Tuesday, April 17, 2007

Hedge Fund Q&A

Hedge funds are regularly disparaged in the media. Mostly, this is simple envy of the wealthy. Mostly, it is based on misunderstandings about hedge funds. So, here are my answers to basic questions:

What is a hedge fund? A hedge fund is a private investment partnership. A group of people agree to hire an investment manager to invest their funds on a pooled basis. The agreement is private and it is voluntary.

How do hedge funds invest? Hedge funds invest in the manner specified in the contract agreed upon by the partners. There are as many ways of investing as there are private contracts between people.

How risky are hedge funds? All investments have the risk of loss. The degree of risk is determined by the particular investing strategy of the hedge fund manager, which is agreed upon by the partners. The agreement can specify what type of securities can be invested in, such as stocks, bonds, options and/or commodities. The agreement can specify whether the manager can invest in foreign securities, and to what degree. The agreement can specify whether the manager can use leverage (borrowed funds), and to what degree. It is entirely up to the partners and the manager to agree among themselves the limits on the investing strategy of the manager. The level of risk is agreed upon by the partners.

How are hedge fund managers paid? Managers are paid according to the agreement between the manager and the partners. Typically, a manager is paid an annual maintenance fee of 1% or 2%, and a percentage of the fund’s profits, which can range from 10% to as high as 50%. The fee is contractually set and can be anything that the partners and manager find to be mutually beneficial. One typical provision of a hedge fund contract is a “high water mark” provision. This provision means that a manager cannot be paid a percentage of the fund’s current profits until losses from prior periods are made up.

Are hedge funds regulated? Unfortunately, hedge funds are extensively regulated. Federal law states that only accredited investors are permitted to become hedge fund partners. That limit is currently being raised so that only investors with $2.5 million in liquid funds can invest in hedge funds. Someone with less money is legally forbidden from investing in hedge funds.

Hedge funds can accept no more than either 100 or 500 investors, depending on the applicable regulation.

Hedge funds are not permitted to advertise. They cannot publicly advertise their performance or explain their strategies. They cannot even have websites accessible to the public that explain their funds.

Other rules. Special rules prevent hedge funds from easily investing in both commodities and stocks in the same fund. Special tax rules make it impractical for foreigners to invest in domestic U.S. hedge funds, so hedge fund managers are forced to set up offshore funds for foreigners. Hedge fund managers are required to disclose their positions in securities periodically when those positions are sufficiently large. Hedge fund managers must set up as many as three legal entities in jurisdictions such as New York because of special taxes that target limited liability partnerships. Hedge fund managers cannot accept more than a certain amount of money from pensions and other retirement plans regulated by the federal government.

These are just a few of the rules hedge funds operate under. Hedge funds are private agreements between willing investors and the manager they hire to invest their funds. Nevertheless, they are highly regulated, and the regulations grow every day. Large legal and accounting costs must be borne by any hedge fund to comply with these changing and growing rules.

Are hedge funds less regulated than other business enterprises? How many business enterprises are legally forbidden to advertise? Even tobacco companies still have some legal advertising avenues open to them. Hedge funds cannot even legally advertise with a public website. How many businesses must legally turn away customers who aren’t wealthy enough? How many businesses must stop accepting customers when the number of customers reaches a legal limit? Hedge funds are more regulated than most other businesses.

Despite these rules, investors keep putting money into hedge funds. Globally, investment in hedge funds grew 30% last year to $2.1 trillion dollars under management, $1.4 trillion managed in the United States. This is a faster rate of growth than mutual funds and most other investment classes. Over 9,000 hedge funds operate in the United States today.

Why do investors keep putting their money into hedge funds? One reason is because the other investment alternative, mutual funds, faces different regulations that make them less attractive as investment vehicles for many investors. The differences affect the incentives that mutual fund managers face, and their freedom to invest. In both areas, mutual funds suffer disadvantages relative to hedge funds.

Incentives: Hedge fund investors can pay their manager in whatever manner they mutually agree upon. The method typically used, where the manager gets a percentage of the fund’s profits, provides an enormous incentive for the hedge fund manager to work hard and generate profits. Both he and the fund’s investors share in the fund’s profits proportionately.

