Hedge
Funds: A Modern Day Gold Rush
A day doesn’t go by without hedge
funds being mentioned in the papers.
The phrase is now synonymous with a
group of savvy investors who try to
gain by short-term transactions on any
markets. Amongst professionals this
strategy is known as Global Macro: investing
in global macro-economic trends and
profiting from it. Besides this strategy
there are a dozen other strategies that
hedge funds use. From Long/Short to
Event Driven, all these strategies are
different from those of the traditional
fund manager who invests in an asset
class and waits for a profit to arise
when the investment goes up in price.
The mutual fund industry is growing,
but the growth of the hedge fund industry
is staggering. Sociologist, author and
financial journalist Alfred Winslow
Jones is credited with setting up the
first hedge fund in 1949. Jones was
followed by people like Soros, Steinhardt,
Robertson and many other historic names.
Where there were only a couple of hedge
funds in the 1960’s, nowadays there
are around 10,000 with estimated assets
under management of approximately $1.5
trillion, and with new funds hitting
the markets every day.
Analysts say the main reason for this
popularity is the difference in fee
structure. Where normal mutual funds,
depending on the asset class they invests
in, charge a fee of 1-2%, hedge funds
go by the golden rule of 2/20, which
stands for a management fee of 2% and
a performance fee of 20%. The performance
fee means that the hedge fund manager
is entitled to 20% of the profits above
certain performance goals.
Many portfolio managers say money has
no loyalty and it flows to where it
thinks it will get the highest return.
In today’s world, investors have become
more opportunistic and they seem to
be chasing short-term gains. The stellar
growth of hedge funds and the attention
they receive from private and institutional
investors is a result of some exceptional
examples.
James Simons’ hedge fund Renaissance
Technologies charges a management fee
of 5% and a performance fee of 44%.
Expensive you say? The fund has approximately
$30 billion of mainly institutional
assets under management. For this cost
structure investors receive probably
the most advanced black boxes in investing
around today. The total capacity of
Renaissance is said to be $100 billion.
Yes that is $100,000,000,000.
Renaissance uses computer-based models
to predict price changes in easily traded
financial instruments. The predecessor
to Renaissance was a hedge fund called
Medallion. This fund has managed to
return an unbelievable 35% annual rate
of return (after fees) since 1989 and
is viewed by many as the most successful
hedge fund in the world. Unfortunately
it is closed to outside investors and
nowadays Medallion only manages the
money of the employees of Renaissance.
It is no surprise that James Simons
ranks among the highest paid hedge fund
CEO’s with an estimated net worth of
$6 billion. In 2007 after 3 years in
the lead, he had to accept being second
best and the first place was taken by
John Paulson. He made his fortune by
betting against the sub-prime market
in the period 2006 to 2008. From 2006
to 2007 one of his funds managed to
return almost 600% to its investors.
Of course his investors weren’t the
only ones to benefit. Paulson earned
a staggering $3.7 billion in 2007 and
was the top earning hedge fund manager.
The story continues: a star manager
at fund house GLG gave up $250 million
in stock to set up his own hedge fund;
Transtrend, Holland’s most successful
hedge fund was sold to Robeco and so
on. Such successes attract the attention
of many entrepreneurs and of course
the occasional opportunist. Not surprisingly
many traditional fund managers are becoming
hedge fund managers, as are research
analysts and some people with no experience
at all. All of them aim to do well,
either for investors or for themselves.
The higher fees in hedge funds lure
new managers, and they are justified
by the more complex investment processes
and higher fees charged by top consultants
and lawyers for brokering deals.
This world does not only have success
stories. For every success story there
are 10 failures. Permal Investment Management,
one of the largest and most respected
fund-of-fund hedge fund managers in
the world says they are only looking
at 1-2% of the hedge fund industry to
invest their money in. Being a hedge
fund manager they only invest in other
hedge funds, after over 35 years of
experience they have seen more failures
than success stories. One of the biggest
failures was the Long Term Capital Management
collapse of 1998, supervised by Noble
Price winners Myron Scholes and Robert
Merton, who lost $4.8 billion. More
recently Brian Hunter from Amaranth
lost a record of around $6 billion from
investors in 2006 by betting in commodities.
Even the brightest minds from Goldman
Sachs lost billions of dollars in the
2007 market slump. At the very top of
these failures is the giant Ponzi scheme
run by Bernie Madoff and his family.
The latter is a perfect example of people
wanting to believe in an endless money
machine with little or no risk at all.
For the latest updates on imploding
hedge funds http://hf-implode.com/ provides
a clear and present picture of the state
of the hedge fund world.
Given the unregulated environment, hedge
funds and the black boxes they sometimes
operate, offer looming risks. The odds
seem to be against finding a successful
hedge fund.
Harry Kat of the Cass Business School
in London has been the biggest hedge
fund critic. He argues that many of
the high fees can’t be justified by
the simple composition of certain portfolios
and their performances. By using low
cost products that are highly traded
and transparent, Kat has proved that
many hedge funds overcharge their clients
and that the returns they generate do
not relate to the high fees charged.
Kat is one of the most highly read business
authors on the Internet and at www.fundcreator.com
he provides a model by which people
can replicate their own hedge fund returns
using certain given parameters. He developed
this model, to demonstrate how to generate
the returns at much lower costs. This
new phenomenon is seen by many as the
next evolution in this industry.
Although many (new) hedge fund managers
will claim their investment process
is unique, and it could be, the future
returns will remain a mystery. Even
inferior investment processes can do
well when marketed the right way. This
world has changed from being all about
investing to being all about marketing.
For the future it is highly likely that
more money will be concentrated among
the top hedge funds and beside them
a large pool of smaller hedge funds
will exist. A pool which, in the current
economic crisis, is getting smaller
by the minute.
There is no doubt that this industry
is the latest Gold Rush, one bigger
than ever seen
before. We will probably read lots more
about hedge funds in the years to come…
Ricardo Fakiera MSc wrote this column
on personal signature for my book “Beyond
the Crisis”. In daily life he is Vice
President of Merrill Lynch International
Bank in the Netherlands. He has his
roots in Europe, India and South-America. |
