Fear of a Black Box
Sure, they're MYSTERIOUS, PRONE TO BLOWUPS, and employ INSUFFERABLY RICH 39-year-olds. But guess what? The economy and the markets need HEDGE FUNDS.
(FORTUNE Magazine) – Here are some things that don't happen at mutual funds: Managers don't falsify results and hide for years the fact that they've squandered their investors' money, as happened at the hedge fund firm called Bayou Group. They don't put 65% of their assets in the stock of one troubled company without telling anybody about it, as the SEC says another hedge fund, Wood River Capital Management, did during the summer. They don't make bad bets that threaten to knock out the global financial system, as happened at the most infamous hedge fund of all, Long-Term Capital Management, in 1998. Yes, something needs to be done about these hedge funds. "They are," wrote Cliff Asness last year in The Journal of Portfolio Management, "relatively unregulated (for now), charge very high fees, will not necessarily give you your money back when you want it, and will generally not tell you what they do." Not to mention that they are run by smug, insanely rich 39-year-olds in Greenwich, Conn. There ought to be a law!
But wait a second. Asness is a 39-year-old hedge fund manager, head of AQR Capital Management in--shocker--Greenwich, Conn. Not surprisingly, he thinks that despite their flaws, hedge funds are a good thing. So do the hordes of sophisticated investors who have poured money into them for years. They've done so because hedge funds appear to deliver better returns--and returns that don't just follow the ups and downs of the stock market--than the heavily regulated, transparent, largely blowup-free mutual fund industry.
One must emphasize the word "appear." Hedge funds remain, as a group, something of a black box. They are under no obligation to report performance data, so the statistics that show them outperforming the stock market with less volatility over the past decade (see chart, "Better Than Stocks") are probably biased upward because funds that flop keep quiet. But hedge funds are at least structured to give their managers the tools and the incentives to deliver market-beating returns.
It is that very structure that makes hedge funds so mysterious and ominous. The spooky mystique worked when hedge funds were a sideshow, but is problematic when more than 8,000 of them manage $1 trillion--plus, according to industry estimates. If the stream of hedge fund scandals continues--and the following article details how the next one might be at Millennium Management--there will be calls to rein them in or maybe even stamp them out. Already, starting in February, hedge funds of more than $30 million will have to register with the SEC. The registration is mostly busywork, but it opens the door to future regulation. What's more, investors in hedge funds are beginning to demand to know what's being done with their money.
The pressure for more regulation and disclosure is understandable, even laudable. But remember: We already have a heavily regulated, transparent sector of the money-management business--and its weaknesses have fueled the hedge fund boom. Mutual funds may have mostly avoided the scandals and blowups that hit hedgies, but they can't escape one scandalous truth: They ingest billions of dollars from investors in fees every year in return for performance that trails the S&P 500.
It's possible that hedge funds will grow so large that they, too, will deliver nothing more than expensive mediocrity. But the laws governing mutual funds make it especially hard for them to do better. Those laws grew out of the experience of the 1920s, when unregulated funds engaged in all sorts of dubious practices that, after the 1929 Crash, rendered their shares pretty much worthless. When Congress got around to writing rules for money managers in 1940, it prescribed a very specific model: the open-end mutual fund, which generally couldn't sell stocks short, couldn't speculate using borrowed money, couldn't charge performance fees, had to disclose its holdings periodically, and had to let investors redeem shares for cash on a daily basis. Those restrictions haven't crimped mutual funds as a business--open-end funds in the U.S. now manage $8.6 trillion. But they do make it hard for fund managers to take risks and do the things needed to get an edge on the market. The very massiveness of the big mutual fund families also encourages caution and herd behavior: The way to make more money in the mutual fund business is to gather more assets. Better investment performance can help with that, but it's not essential.
Congress left a loophole in 1940: Money managers with a smaller, more sophisticated clientele could go about their business without adhering to all those rules. It is inside that loophole that the hedge fund industry grew. The name came from Alfred Winslow Jones, a former FORTUNE writer who launched a "hedged fund" in 1949 that both bought stocks and sold them short in order to hedge its exposure to the market's ups and downs. In the 1960s the term caught on, slightly altered, as shorthand for all unregulated investment funds.
The Jones-style hedging strategy is no longer unique to hedge funds--mutual funds can now sell stock short. But few do, and hedge funds are far more likely than mutual funds to pursue market-neutral strategies that aim to profit regardless of what stocks or bonds do. Hedge funds can invest in exotic derivatives and illiquid assets that are largely off-limits to mutual funds, and they can more readily juice their returns (and their risk) with leverage. They charge fees that lavishly reward good performance--the standard is 1% of assets under management plus 20% of any gains, although especially successful hedge funds can charge more. And they usually "lock up" new investors' money for the first year and require ample notice--a month or 90 days, usually--for withdrawals after that.
All these characteristics bring added risk for investors. But they also allow a truly skilled money manager to exercise that skill to its fullest. Another big advantage: Hedge fund managers, reasoning that they don't want to tip off the market to their moves, traditionally haven't told their investors what they're doing. The secrecy became even more intense with the advent of quantitative funds that used computers and fancy math. All that nerdulent voodoo begat the term "black box": Money went in, even more money came out. There are other black boxes around. Think Refco, which just blew up, or even Goldman Sachs. But hedge funds have made a particular art of it.
The push for transparency is changing that--a bit. "We try very hard to avoid disseminating information about our predictive techniques that could be damaging to our clients if it were to fall into the wrong hands," e-mails David Shaw of D.E. Shaw, a leading quant management firm. "On the other hand, we provide our clients with a great deal of information about, for example, the aggregate composition of the portfolios we manage for them, the degree of leverage we employ in different strategies, certain risk factors to which our strategies are exposed, and various operational issues."
So far, that's the kind of disclosure that regulators and hedge fund clients seem most interested in. The far bigger challenge for the industry may simply be that the flow of new money will make it harder to find moneymaking opportunities. The CSFB/Tremont hedge fund index, after achieving 25% annual gains in the mid-1990s, has lately posted increases mostly in the sub-10% range. "This is what the economy does," says Cliff Asness. "It finds things that seem to work and pours money into them until they become not necessarily a bad deal but a fair deal." Increasingly, hedge funds are selling themselves less as market beaters than as investments returns that zig when the market zags.
Even that may be an illusion. Andrew Lo, a finance professor at MIT who runs a hedge fund on the side, has researched systemic risk among hedge funds and found that, while in good times they deliver returns mostly independent of the stock market and of each other, in times of crisis they go down together. The last time that happened was in 1998, when Long-Term Capital melted down after Russia defaulted on its debts, many other funds threatened to follow, and the stock market briefly tanked as well. In a paper that has attracted much attention in the hedge fund business, Lo and several co-authors detail evidence that such pack behavior has returned as hedge funds scrounge for profit opportunities in an increasingly crowded market.
Couple that with the occasional unsystemic blowups like those at Bayou and Wood River, and it's enough to make a person stick all his money in index funds. But that truffle-pig-like rooting about for an edge is what makes hedge funds such an important alternative to the dominant mutual fund model. Consider short-selling: Mutual funds avoid it because it's controversial and risky, but hedge funds embrace it. (For an account of one company's campaign against short sellers, see the following article on Overstock.com.) In a market full of hyperventilating cheerleaders who only want stock prices to go up, the short-selling hedgies are trying to get prices right--which happens to be essential to making a capitalist economy work. Hedge funds are the vanguard of the investing world. They take the big risks, and they find the big, if rare, rewards. That they're also a little scary is part of the game. If they weren't, they wouldn't do us any good.