Mutual funds are not allowed to pay their managers in the same manner. Under the Investment Company Act of 1940, which regulates mutual funds, mutual fund managers cannot be paid a straight percentage of the fund’s profits. That is why mutual fund managers are typically paid a salary plus a variable bonus that is more loosely connected to the fund’s profitability. A weakened connection to profitability means a weakened incentive to work hard to find profits. Mutual funds are also not allowed to have a “high water mark” provision where they agree to forgo their fee until a prior loss is made up. This also reduces their incentive to achieve profits.

Freedom to invest: Hedge fund managers have few legal limits on what they can invest in. Their limits are those agreed upon by the partners and the manager. A particularly important advantage is that hedge fund managers have the legal ability to take short positions in securities. A short position in a security is one where the investor makes money when the security price goes down, instead of up. Short positions are very advantageous when the stock market is declining, as it did for much of 2000, 2001 and 2002. Because of their ability to invest in short positions, hedge funds as a whole outperformed most other investment categories, such as mutual funds, during those years. If risk of loss is a concern, hedge funds as a whole were less risky than mutual funds during those years. Such a reduction in risk was possible because hedge funds could take short positions.

Mutual funds face regulations that make it very difficult to invest in short positions. Although those rules have been loosened recently, as a practical matter most mutual funds find they can only invest in long positions. Long positions go up in a rising market and decline in value in a falling market. Hedge funds can blunt the loss of value in a falling market through short positions; mutual funds are largely legally precluded from taking the same steps to protect the value of their portfolios.

Advantages of mutual funds. Mutual funds have some advantages that hedge funds do not have. The biggest are that they can legally advertise and they can accept money from anyone. There are also no limits on the number of investors they can have. So, their role in the financial world is assured. While only rich people (those with more than $2.5 million in liquid assets) are allowed to invest in “secretive” hedge funds (which are secretive largely because they are forbidden by law from discussing their performance), the so-called little guy can invest in mutual funds which he can study and learn about from advertisements, websites, etc.

There are other investment vehicles that are alternatives to hedge funds, such as exchange traded funds and closed-end funds. Each of them is a product of the peculiar regulations that govern it. Each has advantages and disadvantages, many of which are solely a consequence of differences in regulation.

Conclusion. In a world where everyone had the freedom to invest his money as he saw fit, without facing Depression-era rules designed to “help” the so-called little guy (but really just close off certain investment opportunities from him), there would be no legal distinction among investment pools. The distinction between hedge funds and mutual funds is a creature of regulation. To escape from the rules limiting mutual funds, hedge funds agreed to operate under a different set of rules that limit who they can accept as investors. By accepting one set of rules, they are freed from others, including those that limit investing in short securities, and how managers are paid.

Quite often, the history of financial innovation is a history of creatively finding ways around government edicts. The rise of the hedge fund industry is an example of that phenomenon. I look forward to the day when all those rules are repealed, when everyone’s inherent property right to contract with whom they please on whatever terms they choose is acknowledged in the law. When that happens, the creativity of investment managers, lawyers and accountants will be spent solely on developing the best investment vehicles for their willing clients, instead of having to destroy a portion of their time complying with the growing, changing and arbitrary rules emanating from Washington.

The larger issue is that all individuals can manage their own lives and should have complete freedom to do so. This includes the freedom to manage all aspects of their financial affairs. The only role for government is as protector of property rights. Governments exist to enforce the terms of contracts and punish those who commit fraud. The current hostility against hedge funds is of similar ilk as the hostility toward the “robber baron” industrialists of the late 1800s and early 1900s, and the junk bond and other financial innovators of the 1980s and 1990s. It is envy of the successful for being the successful, and resentment of the rich. The current hedge fund rules do nothing other than close off that investment vehicle from the masses, keeping them with their faces pressed to the glass looking in on a world that they enviously want and can’t have. Therefore, they will use the power of government to throttle and destroy that world.


softwareNerd said...

One thing that makes me slightly nervous is when I see pension funds, particularly government pension funds (link one, link two) investing in hedge funds.

The problem is in the nature of pension funds. Unlike a 401(k), a pension fund removes the employee one extra level away from the decision-making. It also makes all employees adopt the same risk/reward.

