Sunday, December 30, 2012

A Hedge Fund, Not a Hedge Fund!

Hedge funds, together, are “Going Nowhere Fast,” says the Economist. Sound the alarms – it’s been “another lousy year, to cap a disappointing decade.” Well, I guess it depends whom you ask: There’s a bunch of people high above New York City streets chary of change – has there been another group paid so much for so little?

And of course, the Economist points out, some hedge funds have done very well. “The top docile of managers has served up returns of over 30% in the past year.” Although, you’ll need more than the newspaper’s well wishes choosing which, of the 8,000 available funds, will be in the top docile.

But anyway, what’s all this about? The geniuses are failing? What else is new?

As usual, the problems are vast – but we could all start with a simple issue: nomenclature. People are grouping together funds that oughtn’t be in the same group, and evaluating them together, by the same standards. I’m not talking about “Event Driven” versus “Fixed Income Relative Value Arbitrage” – God no; I do actually hope you will be awake by the end of this post (I have my doubts). The problem is even simpler. People can’t answer the question: What is the point of a hedge fund? And that, my friends, is crucial to the questions Why invest? and At what price?

By name, at least, a hedge fund should be hedged, which is to say that the downside is insured. There is a cost to that, which, very roughly, comes from the upside. The approach is conservative; conservation of capital is the first priority. On this premise alone, one would think the portion of an average (conservative) portfolio consisting of hedge funds would be the majority.

Yet hedge funds mean more than the name suggests. People running the top funds are among the richest people in the world, and they often have PhDs; two things that can only mean genius. That point becomes utterly unequivocal with all that complex math and law… The people running the funds are most convinced: their strategies are so genius as to be kept top-secret – unknown, in many cases, even to their clients. (In a kind of, what, religo-cultish fundamentalism, you might say).

To emphasize the observation, consider two fine examples: Bernie Madoff, and LTCM. Both went bust; the first was top-secret enough to commit elephantine fraud, and the second had enough Nobel’s to justify leverage of, like, 50:1 on bets that blew up.

Hedge funds have an alter ego: this sort takes big risks, which rely on intelligence nearing clairvoyance, and remains secret to you – you, who merely give them their money.

Now, the crucial part.

Until the past few years, I dunno, to about 2006, hedge funds were mostly identified as opaque, high-risk vehicles, which many of them are. When (conservative) Pensions invested in hedge funds, the allocation was small because of the risk – both operationally (opacity) and instrumentally (type and quantity of securities and leverage). Also – this is decisive – hedge fund managers were compensated the so-called two and twenty. That compensation reflected the risk: small allocations meant the management fee usually was second fiddle: twenty percent of profit is the main game.

Today, hedge funds are viewed slightly differently. You could say the “Hedge” in hedge fund is making a comeback – many, at least, are more conservative. 2008 was tough on hedge funds – but not as tough as it was on equity markets. People were hedged (though in most cases not enough). And from 1994 to 2007 hedge funds returned only a trifle more than the S&P – but with half the volatility.

Mostly, hedge funds are becoming far more transparent, often more specialized, and much more numerous. They cater to what is now their biggest customer: Pensions. And in so doing, as a group, hedge funds have inched closer to the conservative identity. Which is why “Hedge funds now manage $2.2 trillion in assets, up fourfold since 2000,” as the Economist reports.

Yet despite not beating inflation, they still charge exorbitant fees (which, despite slightly lower “negotiated” fees, have probably and excruciatingly amounted to more than has been returned to clients), and still tout their genius. Well, here lies the schizophrenia.

Pensions pay for amazing geniuses to generate mundane security. To (begin to) fix the problem, I think we need to change the nomenclature so that it reflects different general approaches.

But first, an aside:

Nassim Taleb explains the (old, wise) idea of a barbell, or bimodal, strategy as it applies to investments as so: The lion’s share should be allocated extremely conservatively, while the small remaining proportion (perhaps ten percent) should be allocated to the risky business.

That way, roughly ninety percent of the portfolio is (actually) safe, while, therefore, at most ten percent may be lost and much more may be gained.

OkayOkayOkay – I here the shouts and cries to diversify with proper weightings. Let me respond with what hopefully will become a post of its own: that all depends on forecasting correlations, particularly when they spike together, which is, um, impossible. (Just note that when times are best, correlations are low, which at best means your chugging along, while at worst, correlations spike, and your whole portfolio is down the tube…it’s the equivalent of the field goal kicker’s plight: your best possible performance is “Hey, good, you did your job” and at worst is, “WE’RE GUNNA HANG YOU!”

Anyhow, assume the barbell strategy. In that case, the larger allocation is to the ultra safe managers – those who buy inflation protected treasuries, perhaps, and constantly purchase puts on everything. Safe, slow goings.

On the other side, you want the LTCM like people. Go Ahead – use lots of leverage on Greek bonds, the Facebook IPO, RIMM at six bucks, or a ton of OTM calls.

Right, so: Whatever your strategy, my hope is to distinguish conservative funds from riskier ones. Lots of difficulty there – but it’s a good start, I think, to have a different names. The conservative side should be called hedge funds, while the risky side could be called….what? WAIT, we already have a name – but unfortunately its been contained to a single domain. Time to break it free!

Venture Funds! Venture – which comes from adventure – means a risky or daring undertaking. Bingo.

That way, Hedge Funds: Going Nowhere Fast might one day bring sighs of relief.

1 comment:

  1. Nice post. I agree that the term "hedge fund" is a misnomer. Also, what is a hedge fund anyway? Long term focused hedge funds are similar to PE and VC. Some hedge funds don't invest in equities. Some hedge funds invest in mezzanine finance. I just consider hedge funds arbitrageurs - seeking riskless profits.