through the double-digit return line and moving perilously close to 0% for a growing number of longer term time periods. Since Wall Street has left the real estate commissions to the Century 21s of the world, there seems few attractive investments left to generate the fees upon which to support that summer home in Amagansett. Enter stage left – the hedge fund. Now let’s be honest here. Wall Street does benefit enormously from the growing boom in HFs. Such funds are estimated to provide $10 billion annually or more than 7% of the Street’s total revenue via trading commissions. In addition, fees for loans, back-office clearance, and even matchmaking or client introduction services run into the billions as well. But the Street is not the only seller of mining equipment in this hedge fund gold rush. There are now over 7,000 hedge funds managing nearly a trillion dollars of assets, all offering the hope of near double-digit returns in a much lower return investment world. And the price tag averages 2 and 20 – 2% annual fixed expenses and 20% of the profits.

...... What is a hedge fund? Supposedly the genre revolves around an ability to buy assets that will go up in price, sell ones that go down in price and if things don’t move too much, to capture yield or carry during the wait. Somehow, with the exception of shorting, that sounds like the standard active management dictum that has been around for nearly half a century now. Of course proponents claim that HFs attract the industry’s best talent and that the fees provide a significant incentive to identify and focus on winning strategies. Poor babies; thanks to capitalism, HF managers have had the ability to move out from under the oppression of investment management firms that are paying them a paltry few million dollars in bonuses a year at their own shops where they can wring 5, 10, 15 million or more if they make really good lemonade.

Actually their wizardry in my opinion has little to do with buying or selling the right stocks at the right time and everything to do with leverage. Hedge funds in reality are just unregulated banks, operating on a poorly disclosed amount of equity capital and taking the spread between their cost of funds and their riskier and longer dated assets. How much equity capital and therefore how much leverage is a fair question without reliable answers. Grants Interest Rate Observer in a recent issue, while asserting that nearly three quarters of HFs use leverage, surprisingly released their own survey showing $3 of assets on average for every $1 of capital, a figure that would stand in conservative contrast to banks at $10 per $1 of capital ........

Which brings me back to my premise of the eventual demise of the hedge fund craze through the route of competition, excessive fees – and an ultimate realization by sophisticated investors that they can do whatever their hedge fund manager can do at 1/100 of the price. If the magic of a bank, or an unregulated bank – a hedge fund – comes from its ability to borrow more money at a cheaper price than the everyday Joe or Jane, then Houdini’s “Metamorphosis” has now been exposed. Because ANYONE can now borrow more than enough money to make almost any investment they want at the same interest rate that banks and hedge funds do. Such financial wizardry these days comes rather commonly via the use of financial and commodity futures as well as supercharged options on any or all of them .......

....... So if you’re thinking about a hedge fund to bolster your portfolio returns, give it a long think. They’re risky and they’re generally overpriced. You can do better elsewhere or even on your own. On a broader perspective, the growing fascination with hedge funds and indeed the ability to lever almost any asset at minimal borrowing costs which was the heretofore province of strongly regulated banks, promises excessive speculation that inevitably will follow the financial metronome’s pendulum towards greed then back to fear, producing a number of near certain bubble poppings in the process. America’s and, therefore increasingly, the world’s economy is unstably founded on a base of cheap money used as leverage to support certain asset prices of dubious value ......