Forbes.com



The $500 Billion Hedge Fund Folly
, Forbes Magazine, 08.06.01

What's so alluring about unregulated investment partnerships? They soak you with high fees and underperform the market.

What do Barbra Streisand, Senator Robert Torricelli and Bianca Jagger have in common? They have all lost money investing in hedge funds.

You don't have a hedge fund to brag about at lawn parties? That could be because you're too timid to swing for the fences, as these private investment partnerships often do with leverage and exotic derivatives. It could be because you are not well connected. Hedge funds, after all, cannot advertise, so you have to know someone to get in one. Maybe you are not rich enough. These funds for the elite are allowed to take only "sophisticated" investors, defined as people with a $200,000 annual income or a $1 million investable net worth.

Or maybe you are not in a hedge fund because you know better.

Mediocre returns, outrageous fees and a whiff of scandal have not stopped the hedge fund business from enjoying explosive growth in the past decade. Because these investment pools are under no obligation to report their assets or returns to the Securities & Exchange Commission, there is no official measure of their size. But advisers and consultants who work in this field believe that there are at least 6,000 of them out there, with more being created every day. Combined assets probably top $500 billion, according to London-based Global Fund Analysis, which collects data on 2,700 hedge funds. Insiders estimate the total in 1990 was just $15 billion.

The surge in assets probably has something to do with the long bull market, which, despite the weakness of the last year, has left investors with a lot more money to play with. Then, too, the recent correction probably hasn't hurt, since some hedge funds promise to be "market-neutral," meaning they can make money whether the stock market is going up or down. The other factor behind the hedge fund stampede is a psychological one. Celebrities are getting into hedge funds, as are Ivy League endowment programs and even state pension plans. So why not me?

The industry--or, at least, the term "hedge fund"--dates back to 1949 and money manager Alfred Winslow Jones. He pitched the notion that a smart money man could protect investors against market spills by going long some stocks and short others. You'd buy Dow Chemical, say, and short DuPont, and (if you picked the right companies) make money whether the chemical sector went up or down. Since regulated mutual funds back then were not permitted to sell short, these portfolios had to be offered privately in limited partnerships. Jones and his imitators had a run of success for quite a while selling their investment products, but the business fell into disrepute in the 1973-74 market crash. Hedge funds that held restricted securities (not freely salable to the public) got killed.

Trust Me
If you mess up on Wall Street, don't despair. There's room for you in the very forgiving world of hedge funds, where you can get a second chance-witness these financiers.
Michael Berger lost $500 million when Manhattan Investment blew up.
Joseph Jett, disgraced ex-Kidder, Peabody trader, founded Cambridge Matrix.
John Meriwether, Long-Term Capital's bungler, now runs JWM Partners.
Memories of that disaster have faded, and private funds have come back to Wall Street with a vengeance. For many the "hedge" is in name only. They may make lopsided leveraged bets on the direction of the stock market or interest rates. They don't always stick to stocks. Some play with currencies, some make arbitrage bets on convertible bonds, some go in and out of mutual funds looking for market "inefficiencies." And extreme leverage is sometimes part of the game. That's what sank the infamous Long-Term Capital Management three years ago, nearly taking down the whole bond market with it.

If it isn't hedging that defines the genre, what is it? Outsize returns? Not exactly. Some hedge funds have done spectacularly well: Pinnacle Equity made 456% last year; George Soros and Julian Robertson made billions for their early investors. But plenty have been failures: Askin Capital Management and Niederhoffer Investments Fund are among the more spectacular blowouts that destroyed their customers' investments.

We have looked for common features in this thriving industry--which by law caps each fund at 99 investors by the traditional definition (499 if they have $5 million to invest)--and have come up with the following definition: A hedge fund is any investment company that is unregulated, has limited redemption privileges and charges outrageous fees.

The compensation system for hedge fund managers works like the one for racetrack touts. These are the characters who hang around the betting window offering tips and expect a piece of your winnings if a tip works out. If the horse loses, the tout is nowhere to be found.

