From the October 2006 issue of Research Magazine • Subscribe!

Over the Hedge

A recent piece in Vanity Fair describes how multimillionaire hedge fund managers have converged in great numbers upon the once-tony suburban community of Greenwich, Conn., and filled it with nouveau-riche architectural excesses, such as single-family homes the size of the Taj Mahal.

Hedge fund managers not only live in Greenwich, they work there too. Approximately 10 percent of the $1,225 billion in assets under management (AUM) in the hedge fund industry is invested with Greenwich-based funds.

There is nothing wrong with the over-the-top conspicuous consumption or incestuous proximity of fund managers. The problem is that Greenwich symbolizes two problems in the hedge fund industry -- a lot of easy money and a growing correlation among money-making strategies.

The reason hedge funds were called that in the first place was because they were supposed to use hedging strategies to earn lots of alpha for their investors -- i.e., help them outperform the market both on the upswing and the downswing. Hedge funds are allowed to invest in a variety of assets and to take long and short positions at will. Or else they are supposed to identify price discrepancies in various markets and correct them by throwing massive amounts of money at them.

Hedge funds often earn excellent returns -- in part because they bring a lot of capital to bear, turning their bets into self-fulfilling prophecies. George Soros' Quantum fund famously made over $1 billion in a weekend in 1992 by taking a $10 billion short position in the British pound. Hedge funds are also risky: Soon thereafter, Quantum lost hundreds of millions on a bet that went wrong.

Follow the Herd

The popularity of hedge funds has increased hugely in recent years. Nobody knows exact figures, but Hedge Fund Research reported fund inflows of $42.1 billion in the second quarter -- the largest since it began collecting data in 2003. Although there are about 10,000 hedge funds in existence, the largest 100 saw AUM growth averaging nearly 30 percent per year in 2003-2005. By the end of last year they controlled 65 percent of industry assets, up from 58 percent at year-end 2004.

Moreover, since hedge funds use highly leveraged money-making strategies, there is no way to measure accurately their total value at risk at any given time.

Fund inflows have been driven by the search for yield in an environment of extremely low interest rates and high risk acceptance in the investor community. Pension funds and other institutions have become heavily invested in hedge funds, in hopes of improving returns. Other instruments have helped increase exposure to hedge funds on the part of smaller investors, despite adding a new layer of fees. Funds of Hedge Funds now provide over half of the total assets in the hedge fund industry, or over $700 billion.

Hedge funds are costly. They typically charge 2 percent of AUM -- some do even more -- and around 20 percent of all gains. There is pressure on managers to perform -- to provide the sought-after alpha. With so much capital sloshing about, available arbitrage opportunities have been mostly exhausted. Moreover, hedging and shorting can be expensive luxuries in a bull market, such as we've had since 2003.

As a result, there has been a tendency among long-short hedge funds to act more like straightforward long equity funds -- or else to range wider in search of returns, venturing into riskier and/or less liquid investments. Leveraging more has also become a way to increase returns.

Citing losses by hedge funds in April and October 2005, the European Central Bank warned in its Financial Stability Review in June about rising correlation among various investment strategies employed by hedge funds. According to ECB calculations, correlation increased sharply during 2005 and now exceeds levels seen in 1998, when Long-Term Capital Management famously collapsed, nearly dragging down with it the entire global financial system.

According to Merrill Lynch, the performance of the hedge fund industry is now 96 percent correlated with the broad S&P 500 index of the U.S. stock market. This compares to a 32 percent correlation back in 2000 and actually beats some of the traditional index funds that seek to track the index.

The ECB warning couldn't have been more timely. Both strategy correlation and long exposure among hedge funds were ominously on display in May-July, when global stock market indices fell by an average of 15 percent. Emerging markets in Asia, Latin America and Eastern Europe were hit especially hard, and so was the Tokyo stock market. Some of the worst-hit bourses had been the best performers in 2005 and the first four months of this year. Hedge funds suffered their worst losses in four years, which in many cases wiped out all of the year's gains.

Curiously, this year's sell-off occurred in the kind of environment in which hedge funds are supposed to shine, providing the alpha and making all those fees worthwhile for hedge fund investors.

A dramatic run-up in such markets as Mexico, Brazil, Turkey, Poland and Russia -- and, for that matter, Japan -- and their swift decline in May-July raise troubling questions about the role of hedge funds in the rally, as well as the possibility of a massive pyramid, created by inflows of highly leveraged hedge fund capital.

Stampeding for the Exits

A highly correlated environment raises the spectrum of "crowded trades" and a liquidity crunch when too many investors rush for the exit. Other risks facing hedge funds include that of concerted redemptions and margin calls on highly leveraged positions. Such risks are driven by events, and if adverse events affect most investment strategies similarly, the risk of a run on hedge funds intensifies.

On the other hand, the emergence of institutions as major investors in hedge funds has had a stabilizing influence too. Institutional investors may be quicker to shift their money out of underperforming funds, but having different types of investors reduces the risk of simultaneous redemptions and disorderly liquidation of market positions. Moreover, the need to attract institutions and pass their due diligence reviews has prompted hedge funds to introduce greater transparency and tighten their risk management policies. Some 85 percent of hedge funds now have a chief risk officer. About three-quarters disclose the same information to investors as they do to lenders. Close to half inform investors how much leverage they use.

Still, the Securities and Exchange Commission recently lost a bid to force hedge funds to register, and to have the right to audit them.

Hedge funds now wield enormous power on the marketplace -- which may prove destabilizing. Top-level investment and commercial banks have emerged as industry leaders. Goldman Sachs is now the world's largest hedge fund manager, with $21 billion in AUM. Its hedge fund assets have increased almost 2.5 times over the past two years. JP Morgan Chase has boosted its hedge fund operations and now ranks among the top 25 fund managers, as does HSBC.

Banks are exposed in a different way, too. Hedge funds have become major customers for brokerage services. Their active trading can generate tens of billions in annual earnings; even prime brokerage services for hedge funds have grown to an $8 billion-a-year business. To get a piece of this action in an environment of cutthroat competition, banks have had to use their balance sheets, providing leverage to their hedge fund clients and incurring substantial risk.

Being in essence long stock funds has suggested to some hedge funds an obvious next step -- why not try conventional money management? DE Shaw, one of the world's largest hedge funds, has announced its first foray into this side of the business.

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2ND QUARTER 2006 ASSET FLOWS

as a percent of beginning assets

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Fixed Income Arbitrage7.28%

Global Macro7.16%

Equity Market Neutral5.07%

Emerging Markets5.83%

Managed Futures5.87%

Long/Short Equity Hedge3.86%

Dedicated Short Bias3.84%

Multi-Strategy3.11%

Convertable Arbitrage3.01%

Event Driven2.28%

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All Styles4.19%

Source: Tremont Capital Management

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Alexei Beyer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com.

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