In literature, great speculators are colourful characters, as large—and imperfect—as life itself: Trollope's Augustus Melmotte, in The Way We Live Now, or F Scott Fitzgerald's Jay Gatsby. The real world of banking and finance is, sadly, not always populated by such personalities. Yet speculation is again a roaring business. Less conspicuous than in Victorian London or 1920s New York, nowadays it emanates from hushed computer-driven dealing rooms on Park Avenue, New York, or behind brass plates in and around Curzon Street in London's Mayfair. Its practitioners tend to shun the limelight, and have little in common with the flashier crowd of a more recent speculative era, the 1990s; their mystique is bound up with mysterious algorithmic trading models and offshore tax havens. Even the term used to describe them—"hedge funds"—conceals more than it reveals.
Twenty years after London's "big bang" blew away the last of the bowler hats in the square mile and gave further impetus to the globalisation of international finance, it is worth asking who these postmodern masters of capital are. Are they, as the Guardian recently put it, proponents of "casino capitalism," a shadowy and unstable force which should be far more tightly regulated? Or would such a response be "regulatory McCarthyism," as Jonathan Macey, a professor at Yale Law School, put it in the Wall Street Journal? Are the 10,000 hedge funds in existence so diverse that they cannot pose a threat to the global financial system—for when some do badly, others do well? To answer these questions, it is necessary first to try to understand what a hedge fund is.
What is a hedge fund?
The term "hedge fund" was first inspired by Alfred Winslow Jones, a former editor of America's Fortune, who in 1949 acted on his idea to take offsetting positions on pairs of stocks. His rationale was simple, and persists to this day: he thought himself good at picking stocks likely to outperform the market, but not so good at predicting more general market trends. If, for instance, you buy General Motors shares, you expose yourself to several risks which have little or nothing to do with the performance of the company itself. Among them are the chance that the dollar might collapse, or that a sudden rise in the price of oil will depress car sales. Today you can hedge against such risks by selling or buying options in futures markets. In Jones's case, he took bets that undervalued stocks would go up, and then cushioned investors from the risk that markets would fall by "short-selling" overvalued stocks (to short-sell is to sell assets you do not yet own on the expectation that the price will fall; if the price does fall, you pocket the difference between the lower price and the earlier, higher price). This "hedged" strategy is, by definition, low-risk, so to spice up returns, Jones moved his funds offshore, enabling him to borrow money to invest with—something that fund management companies in the US are not allowed to do to this day. He collected no fee for managing his clients' money, but claimed 20 per cent of all profits made. For 20 years the returns to investors, and to himself, were impressive.
A few decades later a rival strategy emerged, known as "global macro." As with Jones's, these funds are private, open only to very rich individuals, with performance-related fees and largely unregulated offshore domiciles, many in the Cayman Islands. Global macro funds are also called hedge funds, though largely for historical reasons; unlike Jones's "long-short" funds, global macro funds are anything but hedged: they involve naked speculation, albeit exhaustively researched. Some are characterised by aggressive use of derivatives, such as swaps, futures and options, which, like insurance contracts, require small down payments for potentially big payouts. Others form a hedge fund branch of the "active investment" movement, which targets underperforming companies. But in the last quarter of the 20th century, global macro funds became by far the most popular—and notorious—part of the hedge fund universe.
Born out of the collapse of the Bretton Woods fixed-currency regime in 1971, the global macro strategists scoured the world, not just the US equity markets, for pricing anomalies on behalf of rich private clients. In the early 1990s, seven out of ten of the largest investors in the hedge fund universe invested in global macro; after the dotcom crash, the culmination of a dreadful few years for such funds, it fell to fewer than one in ten. In his book Inside the House of Money (Wiley, 2006), Steven Drobny, a hedge fund consultant, says that within the global macro strategy there were two broad schools. There were equity and currency legends such as George Soros, Julian Robertson and Michael Steinhardt. There were also alumni of the Commodities Corporation of Princeton, New Jersey, who specialised in commodities.
Soros, of course, made hedge funds famous on black Wednesday in 1992, when Soros Fund Management bet $10bn against sterling's entry level into the European exchange rate mechanism by short-selling the currency. When the Tory government failed to defend the pound with higher interest rates and was forced to devalue, Soros bought the currency back cheaper than he had sold it and walked off with £1bn and a reputation as the man who broke the Bank of England.
