In case you were wondering . . . Part 5 – A Tale of Two Hedge Funds

“The hedge fund industry has grown on the basis of generating uncorrelated, absolute returns and having insight into when to deploy capital into and out of different strategies, sectors, and opportunities.” Simon Lack – “The Hedge Fund Mirage”

While this quote addresses industry, it is the best definition of “hedge fund” I have found. Hedge funds are a type of “alternative” or “absolute return” investment used to introduce diversity to a portfolio.

A hedge fund is a legal entity through which pooled monies are invested. Investors are limited to “accredited investors” or “qualified purchasers” (as defined by the Investment Company Act of 1940). These and other limitations exempted hedge funds from SEC registration. The rules changed under The Dodd Frank Wall Street Reform Act. Individual funds (hedge, private equity and other alternative) with Assets Under Management (AUM) exceeding $150mil are required to register with the SEC by March 30, 2012.

Most hedge fund investors are institutional - pension plans, endowments, trusts, banks – the balance being very wealthy individuals. Such investors manage large portfolios serving long to infinite time horizons. The fund manager has skin in the game and is compensated by management and performance fees.

The key words in Mr. Lack’s quote are uncorrelated and absolute returns. “Uncorrelated” describes diversity. By combining investments that react differently to an economic condition, portfolio design protects against lockstep and tempers volatility. Hedge fund returns are expected to be uncorrelated to other investment types. This can be achieved by selection. As an example, interest bearing debt is uncorrelated to equity. "Absolute Return" enhances the effect.

"Absolute Return" refers to all-in profits – realized or unrealized. Until sold, the absolute return of a non-dividend bearing stock is change in market value and performance is measured against a benchmark, i.e. against the performance of other similar investments.

Hedge funds are expected to produce positive return regardless of environment. To this end, managers can apply leverage – debt and derivative – to a correlated or uncorrelated strategy. The additional alpha cushions market price volatility and the long term effects of inflation. Fund performance is measured against applicable benchmarks.

A hedge fund can be as simple as a long equity strategy that shorts, tactically, to exploit market volatility. Or, it can be a long/short strategy. Leverage puts more capital to work.

You can short any security. To short equities, you sell stock at a price certain for delivery at a future date. You bet the market will drop below the strike price. Depending on the strategy, you can fulfill with owned shares (short against the box) or borrow them for a fee. Then, you replace the borrowed shares at a price less than the strike price.

Profit = Strike Price – Purchase Price or Basis – Loan Fees.

If the cost of money is favorable or there is an opportunity for interest rate arbitrage:

Profit = (Strike Price –Purchase Price or Basis – Loan Fees+/- Net Financing) X Leverage Multiplier

For the long/short combination, Absolute Return combines the gains/losses of the long positions – real and unrealized – with those of the shorts. The hedge fund manager has used derivatives and leverage to create a net outcome uncorrelated to that of the long equity play.

Hedge fund managers seek inefficiencies caused by price volatility (any source), pricing differences and the short investment cycle. No market is untapped – equities, bonds, debt, interest rates, currencies, commodities, precious metals, M&A, and distressed anything. The tools are arbitrage, derivatives and leverage. Some strategies yield slim slices of alpha and leverage is necessary to make it worthwhile – i.e. “picking up nickels in front of a bulldozer”.

This brings us to A Tale of Two Hedge Funds: Investment vs. Speculation.

Graham-Newman Partnership – Founded in 1926 - Closed in 1956 – Average Annual Return =17%. The investment pool Benjamin Graham managed with Jerome Newman included bonds, and preferred and common stocks. General Policies included “arbitrage and hedging operations in the securities field”. I don’t know the details, but the plan was executed beautifully.

Long Term Capital Management – Founded in 1994 - Closed in 2000. The Federal Reserve Bank of NY organized a creditor’s bailout in 1998 fearing a disorganized dissolution would jeopardize global markets. LTCM was founded and managed by the best and brightest. Phenomenal quantitative skills went to work finding thin slices of alpha from very technical trades and used debt to achieve critical mass. It appears the primary strategy was successful. However, the fund got so large other opportunities had to be found. Global events doomed some of these bets; positions had to be unwound untimely to meet margin calls; and the balance sheet spiraled. To illustrate (numbers all rounded):

Assets Liabilities Equity Debt to Equity Ratio

Beg of 1998 $129.2bil $124.5bil $4.7bil 25:1

Beg of 9/98 $2.3bil

End of 9/98 $100.4bil $100bil $ .4bil 250:1

By the end of September, every asset dollar was encumbered. The volume was the source of the Fed’s concerns, of course. Under the bailout, net losses totaled about 4.6bil; apparently within the ability of financial markets to absorb. (Cite: Roger Lowenstein via Wikipedia)

In his book “The Hedge Fund Mirage”, Simon Lack dismisses the value of hedge fund investment to the professional portfolio manager. He concludes the game is rigged to favor fund managers and can be won only by the best in banking and brokerage. As Global AUM by hedge funds is estimated at $2tril, this is a significant statement. However, there is always an exception.

David Swenson manages the endowment for Yale University. In the 90’s he reorganized the portfolio and made a substantial commitment to alternatives, including hedge funds. Simon Lack offers that by 2005, $7.8bil of the $15bil corpus was due to this decision. (Cite: Sebastian Mallaby – “More Money than God”.) Return of this quality reflects expert knowledge of financial markets and portfolio design; access to the best funds; first rate due diligence; and the ability to negotiate beneficial terms regarding fees, liquidity, and withdrawals. Finally, Mr. Swenson advocates active management of investments, i.e.: understand the investment; be ruthless in selection; to the extent possible, lock in protections prior to signing; monitor performance; and know when to leave.

Hedge funds are the children of market volatility and portfolio design. If Mr. Lack is correct, an enormous chunk of global investable capital is being pulled out of circulation and employed most inefficiently. Did I say “inefficiently”? There’s got to be a short and/or arbitrage opportunity here.