Why Hedge Funds Will Defy the Odds - 06/12/01
When the Long Term Capital Management (LTCM) hedge fund drama the news in September 1998, it posed a threat to world markets so great that the Federal Reserve midwifed a bank consortium to take over the fund.
As a result of the attendant publicity, a very nice trend that had been developing for hedge funds as a group almost disappeared.
Earlier in 1998, hedge funds- which offer larger-than-average returns to select investors via trades that are generally risky enough to produce high returns and may carry the name "hedge" whether they cover their bets or not - had finally begun to garner some respect among financially savvy institutions and individuals.
"At the beginning of 1998, one was really seeing more interest, as in unsolicited inquiries about hedge funds, than at any other time anyone in the industry can recall," says George P. Van, Chairman of Van Hedge Fund Advisors International, Inc., a fund-of-funds manager and analyst, who was invited to testify about LTCM before a sub-committee for the House Banking and Financial Services Committee on the same day as Federal Reserve Chairman Alan Greenspan and New York Fed President William McDonough.
The Long-Term Capital Management incident notwithstanding, all is not lost for hedge funds. By all reports, investors who had already decided to allot a portion of their portfolios to these funds have generally decided to stay invested, and some are even increasing their allotments.
The biggest reason more sophisticated investors endowments and foundations, pension funds, and high-net-worth (HNW) individuals - are not running away from their hedgefund investments is that they recognize that LTCM was an extreme example. LTCM had magnified its market bets by adding leverage, or essentially borrowing money to add on more bets, up to at least 50 times its available capital, and perhaps even 125 times its capital if all the leverage inherent in the derivatives LTCM was using is included. But 99.5 percent of hedge funds just simply do not use this kind of leverage.
Instead, according to Van Hedge Fund Advisors' research, 30 percent of hedge funds use no leverage at all. Another 54 percent use less than two-to-one leverage, just doubling their capital. And in the remaining 16 percent of hedge funds, it is unusual to find a fund that even uses over five to 10 times leverage. Investors that have done their research know that even though hedge funds did poorly in the manic market of 1998, as did mutual funds and other investors, that wasn't because these investment strategies are inherently bad.
Financial-investment experience is, in fact, a prerequisite for investing in hedge funds. At least in precept, if not always in practice, these fund managers won't even talk to prospects if they can't show that they have the money and experience to take full responsibility for their investment decisions.
One place where financial sophistication is more likely to be found is in endowments and foundations, serving the larger universities and wealthy family investment offices. These entities are usually private and have greater leeway to invest where the returns are higher. Part of that equation, however, is hiring experienced financial professionals who have had enough experience to understand the intricacies of hedge-fund investments.
One such endowment and professional is Vassar College and its Director of Investments, Jay A. Yoder. Vassar currently allocates 10 percent of its investments to hedge funds. "We will not be reducing that," explains Yoder. "In fact, I am going to recommend to the investments committee that we increase it to 14 percent." That decision, he says, is based upon a belief that "despite the recent adverse publicity, hedge funds can both enhance returns while at the same time reducing the overall volatility of the portfolio."
Yoder's perception that the market holds more attractive opportunities is the reason for his recommendation to Vassar's board. "Various types of spreads have widened and various types of arbitrages have seen the number of players and amounts of money involved dry up," he notes. Many times when there is less money pursuing a deal, it rises in value. "I think the opportunities are going to be extremely attractive going forward, for investors who are farsighted enough to take advantage of the current opportunity."
Part of Vassar's increased allotment will be funneled to a new hedge-fund manager. Currently, Vassar uses four managers, and Yoder and his staff are keeping a close eye on those managers in this market. But the four are doing fine, he says, and a fifth manager would be prudent. The right fifth manager would allow Vassar to retain its higher returns from hedge funds and reduce the risk that "poor performance from any one manager would significantly hurt our portfolio," he says.
What would prompt a serious review of a manager by Yoder? Extremely bad performance in the short term, would be one trigger, or severely poor performance over any period of time, a change of strategy that does not fit what Vassar wants to pursue, or a loss of key personnel by the fund manager. "Those are the major factors that would cause us to revisit a relationship, or to take money away, or fire a manager," he outlines.
Wellesley College's endowment is also active in the hedgefund arena. Katherine Feddersen is the Associate Treasurer for the endowment. She explains that Wellesley currently has 12 percent of its investments in hedge funds, and foresees no change. "We were not invested in Long-Term Capital Management," she says, since Wellesley stays away from much leverage. The endowment does use a range of risk profiles, and has a broadly diversified blend of investments.