Hedge funds made the news again in 1998, when Long-Term Capital Management (LTCM), a totemic US hedge fund, almost collapsed. Set up in 1994 by John Meriwether, former head of bond trading at Salomon Brothers, its directors included Robert Merton and Myron Scholes, Nobel laureate economists. The mathematical wizards working for LTCM had spotted tiny anomalies in bond prices that would converge over time; they placed bets on this convergence with huge sums of borrowed money, and after a few years were making average returns of 40 per cent a year. As success drew in more investors, they went to greater lengths to increase returns, and their borrowing now supported big bets on assets around the world. Indeed, LTCM, which started life looking like a bond-market version of Jones's long-short fund, now started to resemble Soros's global macro fund—although even heavier in debt. At the time, however, it looked like LTCM's investment strategy was so broad that falls in one asset class would not affect another; it thought it had a natural hedge against market conditions.
Not so. When Russia defaulted on its foreign debt in 1998, it set off a chain reaction through bond markets around the world; instead of prices converging, they sprang further apart. To cover their losses, LTCM and other hedge funds began dumping investments elsewhere, and soon, prices of all of its assets were dropping, some simply because they were owned by LTCM and everyone knew it was holding a firesale. Of LTCM's $125bn of assets, $120bn were backed by borrowed money: a staggeringly high "leverage ratio" of 25:1. When investors began withdrawing their capital and bankers called in the loans, it became clear that LTCM would go bust. In less than four months, it lost $4.6bn of capital, and its investors might have been wiped out if the Federal Reserve had not organised a bailout. Ironically, not long after LTCM disappeared, its positions, in the hands of its rescuers, turned a profit: the mathematicians had been right, but LTCM had been unable to stay solvent long enough to prove it.
At the turn of the century, when the world was waking up to the excesses of the late-1990s stock market boom, LTCM must have looked to the hedge fund industry like Napoleon's Waterloo. By mid-2000, many of the biggest funds had fallen foul of the dotcom era. Julian Robertson closed his Tiger Fund, after a badly timed bet against new economy stocks. George Soros's Quantum Fund shut down for the opposite reason: he bet on technology stocks too late in the cycle. Drobny quotes his valedictory letter to investors, which reads like an epitaph of a gilded age: "During its 31H-year history, Quantum provided its shareholders with an annual return in excess of 30 per cent. An investment of $100,000 in the fund at its inception would be worth approximately $420m today."
It turned out not to be the beginning of the end. While regulators, lawyers and the media were poring over the banking industry after the collapse of Enron, hedge funds were keeping their heads down and quietly prospering. A new generation of managers, many of them alumni of Tiger and Quantum, showed their trading prowess, making money for investors as stock markets tumbled. Many funds, instead of taking big bets on currencies and countries, became niche players in under-researched areas of the stock market: convertible bonds, derivatives and commodities. In the tree-lined suburbs of Greenwich, Connecticut and in London's west end, they refurbished their offices to attract a new type of client. Besides the rich individuals that had traditionally sustained them, they began courting pension funds, insurance companies and mutual funds, all scrambling to cover losses from other investments. Their success was startling.
In 1998, hedge funds managed assets worth $200bn. Today they are valued at $1.25 trillion. The number of hedge funds has grown from 2,800 a decade ago to around 10,000. Last year alone, 2,073 new hedge funds opened for business. Most are tiny, and on average only about half will survive the first three years. But those which last longer may find a potential goldmine. In the eight years up to January 2005, according to the Hennessee Group, a New York consultancy, pension assets invested in hedge funds in America grew from $13bn to $71bn.
What has caused this surge in popularity? In the media, the perception of hedge funds is of risky, secretive, highly leveraged investment funds whose managers have become filthy rich by gambling with pensioners' savings. Yet clients are not put off: according to Hedge Fund Research, the funds attracted $44.5bn of new investments in the third quarter of this year, almost as much as during the whole of 2005. In part, pension funds have flooded in because their losses were so great after the dotcom crash that they believe they have to take a flyer on hedge funds to make up the shortfall. They have also been forced into "frontier investments" as part of a search for higher yielding assets at a time of low global interest rates. But in a thoughtful book, How to Invest in Hedge Funds, Matthew Ridley lists other arguments in hedge funds' favour. They are, he says, no broader in their investments than the ordinary investment funds of the mutual industry, which invests in anything from money-market funds to technology stocks; and the vast majority have a risk profile that is lower than mutual funds. In contrast to mutual funds, however, hedge funds are unregulated, their investors need to be very rich, and they are not required to publish data on their performance. Ridley says hedge funds have shown that they can make money in rising and falling markets, and when they do actually hedge, their returns can be steadier. They also provide investors with some of the most talented fund managers in the world, many of whom cut their teeth on the trading desks of top investment banks gambling the firm's money. Now some of the money on the table is their own, and they don't want to lose it.
