A V Rajwade: Markets and hedge funds

WORLD MONEY

Surveys show the returns such funds provide are not as high as you'd expect.

If private equity is one pillar of "finance capital", the other surely is hedge funds. Currently, there are an estimated 8,000 hedge funds in operation worldwide with an aggregate size of $1.2 trillion. Lately, they have become popular in Asia as well, attracting $100 billion of investment. The origin of the name is the long/short investment strategy (say, long in undervalued equities, while short in overvalued ones) they used to follow. As such, their returns were supposed to be independent of the direction in which the market moved. This original model is still being used, but only by a small number. More are engaged in the so-called convertible arbitrage (long positions in convertible bonds, while shorting the underlying share); "macro", directional bets on currency or interest rate movements; purchase of distressed assets (non-performing loans or bankrupt companies); and even equity investments in the market. As the number of funds and the amount available to them have grown, hedge funds are also competing with banks in the lending business "" particularly, the riskier loans banks may not be very keen on, for leveraged buyouts for example. Some analysts also blame hedge fund speculation for the oil and gold price rises.

An estimated 30 per cent plus share of the trading in high yielding securities and credit derivatives is accounted for by hedge funds, who also invest in participatory notes in India. In several headline-attracting cases, hedge fund investors have led shareholder revolts against management particularly in European companies.

While fund management fees remain large (typically 2 per cent of the funds under management, plus 20 per cent of the profit), with a large number of funds chasing the same opportunities and using the same mathematical models for spotting mispricings, making above average returns has become difficult. One recent academic study evidences that less than a fifth of the almost 2,000 hedge funds surveyed, managed to give to their investors returns higher than they could have themselves generated by mechanically trading futures contracts on the S&P 500, T-bond and eurodollars. Another hedge fund survey, over a longer period, evidences that fund returns averaged 13.5 per cent a year over 1990 to 2004, as against 10.9 per cent a year for the S&P 500. A Merrill Lynch study showed a strong correlation between a hedge fund index and the S&P 500 "" as high as 0.8. One also wonders to what extent the survey results are painting a more favourable performance than warranted, if only because of the so-called "survivor bias" "" the failures vanish and do not form part of the surveyed sample. Even in this environment, some fund managers have made tonnes of money "" a couple of individuals made as much as $500 million each last year with many others in the $100-milion bracket.

As more institutional investors get attracted to hedge funds, "fund of funds" are also getting popular: as the name signifies, they invest in other hedge funds, thus diversifying the investor's risk, but at the cost of one more fee. An estimated half of the funds under management are institutional, and three quarters of these are invested through funds of funds. Not only the fund investor base, but fund management is also getting institutionalised, with many large banks entering the business. With competition, some funds are accepting amounts as low as $10,000 from investors.

The number, amounts and transactions originated by hedge funds have grown so rapidly that many brokerage houses have become dependent on hedge fund business for a significant proportion of their fees. Even major investment banks, which provide the so-called "prime broking services" (back office, settlements, securities lending, credit support, and so on) to hedge funds are also increasingly beholden to them.

Regulation remains light handed, particularly in the US. When the recent deadline for registration with the SEC expired, only half the hedge funds are estimated to have registered, the rest accepting limits on investors instead of registering. Regulation is somewhat stricter in the UK.

One major change in the industry has been that, as a result of the lessons learnt in the collapse of Long Term Capital Management (LTCM) in 1998, banks have become much more conservative in providing leverage. Another is that, like their private equity cousins, hedge funds are taking over companies in trouble with a view to turning them around after restructuring. "Finance capital" is well, alive and kicking!

Tailpiece: Mark Gilbert of London has suggested some interesting definitions for the bond market. One of my favourite is: "Alpha: The amount of excess return promised by a hedge fund manager to justify his pocketing 2 per cent of your capital and 20 per cent of any profit. It seems there are only two ways to generate alpha. The first is to sell General Motors Corp bonds and simultaneously buy those of its finance unit, GMAC. The second is to go long GMAC debt while being short GM securities. Anyone who can't see the difference between these two trades clearly isn't as bright as the hedge fund guys. They are displaying their individuality by making identical bets on GMAC regaining its investment-grade rating while GM slides further toward filing for bankruptcy protection."

Email: avrco@vsnl.com