Hedge funds get, by tradition, a 20% cut of any trading profits, a reward known as the "incentive fee" or "carry." This is on top of the annual management fees, typically 1% to 2% of assets under management. Why is this outrageous? Because the managers share none of the downside. Heads, they win; tails--well, it was your money.

Contrast the fee structure at a regulated mutual fund; that is, one open to the public and supervised by the SEC. A 1% to 2% annual expense charge (covering overhead and the manager's fee) is typical. The manager can, if he wants, structure his fee so that he gets a bit extra if he beats a benchmark. But the SEC compels him to make this fee symmetrical. Losing to the benchmark means forfeiting a comparable piece of the normal fee. Managers can't abide such terms, and you will rarely see an incentive fee in a public fund.

It's easy for a hedge customer to be blind to the unfairness of the one-way incentive fee. The hedge manager's pitch will be something like this: I'm using some sophisticated arbitrage strategies, and I'm going for a 50% return. No guarantees, you understand; this is a very risky investment. But if I make the 50%, I want a fifth of it. You still get 40%. Not counting the 1% management charge, which covers my costs, I only make money if you make money. Is making only 40% such a bad deal?

Yes, it is. It's dreadful. That fellow with the sophisticated strategy is taking your money to the horse races. Imagine that you placed $100,000 with him and $100,000 with another horse player. One makes 50% and the other loses 50%. Before incentive fees (and not counting the annual fee), you are breaking even. After incentive fees you lose $10,000. You are down 5% overall.

This gets worse. If you don't know which hedge funds to buy, various middlemen will find some for you--and charge another fee for doing so. Morgan Stanley, for instance, sponsors a fund of funds, Liquid Markets Fund I, that puts investors' money into an assortment of hedge funds that each impose one-way incentive fees (plus annual management fees). Liquid Markets layers another 1% fee atop all these and also gets its own incentive fee: 5% of the pool's profits, if those profits top 8%.

Those funds of funds say their extra cost buys you the assurance that they've vetted member funds. Investors in three--Olympia Stars, Sabre Elite Managers and Matrix Himalaya--found out the hard way how hollow this assurance can be. The trio put money into Michael Berger's Manhattan Investment Fund. Last November Berger admitted to committing a massive fraud by grossly overstating his performance since 1996.

The usual hedge fund contract at least protects you from getting whipsawed by a manager who makes money one year, loses it the next and makes it back the third year. The "high-water mark" provision works this way: If the manager gets an incentive fee for taking the fund up X%, he doesn't get additional incentive fees until the fund tops a cumulative X% return. Say the manager doubles a $10 million pot to $20 million, pocketing a $2 million incentive. The next year the $18 million pot shrinks to $10 million. Additional incentive fees are due only to the extent the manager pushes the fund above $20 million.

Sadly for investors, the high-water mark carry has created a flight syndrome among hedge operators. If they have a really bad year they just fold up shop. After suffering heavy losses in 1999 Julian Robertson simply closed up what was left of his $22 billion (peak) Tiger Management hedge fund. It would take years for him to climb out of the hole. Of course if he ever wanted to start fresh with a new management company, there would be no high-water mark.

If you want to know what's wrong with the hedge fund concept, spend some time with John Bogle, founder of the Vanguard Group. He has spent his 50-year career agitating for lower investment costs and so is naturally hostile to things like one-sided incentive fees. But he makes a compelling argument. When you are contemplating the returns you can get from investing this way, he says, don't think about the 456% that this or that manager made in a good year, think about the collective returns from the whole style.

"I think it's inconceivable that you could take $500 billion run by 6,000 different managers and expect these managers to be smarter than the rest of the world," says Bogle. If the overall market is up 10%, he calculates, then hedge fund operators would need a 17% return to beat that--given a 20% carry, a 2% annual fee and taxes. "I don't think that $500 billion has a remote chance of beating 17%," he says.

Here's the beauty of hedge funds for operators, if not investors: Anybody can open one. "Every Tom, Dick and Harry is putting out a shingle," laments Elizabeth Hilpman, a partner in Barlow Partners, a seven-year-old New York hedge fund of funds. "It's become harder to tell the good managers from the bad."




