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November 1, 2007

Don’t Believe The Hype

By Spear's

Merryn Somerset-Webb on why hedge funds, despite the promises and glamour and mystery, are not all they are cracked up to be and often fail to achieve their potential.

The second half of 2007 should have been heaven for hedge funds. The credit crisis and all the nasties that spun off from it meant hugely volatile share prices – some bank stocks rose and fell five to ten per cent on single days, while those with an eye for them, have been able to spot pricing anomalies all over the place.

At the same time, there was massive scope for betting on oil prices and soft commodity prices while gold, a hedge-fund favourite, hit 26-year highs. This should be the kind of environment that good managers relish: in good markets everyone makes money, but in slightly bonkers markets such as these, only the highly skilled and the exceptionally lucky do.

And hedge-fund managers are highly skilled, aren’t they? Apparently not. Some funds did amazingly well during the various early stages of the credit crunch. It’s hard to visit a City bar without someone telling you of the killing he made shorting shares in Northern Rock (at one point 30 per cent of its shares had been sold short and fortunes were being made all round).

But on average most hedge-fund managers have made, well, entirely average returns. The MSCI Hedge Invest Index had risen 5.81 per cent by the end of October this year. The Dow Jones returned 8.6 per cent and the MSCI World Equity Index 5.5 per cent over the same period. And there have also been some very conspicuous blow ups. In August, a sub-sector of the industry – the quant funds, which use computer-generated ‘blackbox’ trading systems to trade their portfolios – all suffered horribly as markets moved in unexpected ways, while a number of funds that operated mainly in the credit markets have been shut down.

The upshot is that to the cynical eye hedge funds are beginning to look like little more than a complicated way for investors to make no more, and often rather less money, than if they had stuck with buying a few index funds instead.

So what’s going on? The first thing to note is that hedge funds are not a distinct asset class in the way that, say, equities and bonds are. Instead as Tim Price of PFP Group puts it they offer access to specific kinds of ‘skills based’ investing. They can trade across all kinds of asset classes from equities to commodities, currencies and derivatives of all of these and use any old strategy to do so.

Most tend to pick one area to operate in – they’ll only make macro bets on big moves in currencies or they’ll focus on looking for tiny pricing mistakes to exploit in just one sector for example. So while there are 8,000-plus hedge funds on the go at any one time (barriers to entry are low but so are failure rates so there’s a lot of turnover inside the 8,000) it’s hard to categorise them very clearly. Indeed, if it comes right down to it, most hedge funds have only three things in common with each other.

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First, they promise to make you absolute returns regardless of market conditions and to provide your portfolio with a degree of diversification. Second, they tend to fail to do either of these things. And third, they charge you vast amounts of money for the privilege of being invested in them, whether they make absolute returns or not.

The first point needs no back up – it says so in the marketing bumf that comes round with every new launch. Nor does the second – we can see it in the numbers. Why most funds fail to deliver is also pretty clear. The hedge-fund business is far from new, but its recent expansion has been very fast indeed. This has meant that thousands of hedge funds are run by men who were trained as long-only managers.

They are generally perfectly good at buying shares and holding them while they go up (not exactly a tricky way to make money in the kind of massive bull market we have lived through for the last two decades or so) and when allowed to borrow money to leverage up they can look really good in bull markets. But they mostly have no more clue how to short stocks and to run properly hedged portfolios in any sector than I do.

This is a tricky business. It needs proper maths. It needs charts. It needs complicated spreadsheets, models and the kind of level of intelligence that understands that models don’t always work: their success is a function only of the skills of their creators and dependent on the market operating as their creators expect (which it often doesn’t). And on top of all that it needs a wealth of creative thinking.

A background that involves a degree in ancient history from a middle-ranking UK university followed by a decade spent comparing the p/e ratios of UK large caps with the help of a team of 30 analysts for one of our giant fund management companies just doesn’t cut it. Anyone can start a hedge fund these days and unfortunately they do.