Hedge funds, too, have sharpened up their image to appeal to the "suits" in the pension fund business. The dress code tends to be more elegant than flashy. On Curzon Street, where most hedge funds are located, the traders pile out into the bars after work at 7pm. But their managers are more likely to stay at their desks, scanning screens for prices from around the world. Many live near the shop—so near, in fact, that the quaint old red-light district of Shepherd Market has become infested with bachelor pads furnished with empty fridges and rowing machines.
Visit this new generation of hedge fund managers for lunch, as I have a few times, and they take pains to appear as down to earth as possible. One manager asked me to bring my own (and his) sandwiches; another provided takeaway sushi. The messages they delivered were as simple as the food. Hedge funds have grown up, they said: their most important hirings nowadays are of chief operating officers to manage risk and potential conflicts, rather than brash young traders; they have systems in place to prevent massive blow-ups. They even give away some of what they earn. One hedge fund charity event in Pall Mall this summer raised £18m in a night; a yoga session with Sting went for £70,000; a guitar lesson with Coldplay's Chris Martin and dinner with his wife Gwyneth Paltrow went for twice that. They hope this will be good publicity with governments and pension fund trustees, eager to know that workers' savings are in good hands. But will they continue to make the returns to justify their high fees?
A bumpier ride
Recent months have given us plenty of reasons to doubt that. In May and June, when stock, bond and commodity markets tumbled around the world, hedge funds were caught out like everyone else. The popularity of hedge funds took a further knock in September, when Amaranth Advisors, a popular hedge fund based in Connecticut, lost at least $6bn of its clients' money—almost two thirds of its assets—in bets on a single commodity: natural gas. The losses were incurred by a 32-year-old trader, Brian Hunter, who was not even based at head office. That made a mockery of risk-management procedures. Worse still, Amaranth was a "multi-strategy" fund, offering investors a wide choice of investments to diversify their portfolios. It had attracted pension funds, including the San Diego County Employees Retirement Association, which lost over $100m. When the association's chief executive said he would review its use of hedge funds, many other fund managers must have resolved to do the same. Not long after, Vega Asset Management, which two years ago was the largest hedge fund in Europe, managing $12bn, suffered steep losses as its bets on US bond markets went wrong. Like LTCM, the markets later turned, proving its hunch was right. But not before many investors had pulled out.
Such setbacks have cost the hedge fund industry a good deal of its lustre lately. Regulators are fingering their nooses. In Germany, which is suspicious of any active investors, concerns about hedge funds linger from the days when several hedge fund managers shot to pieces Deutsche Börse's bid for the London Stock Exchange and forced out its chairman and chief executive. That earned them the sobriquet "locusts." In America, the Securities and Exchange Commission (SEC) is poking into allegations of insider trading. And a Democrat-heavy congress may make some regulation inevitable.
Meanwhile, poor returns are raising renewed concerns among investors. According to Hedge Fund Research, in the third quarter of 2006, when the Dow Jones Industrial Average neared record highs, the average hedge fund returned just 1 per cent, down from almost 6 per cent in the first quarter. Analysts are increasingly questioning whether hedge funds are worth the high fees they charge of, say, 2 per cent of assets under management (plus the 20 per cent of performance). Fees are even more of an issue in so-called funds of funds, which are baskets of individual hedge funds that charge their own management fees on top of that charged by the individual hedge fund manager. In September, the lacklustre performance compared with the S&P 500 was spelled out with unusual candour by Henry McVey, a stock market analyst at Morgan Stanley, one of two investment banks that does most lending and broking for hedge funds (the other is Goldman Sachs). "If we are right, more investors are likely to feel tricked, rather than treated."
Even industry greybeards are casting doubt on the value of hedge funds, and the staggering sums earned by some. Steven Cohen, head of Connecticut-based SAC Capital, pulled in $1bn-plus in fees last year according to Trader Monthly; his success rate enables him to charge performance-related fees of up to 50 per cent (and to buy expensive art, such as Damien Hirst's pickled shark). But there are many who do not deserve what they are paid. In an article in the Wall Street Journal in April, Michael Steinhardt, whose own investments produced annualised returns of 24.5 per cent over 29 years, described hedge funds with a note of disparagement as the "highest paid industry in the world," adding that, "realistically, there are a limited number of truly superior fund managers."