No kidding. Paul Mozer, whose fast-and-loose bond trading landed him a prison term and almost tanked Salomon Brothers, is said to have started a hedge fund. And John Meriwether, a figure of widespread ignominy after Long-Term Capital imploded, has simply launched a new hedge fund, JWM Partners.

Look at some of the charlatans who have invaded the field. The secretive nature of hedge funds makes them enticing vehicles for con artists (see p. 72). For instance, after the SEC suspended him in 1993 ex-Goldman Sachs mortgage trader Michael Smirlock raised $700 million to start three hedge funds. Last December he again fell afoul of the SEC, which sued him for hiding $70 million in losses from his investors.

And then there's the silliness. Here's Bogle again: "I looked up one of the guys from the Worldwide Integrated Equity Selection Fund. He has a million dollars in proprietary capital, and he thinks assets are going to double. He says that while other market-neutral managers are making educated guesses, he analyzes the co-integration of stock prices. I don't know what to do about a fund like that. I don't know what to do about Scion Capital, started by Michael Burry M.D. after leaving his third year of residency in neurology. He started it mostly with his own money, $1.4 million, and he's looking for more. He looks for opportunities to take advantage of illiquidity and inefficient sectors. His technique to manage risk is to buy on the cheap and, if he takes a short position--I hope you're all sitting down for this--it is because he believes the stock will decline."

The obituary list of hedge funds should give pause to anyone imagining that all these contraptions are bound for glory. Bad bets blew a hole in Streisand's fund, BKP Partners, in mid-1998. She was party to a class suit against manager Robert K. Pryt and his onetime $270 million fund, finally striking a settlement for 1% to 2% of investors' initial outlays. Torricelli, the ever-controversial New Jersey Democrat, and his ex-girlfriend Bianca Jagger (Mick's ex-wife) were in the $13 million Porpoise Fund when it went south, also in 1998. Rick Yune, the hot young movie actor (The Fast and the Furious), used to be a Wall Street trader; still, he lost money in three hedge funds and now is out of them entirely.

The unhappy truth is most hedge funds can't deliver on their promise of beating the broader stock market over the long haul. During the last five years (through May 2001), the S&P 500 returned an annual 15%. But 9 of the 10 weight-averaged classes of hedge funds monitored by CSFB Tremont delivered sub-S&P returns, after fees. Over ten years hedge funds look even worse. According to MarHedge, another hedge fund tracker, of its 14 major hedge fund categories only 1, called Global Established Markets, beat the S&P's 18% return from 1990 through the middle of last year, and it did so by a rounding margin.

Even worse news: These system-wide figures are too kind to hedge funds. Their managers have no obligation to report returns to the SEC. This business has no Morningstar or Lipper; hedge fund trackers cover just a portion of the business. If hedge fund operators don't feel like answering a survey during a bad quarter, they don't. In 2000's first quarter 1,068 hedge funds reported to MarHedge, by year-end 160 of them, or 15%, were missing in action. Commodities speculator Victor Niederhoffer reported assets of $125 million to MarHedge in July 1997. In October of that year his position on the Thai baht wiped out his fund. Rather than record a 100% drop in the fund's assets, Niederhoffer simply disappeared from MarHedge's list.

Auditors are no help, either. Unlike those examining corporations and mutual funds, where they work for investors, hedge fund auditors are in the employ of the managers. Whatever independence accounting firms can muster in their corporate work, it stands to reason they have still less with the hedgies. Ernst & Young and Deloitte & Touche both did audit work for scamster Berger. It wasn't their fault, they said; Berger deceived them.

Still, you're thinking, aren't there geniuses out there who could make money for me? Didn't Warren Buffett have a hedge fund back in the 1960s, before he bought control of Berkshire Hathaway? I just have to find the next Warren Buffett.

Good luck. You and several hundred thousand other investors are looking for a few geniuses camouflaged in a crowd of racetrack touts.



Sidebars
The Money Vanishes
The Peddlers
No Hedging Here (web exclusive)
-