The fact that too many hedge fund managers are really long-only managers looking to make a fast buck in a booming sector is also reflected in the failure of most of the industry to offer punters much in the way of diversification. According to Jan Vilhelmsen of Absolute Return partners, the correlation between the average equity long/short fund with the market as a whole (as represented by the MSCI World Index) is now about 90 per cent.

When markets go up, these funds make money. When markets go down, they lose money. Just like ordinary funds. And it isn’t just the equity long/short part of hedge fund land that is effectively useless as a diversifier, says Vilhelmsen: most others are too. The result? ‘Seventy to 80 per cent of all hedge funds offer investors limited or no hedge against their traditional portfolio.’

Anyone in any doubt about all this need only look to events in Japan in the summer of this year. By August, the Nikkei was eleven per cent off its highs for the year. Most of the hedge funds I was watching did at least as badly. Many did worse. So much for creating alpha (hedge-fund talk for outperformance).

But the thing that I think will make most people think again about hedge funds is the third thing they all have in common – the fees. The charging system for most funds is based on ‘two and twenty’ – they take two per cent of the total assets under management in annual management fees and then keep twenty per cent of any gains they make (sometimes above a benchmark of some kind, sometimes not). This sounds nice – it gives them an incentive to do well for their clients so they can all get rich together.

But it doesn’t quite work like that. A friend recently sent me a chart of the performance of a hedge fund run by some people he doesn’t like much. It shows the fund doing fantastically up until the middle of 2005. Then it shows things falling off nastily through 2006. Anyone who invested in 2003 and 2004 is more or less evens. Anyone who invested after that has lost a lot of money – if you gave the fund your money at the peak you’d be down around 30 per cent.

Now this isn’t unusual – we’ve already looked at the nonsense of most absolute returns promises. But here is the problem this chart made clear: the risk in this fund was all on one side – that of the investors. The two founders of the fund paid themselves $50 million in performance fees in 2005 (their 20 per cent of the returns). But when all that performance subsequently disappeared they didn’t have to return any of it: like other managers, they make hugely disproportionate amounts of money when their fund does well but are in no way financially penalised when their fund does badly.

This provides all the wrong incentives. Last year, before the sub-prime crisis in the US really blew up, I had a conversation about all the various ‘investments’ related to US mortgages with another young hedge fund manager. We agreed you’d be completely nuts to buy any of them. Or I thought we’d agreed you’d be nuts.

He, after a few seconds thought, announced that there was an exception: if you are running a newish hedge fund manager who has managed to persuade £50 million or so out of a few gullible investors and you want a chance of getting rich quick, he said, buying this stuff makes sense. Sure, everyone knows the sector is going to blow up, but no-one knows when, and in the mean time you can make excellent returns from fiddling around with mortgage-backed securities and their many derivative products.

So why not do it? You can charge whopping performance fees until the crash comes, then when it comes you can just shut up shop and go home. Your clients will have lost money but as long as you get a couple of years at the trough – or even just one good one in the case of our friends above – you’ll be set up for life. And even if you don’t shut up shop but just hang on and take the management fees, you should do fine (two per cent of £50 million is £1 million and small hedge funds often have low overheads) until your clients get wise and demand their money back.

I wish I could be more positive about hedge funds. When the boom kicked off, it all sounded so good. I loved the idea of being able to invest in something that would make me absolute returns whatever the conditions in the market and that would always make bigger average returns than a bog-standard unit trust. I still do. It’s just that so far it doesn’t seem that the average hedge fund is that something: there are amazing managers out there.

It’s just that there aren’t, as the last few months have proven, 8,000 of them. Instead there are probably more like 20 and most of us aren’t ever going to find them. So what should you do? Put a bit of money into some of the listed hedge funds if you must (there are a good 50 on the UK market alone). But otherwise do what you used to do before the hedge fund hype started. If you think stock markets are going to do well over the next few years, get yourself some nice, cheap exchange-traded funds with exposure to the markets you like.

And if you don’t, buy a stash of gold and find a nice, high-yielding bank account. That way you really can’t lose.

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