July 2005

Demystifying Hedge Funds

This July 26 AEI conference was the first in a series of AEI conferences to increase understanding of the role of hedge funds in global capital markets. The pursuit of extraordinary returns on investment has created a hedge-fund culture of secrecy, as hedge-fund managers guard their profit-reaping strategies. As an infant industry limited to a small customer base of very rich private individuals, hedge funds passed unnoticed by the press and government watchdogs. They have now become a major component of the financial markets with an expanded retail and institutional investor universe. This closed society has aroused fear and suspicion in the public mind, encouraging media interest and spurring fledgling efforts by the Securities and Exchange Commission to regulate the industry. A panel of practitioners and academics discussed the prospect of regulating hedge funds and the hedge-fund industry more generally.
 
Tanya Beder
Citigroup

This is a really new industry; all the names which we associate with the founding of the industry--Caxton, Morris, Tudor, Tiger, and Soros--were started in the mid 1980s, and by the end of the decade they had only about $1 billion each. Today, there is about $1 trillion in hedge funds, and this is expected to grow to $5 trillion. The industry is about to go through some massive changes. There are 15,000 people and 8,000 hedge funds in the industry, so it is very fragmented. The average hedge fund contains $150 million in the United States, $100 million in Europe, and $65 million in Asia. In contrast, there are $18 trillion and 9,500 employees in traditional asset management, global equity markets are $30 trillion, and global bonds markets are $40 trillion. In order for hedge funds to grow to that size they are going to have to do things in an unconventional manner, and it will turn previous economic thinking on its head.

Chester Spatt
Securities and Exchange Commission

I am not going to speak about the registration of hedge funds, but rather the role of hedge funds in our capital markets. The relatively efficient price signals in the market are very important because they allow efficient investment choices, making it possible for even uninformed investors to make good decisions. They thus benefit from the arbitrage process and make the capital markets more efficient. Although market prices usually reflect the information available, it is important that there are incentives to do the costly analytical calculations needed to keep it that way, and hedge funds provide such incentives.

A key ingredient in creating efficient market prices is the force of large investment pools, which hedge funds provide. Also, the ability of hedge funds to operate across different market sectors makes them useful for insuring the fairness of prices across the entire market. Thus, hedge funds play a very important role in creating efficient prices.

You would expect that skilled asset managers in hedge funds would be able to collect a good deal of the associated economic rents. In practice, the structure of hedge funds often allows the general partner to share significantly in the economic rents, specifically because of the common option like payoff structure where the general partner earns 20 percent of the returns above a base amount.

One thing that limits the ability of skilled managers to collect rents is the difficulty in determining if a strategy really offers better performance. There is a lot of variability or noise in the measurements, so historical returns do not provide enough data to statistically evaluate if a strategy is effective. I believe that this effect causes estimates of historical hedge fund returns to be overstated.

This conclusion complements an observation in a paper a by Mila Getmansky, Andrew Lo, and Igor Makarov. They argued that liquidity issues in the underlying holdings of hedge funds tend to inherently smooth their returns and, consequently, understate the risks associated with hedge funds. This makes them seem more attractive then they really are.

Divergent incentives for the principals and agents in hedge funds have given some policymakers concern. For example, the payoff structure option allows the general partner to share in the gains but not in the losses. This can cause the manager to assume more risk then is otherwise advisable.

Another example of divergent interests arises because the fund adviser, the agent, is working for many different principals. Specifically, there can be allocation problems when different accounts are not treated equally. This could happen because different accounts have different incentives, such as fee rates. This is not to say that one agent should not work for several principals, just that it is important that there are objective and well-defined processes for handling such situations.

Another example of a problem created by multiple accounts can be seen when allocating trades. When executing a bunch of orders for many clients, the clients whose orders get executed first are systematically advantaged because their orders will have less price impact. Again, it is important to have a process that handles this fairly.

John H. Makin
AEI and Caxton Associates

Hedge funds form a very heterogeneous population, so not all these remarks will be generalizable. I will start with a bit of history. As far as I can tell, hedge funds started off in the early 1980s with some skillful traders--such as George Soros, Bruce Kovner, and Louis Bacon. They could invest more money than they had access to, so wealthy individuals approached them and told them to take their money and make it grow. I am not sure where the term “hedge fund” came from, but it was not in use at the time.

Because they were so good at what they did, they could name a fee structure--typically 20 percent of earnings and 2 percent of the total to cover fixed costs. They made 20, 30, or even 40 percent a year and probably did help make the markets more efficient. At first, they earned their rents simply by outperforming mutual funds, many of which invested in a specific area. That seems like a silly idea; why not just invest where it is best and makes as much money as possible? Such funds were very unimaginative--they only bought long. Hedge funds would buy long or short and trade bonds, commodities, stocks, or anything that was moving. In short, their goal was simply to make money by whatever means were available.

However, there were high minimum invests for hedge funds--often $1 million--to keep accounting simple. At Caxton, our minimum investment is $100 million.

Contrary to common opinion, the hedge funds in the first ten years were all very good risk managers, and the ones that have stuck around still are. Lapses in risk management can lead to funds folding, as happened to Soros’ Quantum Fund in 1999. Part of hedge funds’ cowboy image has made them the scapegoats for anything that goes wrong in the market, and everyone from the German government to the Chinese government has blamed them for their ills. I cannot believe that hedge funds are really guilty as charged.

As already mentioned, the industry will be much different in the future if it grows to $5 trillion, but I believe that it will end up looking like the old mutual fund industry. In other words, things will have come full circle. There will probably be benchmarks, and it will become a fee-driven industry. Moreover, people will realize that just because something claims to be a hedge fund, it does not mean that it will have a great return. Part of the reason for hedge funds’ recent popularity is that enterprising individuals discovered that, if they could round up $500 billion and start a “hedge fund,” they could get some easy money. They would try to hit a home run with some investment, but failing that they could just close the fund in a few years and walk away richer.

AEI intern Leon Maurer prepared this summary.