Galileo Blogs said...

No regulation can substitute for good judgment. Any pension manager has the obligation to choose his investments carefully, among all the choices that he is legally allowed to make, whether among mutual funds, hedge funds, domestic securities, foreign securities, real assets (such as real estate), etc.

As for whether to include hedge funds, if I were an employee with a pension, I would encourage the pension fund manager to prudently invest in hedge funds. The reason is simple. Hedge funds as a group outperform mutual funds in declining stock markets because they can short stocks. If I care about preserving the value of my pension when the stock market declines, I will choose hedge funds.

Hedge Fund returns vs. S&P 500 (%), 2000-2006

Funds S&P 500

2006 11.40% 13.62%
2005 7.85% 3.00%
2004 8.25% 8.99%
2003 18.78% 26.38%
2002 -2.89% -23.37%
2001 4.35% -13.04%
2000 8.16% -10.14%

TOTAL 69.32% -3.47%

Source: Hennessee, http://www.hennesseegroup.com/Indices/hhfiAnnual.html

Clearly, the above data shows that hedge funds overall had greater total returns with much lower volatility and a much better “worst year” than the overall stock market had. This data shows why so much money is flowing into hedge funds. As part of a portfolio, a hedge fund investment *reduces* risk. The overall stock market is much riskier than the average hedge fund.

Finally, "hedge funds" is not really an investment class. There are multifarious strategies among hedge funds, some conservative, some aggressive. A hedge fund is merely an investment vehicle that offers several regulatory advantages over mutual funds, as I explained. A pension fund manager would have to exercise the same care in selecting a hedge fund to invest in as he would if he were picking securities to invest in himself.

With regard to fraud, let’s look at the example you linked to, Amaranth. That fund suffered $6.6 billion in losses. That represents a loss of 0.47% of the total $1.4 trillion now invested in U.S. hedge funds. That is not exactly a good argument that there is a fraud problem with hedge funds as an investment class. Just how many of the 9,000 hedge fund managers are corrupt? How does that percentage compare with other fields?

Fraud and/or incompetence exist in every discipline. When someone is sold a lemon from a used car lot, he doesn't pester his local politician for onerous regulations or a ban on used car sales. How about a shady real estate agent, or an unethical doctor or lawyer? There is nothing unique or excessive about malfeasance among hedge fund managers. The only thing unique about hedge funds is that some of the managers make a lot of money and a whole lot of people are jealous. Because of that, the media focuses with laser intensity on every instance of unethical behavior among hedge funds managers, advocating ever-growing regulations to rein in this outlaw group of “cowboy capitalists.” If only they had the same diligence toward plagiarism among newspaper reporters, or bribe-taking and vote-buying by politicians. But no, such people are self-anointed as bearers and advocates for the public interest. Therefore, ignoring some of their “foibles” is okay.

Meanwhile, as long as hedge fund managers maintain some degree of freedom, the market has chosen to vote with its dollars. I cited the dollar flows into hedge funds. Is that smart money or stupid money?

Galileo Blogs said...

I'll answer my question this way. No politician or regulator has the right to ask that question.

softwareNerd said...

GB, I agree with everything you said. Many of the best and brightest managers are in hedge funds, so it would be surprising if they had a higher rate of malfeasance than regular mutual funds, and not surprising if they were more honest.

I don't like company-sponsored pension funds, because of the extra layer they place between the employee and his investments. Nothing wrong with it legally, of course. In general, (apart from tax-reasons) I prefer monetary compensation over company-funded benefits, because the latter removes the consumer from the decision-making. In things like retirement savings, I think it's important for the individual to decide.

I would love to invest in hedge-funds; heck, I even know a couple of actual names I'd love to be with (assuming they'd bother with my money). If the law did not set restrictions, perhaps some funds would evolve a way to make small-investors an attractice proposition to them (e.g. longer lock-in periods for small-amounts might be an attractive option to some managers).

My nervousness about government pension-funds investing in hedge funds is that it gives the government an excuse to regulate hedge funds. (It's similar to why I wouldn't want to see the government change Social Security into a real fund and put the money into the stock-market as long as the government keeps control.)

Galileo Blogs said...