Pension funds are also active investors in hedge funds, but less so than endowments and foundations. Although pension funds may be the repository of much of the world's wealth in actual dollar terms, they can also be run by people who started out on a non-financial career track.
It is not uncommon for a pension fund's manager to have spent much of his career as, say, a fireman before working for the firemen's pension fund, for example. In addition, pension funds are much more likely to be governed by state or even federal regulations. In fact, there may be some states that do not even yet allow their funds to invest in anything other than bonds.
One pension fund that is active in alternative investments is the State of Virginia Retirement System. Virginia has about six percent of its total fund in market neutral funds, which are defined as hedge funds by some, as well as some venture capital and leveraged buyout investments. Regarding the fallout from LTCM, however, there has been no change in Virginia's activities. "There's been a few additional discussions and information sharing," says Craig Scholl, Managing Director of Public Equities, "but we haven't changed a thing."
Not surprisingly, those "additional discussions" were prompted by questions from the board and management, "but they were thoughtful, considered questions on the issues," says Scholl. "We see this year as an opportunity to more seriously evaluate an area that had appeared to be getting over subscribed. We're not taking any specific action, but we are looking more carefully at increasing our commitment to these investments."
A third type of investor in hedge funds is the high-net-worth (HNW) individual, or accredited investor, which is defined as someone with at least $1 million in net worth. Such people are a significant source of money for the medium to small hedge funds that, even if they could get the attention of big investors couldn't, probably handle the huge chunks of hundreds of millions of dollars that some of the large endowments or pension funds want to efficiently invest.
A division of consultant Frank Russell, Russell Private Investment Services (RPIS), with about $2 billion under consultation, works with a lot with HNW clients, as well as some family money in foundations and a couple of institutions that use Russell's considerable database.
There hasn't been much change in HNW activity, says Daphne Bradshaw-Mack~ Senior Investment Strategist at RPIS. But then, she explains, "we typically don't have our clients in the large macro funds or the directional funds," the very strategies that fared the worst last fall. "The greater appetite by our clients tends to be more long/short equity structures, predominantly in the US, maybe a little international."
Additionally, her HNW clients use some event-driven strategies, such as merger arbitrage or risk arbitrage or convertible-securities arbitrage.
That's not to say Russell's clients aren't watching their hedge-fund investments intently. It may be just five percent to seven percent of their portfolios, "but they do consider, when the market was going to tank, this was supposed to work. This was the hedge," points out Bradshaw-Mack.
She has one client that is actually funding a new hedge-fund manager. But that decision had been made prior to the LTCM fiasco. In looking over the general movements of assets lately, "Our clients aren't rushing to put more in [to hedge funds]," she says, but by the same token, "they aren't taking it off the table," either.
If anyone changed after LTCM, it was the banks and prime brokers who had allowed that fund to leverage up so much. The list of consortium members is well publicized, but other banks (who invest in hedge funds and lend leverage capital to investors) and prime brokers (who via their brokerage activities end up providing leverage directly to hedge funds) have also reportedly pulled back.
During the liquidity crunch in the market last fall, there were reports of prime brokers making large margin calls on hedge funds' investments, and sometimes forcing them to liquidate at fire-sale prices to make margin calls.
Banks and prime brokers in response have enacted several changes. Generally, loan maturities are now shorter. Many institutions no longer accept mortgage-backed securities as collateral. And many have raised the haircuts on valuation of collateral accepted in some cases doubling the haircuts. Where it used to be that 75 basis points were taken off the top of the value of the zero to five-year securities before being counted as collateral, now 150 basis points are cut. For five to seven-year securities, the average haircut is now 175 basis points. For seven- to 10-years, it is now 200 basis points. The end result is that some of LTCM's deals - in which they would buy at 29 and turn around and sell at 30 would no longer be profitable, and thus would not have been done in the first place.
Bear Stearns & Co., Inc., a New York-based hedge fund prime broker, however, hasn't changed its policies, says Richard Harriton, President of Bear Stearns Securities Corp. "We have a very elaborate risk control system," he says. "I was very pleased that it did everything we expected it to do in a crisis situation."
Bear Stearns's risk-management system performs 200 calculations every day on each of the 850 hedge funds the company deals with, looking at what happens to the accounts if the markets move up or down, or if the currency interest spreads change, or the volatility. "And we work with the accounts [where] we are uncomfortable with the risk," explains Harriton. "We either help them hedge the risk down or reduce the positions, or I ask them for more equity. So when there was this liquidity crunch, we didn't raise our margin, or any of our requirements."
