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No Hedging on Hedge Funds

Rick Roeder       March 24, 2009

The average person on Main Street is hearing that hedge funds are one of many culprits in America’s current economic mess. Yet most folks would be at a total loss to define what a hedge fund is.

Even for financial professionals, defining a hedge fund is no easy task. Like Supreme Court Justice Potter Stewart once said about pornography, perhaps it is easiest to start with what a hedge fund is not – traditional, unleveraged investments in stocks and bonds. Hedge funds are restricted to only a limited number of high net worth individuals and institutional investors because hedge funds are exempt from general rules relating to leverage, use of derivative instruments (ie, futures contracts, options & puts), short selling, fund liquidity and fund management fees: Bigger reward/risk for deeper pockets. In other words, hedge funds would have fit perfectly in the Wild, Wild West.

The thrust of this Ramble is not targeted to the use by wealthy individuals of hedge funds but to the institutional users of hedge funds such as pension plans. I have attended pension conferences for 25+ years and noticed that there was much more interest in hedge funds immediately following the tech stock collapse in the first half of 2001. This, despite the fact, that most hedge funds had little in the way of a documented track record.

My sense is that the increased level of institutional interest came because plan sponsors and trustees were increasingly concerned about being able to meet their net investment return assumptions of 8% (or so) via traditional investments in light of 2001’s significant market correction. Setting the investment return assumption has major short-term implications for plan sponsors. If the investment return assumption is lowered, there is a corresponding increase in needed contributions to meet long-term fund objectives. To make matters worse, many public plan sponsors had raised pensions to unprecedented levels as a result of the giddy market run up in the previous decade. Increased benefits increased contribution requirements. It would have been embarrassing and politically unacceptable to ask for a second contribution increase in a short period of time by reducing the assumed investment return on trust monies. Of course, there were a few politicians who said to heck with embarrassment, outrage or political consequences: In California, Gray Davis asked for contribution relief in 2002 -- a year after a massive pension increase for state employees was granted (See my April 1, 2002 Letter to the Editor in Pensions & Investments in this regard).

So, many plan sponsors stubbornly clung to their 8% return assumption. Hedge funds offered potential salvation because of touted potential double digit returns. This “lifejacket” was offered just in time as the unprecedented 18-year bull market (1983-2000) came to a sudden halt. In some cases, the lifejacket turned out to be an anchor. In addition to the lack of a track record, there were other problems with hedge funds. Many large trust funds have a carefully calibrated investment allocation strategy to optimize meeting fund objectives. Hedge funds that are allowed to short sell and use leverage can unhinge asset allocation policy if they have meaningful holdings.

There was one further seduction made by hedge funds – how they charged clients. Some groused about the fee structure of mutual funds. The mutuals traditionally charge as a percent of assets held – irrespective of fund performance. Numerous hedge funds pitched their fee structure as follows: “Don’t pay us a penny unless we attain a specified level of return for you.” Sounds great but there can be a problem. Suppose that the end of a measuring period is looming and it does not look like the hedge fund will make its bogey. This fee structure encourages lagging hedge funds to take even more risk in an effort to “catch up.” This catch up issue was highlighted by the collapse of Amaranth Advisors in 2006. In one week, Amaranth lost almost two-thirds of its nine billion dollar portfolio in natural gas futures as it kept “doubling down” on its highly leveraged position.

The last problem is not restricted to hedge funds but is sadly endemic to much recent American financial behavior: moral hazard. Last month, the FBI arrested the two principals of WG Trading Company for securities and wire fraud relating to its $554 million portfolio. Apparently, it is not just Bernie who made off with the money.

James Cramer, a hedge fund manager, had an interesting observation in New York Magazine, “No pension manager in his right mind should ever risk his capital in such an open-ended fashion (as Amaranth Advisors). I recall turning down a county’s pension plan whose stewards had heard I was a good hedge fund manager with a great return. I told them giving me the money would be reckless, even though I barely used leverage. Pension managers simply do not have the sophistication and experience to properly assess and monitor hedge funds’ performance.”

There may be a place for small exposure for hedge funds in institutional funds with well defined missions and in a manner that does not conflict with a fund’s overall investment strategy. It is best to remember that hedge funds are like power tools: They can be useful in the hands of the wise and savvy. For the unwary, beware! As for those chastened public funds who have reduced or are in the process of reducing their hedge fund exposure, they can really relate to Smokey Robinson’s 1967 hit “The Love I Saw In You Was Just A Mirage.”
Rick Roeder

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