The Running of the Hedgehogs ... part II

Byron Wien, one of the most popular commentators in the history of Wall Street, left a cushy job at Morgan Stanley in 2005 in order to join Pequot Capital, a hedge fund, as chief investment strategist. He apparently wasn’t forced to take the industry’s vow of omertà. When asked to explain the staggering growth of late, he puts it quite simply: “One of the main reasons is that it became legitimate for institutions to invest. In the early days, you signed up in a dark alley with a flashlight. Today, a typical institutional portfolio now has about 15 to 25 percent in such alternative investments.”
There’s no need for flashlights anymore, but the industry still has its critics, who voice everything from concern about leverage and lemminglike rushes that could threaten the stability of global markets to disgust at the astronomical fee arrangements. No less an authority than Warren Buffett has accused the industry of selling hokum, calling the typical compensation structure a “grotesque arrangement.” But whom did Business Week suggest as “the next Warren Buffett”? That would be Eddie Lampert, a hedge-fund manager.

The big are getting colossal.
A year ago, there were only four $20 billion–plus outfits; now, there are seven—JPMorgan, Goldman, Bridgewater Associates, D.E. Shaw, Farallon Capital, Renaissance Technologies, and Och-Ziff Capital. The first U.S. hedge fund to offer its stock to the public, Fortress, gained 67.6 percent on its first day of trading. There will be more firms taking that path.

They’re suffering from wandering eyes.
Among the big players, it is now almost impossible to find a pure hedge fund—meaning one that sticks to a specific investing style or niche. When you have so much money to invest, you can be forced out of your own specialty, lest you end up trading with yourself. SAC Capital just joined KKR, for example, in a $3.8 billion bid for an education company. Some funds are going so far as to invest in the movies.

They’re searching for a needle in a very large haystack.
Ask any hedge-fund manager, and he will tell you that the easy money has already been made, and there are no “obvious trades” sitting around. A recent report by the European firm Dresdner Kleinwort points out that if 4 percent of assets under management go to fees, and another 4 to 5 percent is spent on trading commissions and interest, hedge funds would need to pull in 20 percent annually to justify their costs. That forces them to take ever greater risks.

The club is no longer taking in as many new members.
Believe it or not, it’s harder to start a hedge fund now than it was a few years ago. According to Hedge Fund Research, in 2006, 1,518 hedge funds launched, compared with 2,073 in 2005. Robert Merton, a Nobel Prize–winning economist, couldn’t raise enough to launch a fund last year and abandoned his effort. Not that it can’t be done if you have the right team and a prior track record.

Don Morgan, the former head of high yield at MacKay Shields, left in 2006 to found Brigade Capital. Because of non-hire agreements, he waited a year to launch a long/short credit-focused hedge fund so that most of his former team could join him. The result: At a time when you need at least $100 million in committed investor funds as table stakes, Brigade earned a seat at the table on day one.

Obscene fees are becoming … wait for it … even more obscene.
Hedge funds are one of those unlikely industries where the newcomers charge more than old hands. In one sense, this is crazy: The most lopsided arrangement in finance—you win, I win/you lose, I win—is getting even more perverse in its tilt. But it can’t go on forever, can it? It’s likely that fees will come down if only because of competition itself, but it won’t be anytime soon. At least not while institutional investors continue to throw money at this bandwagon. Cliff Asness of AQR Capital puts it this way: “We often hear in hedge-fund circles that institutions are coming to the hedge-fund world, so fees must fall, as institutions are fee-sensitive. Can this be the world’s first example of predicting that massive demand for a product will lower fees?”

The government is getting nosy.
In 2004, the SEC required hedge funds to register with the agency, which was kind of like getting 19-year-olds to register for the draft. It didn’t have any immediate consequences, but it could lead to something serious. The courts then threw that rule out, and regulatory talk died down until the Connecticut-based fund Amaranth lost about $6 billion on natural-gas futures last year. It’s died down yet again, but is only one meltdown or scandal from flaring back up. All the big hedge funds have bulked up their lobbying budgets of late.

Investment banks are morphing into hedge funds.
If you can’t beat ’em, join ’em, right? More and more, Goldman Sachs and its ilk are making their money from proprietary trading, which means, simply, the managing of their own assets rather than, say, yours. These operations now dwarf many traditional investment-banking practices, like mergers and acquisitions. Goldman Sachs produces hedge-funders like the Dominican Republic produces shortstops. About one in five of the world’s top hedge-fund managers used to work at Goldman. So, hedge funds really are something of a cabal.

Given hedge funds’ uneven performance of late, why has the flood of money not tapered off?
Well, for one, the appetite for risk among investors seems to be at some kind of historical high. But paradoxially, it’s also a desire for downside protection. The popularity of hedge funds still has a lot to do with how they performed five years ago. Seriously. During the bear market of 2000 to 2002, when the market fell 40 percent following the dot-com collapse, the average hedge fund didn’t lose money. With severe losses still fresh in their memories, pension-fund managers and other institutional investors are perfectly happy to shave a little off the top for that kind of downside protection. The question is in how many funds it still exists.

The limelight awaits.
Many successful managers are doing what anyone with a newfound fortune does: trying to get close to political power (via donations) or the social elite (via philanthropy and art-world involvement). Marc Lasry of Avenue Capital recently hired Chelsea Clinton as an analyst.

And now for the doomsday scenario.
The only year that assets under management declined in the history of hedge funds was in 1994. Why? Rising interest rates and the digestion of the massive growth of the previous few years. Sounds familiar, doesn’t it? A sharp spike in interest rates could be devastating to an industry that relies so heavily on borrowed money. Citadel, for example, had balance-sheet leverage of 11.5x last year—meaning it had borrowed more than eleven times more money than it actually had at the time, ballooning its gross-asset exposure to some $150 billion. This level of leverage adds tremendous risk. One prominent hedge-fund manager told me that any single hedge fund, other than three he could think of, could blow up and not really have any effect on the broader markets. But if one of the three did—and he named Citadel in that group—then the dominoes could start to tumble.

So, in the end, when someone blurts out, “Hedge funds are a venal get-rich scheme that we’ll all end up paying for,” should you nod solemnly like you agree? No, don’t do that. Try instead to crib the argument of an actual hedge-fund manager: “The proliferation of hedge funds has both decreased volatility in the market and increased the long-term risk of a systematic collapse. In the first case, it’s because hedge funds are more nimble than traditional long-only funds and can swoop in and correct market mispricings before they can get extreme. But it also means opportunities become fewer. And because hedge funds need good returns through the cycle, this reduced opportunity forces them to take more and more risk, increasing their exposure to risky investments, which, in the long term, will increase the likelihood of a systematic panic in the market.” In their report, the Dresdner Kleinwort analysts had their own term for just such a panic; they called “the great unwind.” You’ll know when it happens because in addition to dire headlines and more histrionics than usual on CNBC, the value of your Manhattan apartment will suddenly drop by half.

Don’t worry too much, though.
While the Dresdner analysts termed the likelihood of it inevitable, they concede that it’s not exactly predictable. Which means that it will happen, but it could be tomorrow or it could be in 100 years, when all of Manhattan will be underwater and your apartment won’t be worth anything anyway.

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