Time for a trim

Buttonwood

Oct 4th 2005
From The Economist Global Agenda

Hedge funds are headed for a lot more transparency, and not before time

FORGET the leadership squabbles at the Labour and Conservative party conferences. The best story in the British press this weekend was of a deal-happy hedge-fund manager who spent £36,000 ($64,000) in a London bar in a single evening, including a £3,000 tip for the bemused waitress. It’s not the amount spent that leaves people amazed, eye-catching though it was. It’s that he was apparently so nice.

What is it about hedge funds? If lawyers hadn’t already taken all the worst jokes, hedge-fund folk would certainly be contenders. The high-paid managers of these lightly regulated investment pools are blamed for everything from the high price of oil to the crumbling of corporate governance. Yet they are looking anything but omnipotent these days, as rumbling scandals combine with so-so performance to turn many traditional investors off hedge funds before newer institutional fans are firmly committed to them.

The long-running financial soap opera that is Bayou Funds finally hit peak ratings last week, as the group's founder and finance director pleaded guilty in a New York court to persistently cooking the books. Investors are still whistling for most of the $300m-plus they put in. Though the Bayou case is the biggest hedge-fund investigation to come before the Securities and Exchange Commission (SEC) in five years, it was never more than a years-long fraud perpetrated by a well-connected Louisiana wide-boy. It matters to the world at large mainly because various experts who should have known better (J.P. Morgan, for example, whose Spinnaker Fund was invested in Bayou) apparently did not.

Potentially more worrying, though no wrongdoing has been proven, are allegations about two other fund groups, Man Group and Gamco Investors, for these sit at the heart of the fund-management establishment. Man Group is tussling with the receiver of a collapsed hedge-fund firm, Philadelphia Alternative Asset Management Company (PAAM). The receiver alleges in a contempt motion filed last week that Man was not helpful in shedding light on the activities of a senior employee at its futures brokerage, Man Financial, who might have helped PAAM to hide some $175m in losses. Man says it has been co-operating with inquiries.

As for Gamco Investors, the man who masterminds the publicly quoted fund-management group, Mario Gabelli, is being sued by two of his original backers who own stakes in the private company that controls Gamco. Unhappy because they have not ended up with marketable shares in a public company whose share price has trebled since 1999, they allege that Mr Gabelli and the private firm’s other directors are “guilty of looting the assets of the company, breaching their fiduciary duties to its shareholders and oppressing its minority shareholders”. Mr Gabelli says that they have treated everyone fairly. As far as the suit is concerned, he says: “The dogs bark and the caravan moves on.”

But these brouhahas in the heart of hedgeland are the least of its problems. In a universe of perhaps 8,000 funds, it is not unusual to find a handful of bad apples and another, bigger bunch whose procedures are not all they should be. More worryingly and more generally, growth is slowing sharply. In Europe, hedge-fund assets increased by only 9% in the six months to June 2005 (to $279 billion), according to EuroHedge, a trade publication, after growing by about 50% in all of 2004. In America, according to a related publication, Absolute Return, the hedge funds with more than $1 billion in assets under management also grew by only 9% in the first half of this year.

That is neither surprising nor necessarily a bad thing. Hedge-fund assets have doubled in little more than four years and a lot of over-eager new players have come into the market. But lately performance has been poor. Hedge-fund returns, net of fees, were 4.2% in the year to August, according to CSFB/Tremont’s measure—less than brilliant compared not only with what they were in the 1990s but with total returns on European shares (though returns on the stagnant S&P 500 were even worse).

What seems to be happening in Europe, anyway, is that the rich private clients who for years have been practically coterminous with hedge funds are losing enthusiasm for the genre. Man, for one, reports that its private clients redeemed more than they invested in the three months to September. GAM, which runs funds of hedge funds, saw net redemptions in the quarter to June.

Meanwhile, the investing institutions that were expected to come rushing in for higher yields have yet to do so in bulk. New research from Greenwich Associates, a research firm, shows that, despite all the talk, European pension funds’ allocation to hedge funds has stayed flat. The proportion of European institutions that say they are planning to start using hedge funds has dropped from 19% in 2004 to 8% this year.

More may be at work here than undistinguished returns. After all, protection of capital in bad markets and good—not stratospheric returns—is a large part of what hedge funds are supposed to be about. They are prized for adding stability to portfolios, for being uncorrelated with mainstream markets and for minimising risk through diversification. There are increasing doubts these days as to how much most hedge funds are really doing that—about whether, in short, hedge funds are hedging.

Several relatively recent studies* reach disturbing conclusions. The first is that hedge funds overall—even those that define themselves as “market-neutral”—are more correlated with equity markets than used to be thought, and that different strategies are also more correlated with each other than they look. So much for diversification. Another conclusion is that because many hedge-fund investments are relatively illiquid, the way in which they are periodically priced tends to “smooth” returns and hence make funds appear less risky than they are. So much for fancy risk-reward measures such as Sharpe ratios. A final conclusion is that hedge funds are now big enough and intertwined enough with banks to be a new source of risk to the financial system as a whole.

The New York Federal Reserve would undoubtedly agree, though perhaps for different reasons. In the Fed’s attempt to eliminate a huge back-office backlog in the fast-growing credit-derivatives market, hedge funds have emerged as even badder boys than the investment banks that deal with them. While trades are unconfirmed, or if one party (usually a hedge fund) unilaterally assigns a trade to a third party, it is unclear what risks lie where. The banks are expected to present a recovery plan to the Fed this week requiring hedge-fund customers to adopt standardised trading procedures and to settle trades electronically through the Depository Trust and Clearing Corporation.

As investors and supervisors are beginning to ask tougher questions, a little more transparency is about to hit this famously murky corner of the financial world. Just as mutual funds, the investment growth story of the 1980s, were eventually forced to divulge more information, hedge funds will be too. The old argument for exempting them from disclosure—that they dealt only with knowledgeable investors—holds less and less true, as more middle-income investors buy their way in through funds of funds and the like, and ordinary workers’ pension funds commit their future wellbeing to hedge funds. Nor is what most hedge-fund managers do beyond the wit of man to comprehend: equity long/short strategies are the biggest investment style these days.

Most hedge-fund investment advisers will be required to register with the SEC by next February, though they will not be reporting anything like the information that mutual funds provide. The most useful sort of disclosure will emerge from the market itself: Morningstar and Lipper are among those interested in rating individual hedge funds, though the difficulties are considerable. One wonders how they will rate the fund that Richard Breeden, former head of the SEC itself, is rumoured to be starting.

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* “Do Hedge Funds Hedge?”, by Clifford Asness, Robert Krail and John Liew, Social Science Research Network; “Hedge Funds: Risk and Return”, by Burton Malkiel and Atanu Saha, Princeton University; “Systemic Risk and Hedge Funds”, by Nicholas Chan, Mila Getmansky, Shane Haas and Andrew Lo, National Bureau of Economic Research.

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