There are two things that limit the ability of a hedge fund to accept small investors: (1) the SEC says investors must have a liquid net worth of $2.5 million; and (2) federal law limits how many investors can be in the fund. The latter rule means that a hedge fund is reluctant to accept a small amount from an investor, since he uses up one of the available investment slots.

As for how to invest in a hedge fund today, apart from possibly passively investing in one through your pension, one method is to buy stock in a hedge fund company. A number of hedge funds have gone public in the United Kingdom. Their stock trades and anyone can buy it; there are no SEC rules to contend with.

In the United States, a large private equity fund, Blackstone, is contemplating an IPO. Although not exactly a hedge fund, there are similarities. Citadel is a hedge fund that is contemplating an IPO. No hedge funds have IPO'd yet in the United States.

Still another way to indirectly invest in a hedge fund is to buy stock in Goldman Sachs or other firms that get a large amount of their profits from hedge funds. Goldman is a huge "prime broker" to hedge funds, which represent a significant source of their profits. Of course, by buying Goldman, you are also gaining a piece of the leading investment bank in the world.

Having said all this, timing is important. Goldman has had a huge run and so have hedge funds generally. I would consider sitting on your cash, wait for a major market downturn and buy aggressively then.

As for pensions, I don't like them either. I prefer managing my own retirement funds, funds that cleanly and easily stay under my control regardless of where I work.

As for public pensions, anything run by the government usually becomes ensnared in mediocrity, as I know you know. The best managers in the investment world typically (although not always) do not work for public pensions. Politics is also a factor that often directs public pensions to invest in inferior, politically-sanctioned securities.

Your final point is absolutely true. Most hedge funds only accept a limited amount of money from public pensions to avoid the stultifying rules they must adhere to. Furthermore, because some public pension money is in hedge funds, every time there is a crisis (Long Term Capital Management, Amaranth, etc.), politicians seek to regulate hedge funds. Because some public pension managers made bad choices, all investors must suffer as hedge funds are reined in and that investment choice is further denied to all.

Myrhaf said...

How would you answer this leftist attack on arbitrage finance:


Galileo Blogs said...

Myrhaf, thanks for sending that over. It gives me food for thought. In fact, probably a little too much food. I will apologize in advance for the length of this reply, which is about as short as I am able to address your question.

There are several positions and fallacies embedded in his argument. Before I discuss his central point, I will make an observation concerning his historical narrative. He implies that yesteryear (i.e., prior to the 20th century), finance was solely beneficial, financing real productive enterprise, but that today (especially in the last few decades), finance is full of speculation and destructive plundering of the real economy. He cites the leveraged-buyouts of the 1980s and today’s arbitrage and use of financial derivatives.

His historical narrative is selective and not representative of the history of business finance. First, the “old days” were not pristine, but were characterized by abundant and frequent manias, wild speculations, and frauds. For example, in 1720 there was the “Mississippi Bubble” where many Europeans were induced to invest in a company that had been set up in France with a monopoly on trade to North America. The Mississippi Bubble ultimately became a sort of Ponzi scheme, where the money from new investors was used to pay off old investors. The whole thing crashed down in a scandal that even included advisors to the king of France. England had a similar bubble, the South Sea Bubble, at the same time.

There was the Panic of 1873 driven by railroad bankruptcies. There was a mania for Florida land in the 1920s that went bust.

There were many more. All of these involved the “less knowledgeable” giving money to the “more knowledgeable” who were quite often cheats. Financial scandal is nothing new to the 20th century.

As for arbitrage, it was highly developed and prevalent throughout the post-Renaissance era. The derivatives referred to in the article were developed several hundred years ago, including call options, puts and warrants. During manias, housewives, butlers, bankers, bakers, wealthy widows and businessmen of all types speculated and sought arbitrage profits.

None of this description implies a failure of capitalism. Rather, often there is some sort of government intervention driving the mania (such as the monopoly on trade with Mississippi). Often there is a legitimate technological innovation (e.g.: radio in the 1920s) or discovery (e.g.: the New World) that underlies a burst of speculation. The market naturally sorts out the winners from the losers, and the investors who picked the losers get hurt. The winners are rewarded for picking the firms that succeed. Speculation isn’t for the faint-hearted. That is why “widows and orphans” shouldn’t do it.

