HEDGE FUNDS
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n a few years, investing in hedge funds will be the norm, and traditional mutual funds will be seen as the risky option. And it makes sense, if you think about it.” The speaker was a senior hedge fund manager and this recently expressed sentiment was obviously self-serving. But it does make sense — if you think about it.
Hedge funds promise to make money both when markets are up and when markets are down. They do this by using aggressive strategies that are unavailable to traditional longonly funds – such as short selling, leverage, program trading, swaps, arbitrage and derivatives. Lightly regulated, they are exempt from many of the rules and regulations governing old-style mutual funds. Trouble is, most of these activities and practices have been implicated in the market meltdown of recent months, leading to temporary restrictions on one of the hedge funds’ core activites, short selling. Short selling is where a trader borrows shares to sell on the belief that they will fall in price, upon which he can buy them back at the lower price, pocketing the difference. This manoeuvre is thought to have made at least €1.5bn in profits for traders who shorted HBOS shares back in the summer, amid rumours that it was in trouble. The kings of shorting include Philip Falcone, who borrowed 3.29 % of HBOS’ stock earlier this year, a bet worth almost €500m. Others include David Einhorn of New York-based Greenlight Capital, who says he shorted Lehman Brothers before it went bust; Crispin Odey at Odey Asset Management; Noam Gottesman at GLG and Paul Ruddock and Steven Heinz at Lansdowne. The UK’s Financial Services Authority recently forced Lansdowne to reveal that it had shorted Anglo Irish Bank and Barclays to the tune of 1.63% and 0.51% respectively. In the face of threats from US securities regulators to subpoena hedge funds for their past trading records, the best managers started to hoard cash instead, begging deeper questions about the future of the industry.
In particular, the best hedge fund manager of the past two years, founder of California’s Lahde Capital, Andrew Lahde, told investors that he was closing his funds, returning monies to investors and shutting up shop. He noted that while he had made money from market volatility, the danger of losing it from a bank collapse was simply too high. One of Lahde’s funds returned 870% last year, underlying how spectacularly a top hedge fund can perform in an otherwise indifferent market. But extreme circumstances don’t disprove the hedge fund model, and according to its disciples they may very well underscore it. The vast majority of mutual funds, unit
THERE ARE 7,500 TO 8,000 HEDGE FUNDS HANDLING €2 TRILLION IN ASSETS trusts and pension funds are generally stuck with just one option: going long. As one manager noted: “It’s like driving a car that can only make right turns.” These are the people who have done badly in 2008, when markets fell precipitously amid a general banking crisis. If anything, wealth managers have been urging clients to put more money into the best hedge funds rather than less, to ‘hedge’ their traditionally overweight stake in equities. A recent survey showed that wealth managers have increased their clients’ investments in hedge funds by an average of 2.5%. This change was reflected, in September, by the realignment of a growth-focused benchmark published by the Association of Private
Client Investment Managers (APCIM), taking the hedge fund component from 5% to 7.5%. According to the APCIM, the composition reflects the average allocation to the various asset classes the association’s members have actually made on behalf of their clients. It said it had seen more money going into hedge funds due to “a strategic move toward more defensive assets as portfolio managers seek to stabilise returns against the backdrop of increased volatility in equity markets.” It’s not an insignificant shift: by increasing clients’ investments in hedge funds by 2.5%, wealth managers have, in effect, increased clients’ exposure by half. These have been largely defensive moves, designed to preserve capital in an increasingly fraught market. The first hedge fund – or at least the first investment vehicle to be given the name – was launched by Alfred Winslow Jones in 1949. A journalist, he was writing a story about investment trends for Fortune magazine when he was inspired to try his hand at managing money. His scheme was to try to minimise the risk in holding long-term stock positions by short-selling other shares. This strategy is now referred to as long/short equity, and is still the model used by the majority of hedge funds. Jones also introduced a number of other innovations: the use of leverage to increase returns, the imposition of a 20% incentive fee to the manager (Jones, in this case) and the classic limited partnership structure. For all this he is now known as the father of the hedge fund. As for performance, he out-paced every mutual fund on the market, often by double-digit figures. The hedge fund industry has grown enormously since then. Presently there are said to be between 7,500 to 8,000 hedge funds handling €1.7 trillion to €2 trillion in assets between them. There are now 14 distinct investment strategies used by hedge funds, some of them fairly exotic. Distressed Debt funds, for instance, buy deeply discounted debt or trade claims of companies facing bankruptcy or reorganisation; Emerging Market NOVEMBER 2008 I CNBC EUROPEAN BUSINESS 29
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