More fund disclosure
But this lack of movement out of hedge funds by investors, and at least some banks and brokers, does not mean that they are not asking some hard questions of the funds. First on everybody's list is transparency of a hedge fund's activities. Indeed, some of the smaller hedge funds are finding they have to give more information about where they're investing, in order to attract money. On the other hand, larger funds that don't feel the need to attract more business are continuing in the practice of giving as little disclosure as possible.
But consider that there are commercial reasons for managers to not disclose their activities, points out Nicola Meaden, Chief Executive at the industry analyst firm, TASS Management Limited, London. It comes down to how much access to liquidity in the markets a manager has. Whereas mutual funds are active in stocks on listed exchanges 98 percent of the time, with specialists that must provide orderly markets even in a downturn, hedge funds are lucky sometimes to find even three or four market makers in the world who may or may not get them in and out of the market in an OTC stock.
"Most of the hedge funds look for stocks not covered by the mainstream, to identify the opportunities," points out Meaden. Say, you decide you want a particular stock to be five percent of the portfolio, in a thin market it's not uncommon to have to build the position over a few days or weeks. "While you're building that position, total transparency is not beneficial" to the manager or the investor in the fund, she points out.
Consider also, a hedge fund building a short position in a stock. The fund's manager wouldn't want to expose that he or she is selling a stock short, "not if you ever want that company to ever give you information again," she points out.
Hedge-fund investors generally understand this, so although they'd like more information, they'll accept whatever they can get. "We don't require complete transparency, because you can't get it in the hedge-fund business," says Vassar's Yoder. "But even though we don't know our hedge-fund positions exactly on a daily basis, we do know the strategies they are pursuing, how they make their money, where their returns have come from, and in general what they're doing. So the lack of transparency is, as long as you're dealing with a reputable organization, not a huge concern for us."
Hedge funds will deal with requests for more information in various ways, ranging from a vague, general public statement, to asking the investor to sign a confidentiality statement before divulging information. Also, if a written statement just won't work, some funds will allow you to stop by their offices and view their books. You may get to flip through the pages, but they'll probably ask you not to take notes.
Regulations vs. global liquidity
In September and October 1998, the hue and cry was for more regulation of hedge funds. But US Treasury Secretary Robert E. Rubin and Federal Reserve Chairman Alan Greenspan have both come out against more regulations, pointing out that the very fact that hedge funds can move their investment ideas quickly around the world is actually a positive for world market liquidity.
In early January 1999, the big banks came together to cobble together some sort of self-regulation of the derivatives market, which is the playing field of hedge funds, amid some positive nods from regulator types and some dubious questions about a fox in the hen house.
Van of Van Hedge Fund Advisors points out that the funds are not exactly without regulation. Even those who are not US registered investment advisors (though more than half of the world's 5,500 funds are registered) are allowed to run funds with a maximum number of 99 investors, must avoid anything that smacks of advertising and have to be able to show that an investor had a significant business or personal relationship with the manager before investing. But that doesn't mean the registered advisors get off easy.
Those managers that are registered investment advisors are governed by the Investment Advisors Act of 1940, and thus are audited every two years. "And the SEC won't go home until they find something," says Van. "Our research shows that 80 percent (including offshore funds) have to tow all these lines from the SEC."
Even the HNW individuals are not that concerned with further regulating hedge funds. "They haven't called asking if the funds are going to have more regulations," says Russell's Bradshaw-Mack. "Most feel it is highly unlikely that the funds will become as regulated as other institutions."
There is growth ahead
There was a spate of redemptions of investments from hedge funds through the last few months of 1998, proving that some investors just decided it would be better to sit on the sidelines until the dust settled.
But that wasn't what fund managers had feared. "We saw a greater amount of redemptions than we've seen in past years," says Bear Stearns's Harriton, "but nowhere close to where everybody was projecting it was going to be."
Rather, after a bit of a shakeout, with the unsophisticated players exiting the business, "which I think will be healthy overall," explains Vassar's.
Yoder, it looks like growth is in the future for hedge funds. Bear Stearns has certainly seen an increase in interest, considering it ran a hedge-fund seminar in November 1998 and there were 210 high net worth individuals, endowments and pension funds in attendance, and 200 people had to be turned down. Needless to say, Bear Stearns plans more such conferences.
Harriton has also noticed quite a few new start-up hedge funds entering the business. It would seem that for hedge funds, as for others who have found themselves in the harsh media glare, it is a case of any publicity is good publicity. Though don't forget, getting the name changed to alternative investments probably helped a little. _x000D_