I will summarize my point on the historical merit of the cited argument. Financial speculation and scandal has occurred throughout man’s history. The old era was not an era of virtuous finance that funded noble, “real” enterprises as compared with the modern era where speculation is rampant and phony, and steals from truly productive enterprises. This is a historically false alternative.

As for the theoretical argument he is making, that arbitrage or financial speculation is somehow wrong, I disagree. He refuted himself best. I will cite his example: “When an Amsterdam investor bought a share of Dutch East India Company stock on the emerging secondary market, that money, of course, did not fund any more journeys for the East India Corporation, but by making the market for its shares more liquid, did indeed make it able to raise funds more cheaply.”

In other words, what he is saying is that trading (i.e., speculating) in secondary markets creates liquidity. It creates a ready, liquid market that anyone can turn to sell their shares. The existence of that market makes it easier for a company to raise funds when it wants and in large amounts. The more liquidity there is, the easier and larger the amounts a company can raise. All financial speculation, whether it is trading of stocks, playing spreads between one security and another (his example: the 30-year and 29-year Treasury bonds), or any other form of trading, creates liquidity. These speculators stand ready and willing to buy stocks or bonds that are offered by companies and governments. They literally “make the market”.

Imagine if such speculation were forbidden, or reduced through taxation, as proposed in the article. Let’s say arbitraging between the 30-year and 29-year bond markets is forbidden. Now the government comes along and wants to issue new 30-year Treasury bonds. As a buyer, that bond is worth something to me. It pays me coupon payments over a 30-year period. I can hold that bond for 30-years, knowing I have a secure source of income. However, let’s say I want to sell that bond only one year after I bought it. Who do I turn to to buy it? I can hope to find someone who wants to buy a 29-year bond and hold it to maturity and/or I can sell it to an arbitrager, who plays the spreads between 29 and 30 year bonds. Do I care to whom I sell it to? No, all I care about is getting the highest possible price. Now if the government has eradicated the speculators, an entire class of potential buyers of my bond (i.e., a large source of liquidity) is gone. There are fewer buyers; therefore, I get less for my bond.

Now, if I get less for my bond in the secondary market, I will pay less for the bond in the primary market. When the government issues its 30-year bond, I will pay less for it if there are no speculators available to whom I can sell it before the bond’s maturity. That is the connection between speculation and a security’s value. Speculation, by improving liquidity, allows issuers of securities to get more for them. They can get more for them because the securities are worth more to the buyers, who know that a deep and liquid secondary market is available to sell the security.

The existence of speculation benefits all primary issuers of securities. By issuers, I mean companies, governments, farmers – anyone who seeks to raise capital in the financial markets. This means farmers who sell grain forward in the futures market to get cash today to pay for seeds to plant their crops. This means governments who sell bonds in order to finance spending. This means all sorts of entrepreneurs and businessmen who sell stocks and bonds to finance their productive enterprises. All of these people get more when they sell securities because of the existence of feverish, grasping and “greedy” arbitragers and speculators in the secondary markets.

The article makes a third point, more by implication than by direct explication. The writer implies that innovative financial transactions, aided by sophisticated computers, are somehow harmful. He merely asserts this point, but in no way proves it. I cannot disprove a negative. I will simply say that all of computer-driven financial innovations act to make deeper and more liquid secondary markets. This allows businesspeople to raise capital in more ways, and also to hedge a greater variety of risks than they could before. For example, sophisticated computers make possible something called a “weather derivative”. A weather derivative is almost a form of insurance, which will pay out money if the weather is too cold or hot, or if there is too much or too little rain. Think of the benefit of weather derivatives for a farmer, who can hedge his crop against a drought, or an orange grove owner, who can hedge his orange trees against freezing temperatures, which would destroy his oranges.

There are a lot more examples of innovative financial products that benefit businesses. All of these are made possible because of complex, sophisticated and often computer-driven speculation and arbitrage in the secondary markets.

These are some quick thoughts on a complicated topic. Did I fail to address some of his points? By all means, let me know.


Myrhaf said...

Thanks for your in-depth analysis.