And even when hedge funds beat "the market," there are reasons to doubt the accuracy of the indexes that measure their performance, because the information they receive is voluntary and only the best performers are likely to provide it. Such "survivorship bias" fails to take into account the losses of hundreds of hedge funds that close down each year.
The universe of hedge funds is now so big and varied that Alfred Winslow Jones might not recognise the creature he helped to create. But they still have certain characteristics in common: aggressive management, wealthy individual or professional investors, the promise of steadier returns than is generally offered by publicly available vehicles such as mutual funds, the ability to go short, discreet operation and small size, and loose regulatory oversight. But is the regulatory oversight now too loose?
The regulators are not alarmed by the recent poor performance of the funds; indeed, some say they would happily see one or two large hedge funds go bust as a lesson to the rest of the industry. They acknowledge that hedge fund clients are mostly sophisticated people able to look after themselves. So far, what American regulators quaintly call "mom and pop" investors are not allowed to put their money directly into hedge funds. That is why the regulatory burden on hedge funds is so light. A move this year to force most US hedge funds to register with the SEC was struck down after being challenged in a US appeals court.
In Britain, the Financial Services Authority (FSA) has what is considered a slightly more intrusive mandate. It requires hedge funds to seek authorisation before beginning to operate, and hedge fund managers under its supervision are responsible for about $256bn of assets, or 20 per cent of the global total. But it says it is not persuaded to regulate the industry any more directly. In September, Hector Sants, the FSA's head of market supervision, said: "Much of the debate about hedge funds raises the view that 'the risk' is due to a lack of regulatory oversight. We do not subscribe to this view. We believe the issue is the complexity of risks they pose and we cannot diminish this challenge by increases in our regulatory powers."
In regulators' minds, hedge funds are seen as part of a technological revolution in finance. In America, for example, hedge funds hold just 5 per cent of assets under management, a fraction of the vast sums controlled by pension funds, mutual funds and other institutional investors. Yet they generate 30 per cent of all trading activity, and have become hugely important to banks as buyers of unwanted loan portfolios, derivatives and a component part of shares and bonds created by the new wave of financial alchemy. This liquidity provision is very useful to the markets; the increased turnover helps to make them more efficient, ironing out pricing anomalies.
In a speech in October, John Gieve, deputy governor of the Bank of England, said a mixture of technology and financial theory had caused "a ferment of financial innovation." He believed the financial system had become safer as a result because big banks were able to sell to hedge funds some of the risk they had previously held on their balance sheets, meaning the burden would be shared if borrowers go bust. He noted, however, that hedge funds have flourished lately in a particularly benign period; even the falling natural gas prices that had brought down Amaranth were good for the global economy overall, which may explain why its troubles did not reverberate more widely. There are worries about what might lie in store if markets deteriorate for longer periods and several hedge funds collapse at the same time—"a perfect storm."
Of particular concern is the exposure of large banks to hedge funds via their brokerage arms—the units that lend cash and stocks to hedge funds to trade with. In September, Timothy Geithner, president of the New York Fed (and Wall Street's chief regulator) warned of the dangers of brokers lending to hedge funds without receiving enough collateral. The use of derivatives has ballooned in the hands of hedge funds; for instance, the notional amount of a popular sort, credit derivatives, which insure against a company going bust, has risen to $26 trillion, seven times as much as in 2003. Geithner urged banks to be more conservative in assessing the risks hedge funds posed to them and to the banking system.
Regulators are paid to worry about the risks to financial stability, however, and it is hard to prove that their fears are justified. This point is made by Jonathan Macey in his commentary on regulatory McCarthyism: "Precisely because of this enormous diversity, the investment strategies of hedge funds cannot pose systemic risk… When some do well, others are bound to do poorly because their investment strategies are in no way correlated… Those that perform well for their investors will flourish. Those that perform poorly will wither. This is the… only form of regulation that hedge funds require."
But the market as a whole has yet to confront the impact of a prolonged sell-off, stretching across many asset classes, that removes the cheap and abundant financing hedge funds have enjoyed this decade. When that happens, hedge funds that have supplied liquidity may start to drain it, exacerbating the problem. Banks exposed too heavily to hedge funds will feel the effects. At that time, the challenge for hedge funds will be to confound the dictum, attributed to John Maynard Keynes, that markets can stay irrational longer than investors can stay solvent. Those hedge funds that cannot will be part of the problem. Those that can may help to provide the solution.
