The Beginning
In 1949 Alfred Winslow Jones, a sociologist and former editor at Fortune magazine, started the first modern hedge fund. In addition to simply buying shares, he used two additional investment tools: short selling and leverage. These tools helped him reduce his exposure to broad market moves. Jones balanced the shares he purchased by selling other shares that he did not already own but had borrowed, in the hope of buying them back at a lower price. If the market went down, the money he made on his short position was intended to offset the losses on his long positions.
Jones’s long/short hedge fund outperformed all of the top mutual funds of his day. As word spread of Jones’s success, other managers set up hedge funds. In 1969, George Soros, then 39 and managing money at banking firm Arnhold & S. Bleichroeder Inc, started what would become the Quantum Fund with $6m. In 1980, at the age of 48, Julian Robertson, a former Kidder Peabody & Co stockbroker, founded Tiger with $8m.
By the early 1990s, Robertson and Soros were each managing several billion dollars, investing in stocks, bonds, currencies and commodities around the world. The Tiger Fund became the largest hedge fund in the world when it peaked at $23bn. In 1990, such global macro strategies, which attempt to profit from large macroeconomic trends, accounted for 71% of the $40bn hedge fund industry.
Hedge funds have historically been considered as investment vehicles for the wealthy, with managers enjoying loose mandates and investing wherever they thought the best opportunities were. Little information was disclosed as long as the returns were good.
Today the situation is somewhat different. Institutional investors have entered the market with different demands and expectations. More clearly defined investment processes, larger teams, more capacity, transparency, moderate to low volatility and non-correlated performance are high on their agenda.
Current Situation
The arrival of this new breed of institutional investor has been a driving force behind a maturing and broadening of the industry. The change can be seen in the typical hedge fund portfolio construction where less-risky strategies have gained weight in portfolio representation versus big bets on macroeconomic changes.
Hedge Funds’ assets under management 1990: $39bn
Hedge funds’ assets under management 2004: $900bn
Today’s more institutionalised hedge fund industry aims to produce a more stable, lower risk and of course lower return profile, in industrial quantities. This is an approach with appeal to large endowments, insurance companies and pension funds who are likely to pour hundreds of billions of dollars into hedge funds over the next several years. In the past three years $217bn of new capital flowed in to hedge funds. Total hedge fund assets are expected to rise to $3.2tr globally by 2008.
This insatiable appetite from investors has been satisfied by growth in the number of hedge funds which has almost doubled to 7,165 worldwide over the same period. Senior hedge fund figures believe the industry is at the same point in development as U.S. mutual funds were 15 years ago. Like mutual funds before them, many hedge fund managers are becoming asset gathers, more concerned with dollars under management than with investment performance. As those managers worry about asset gathering, they take fewer risks and shift their focus to the protection of franchise value.
Hard To Live With?
One of the biggest differences between hedge funds and traditional mutual funds is the fee structure. Historically traditional managers have been paid a percentage of assets under management. Equity mutual funds typically charge 1% of assets under management, while segregated pools of equities for pension funds and endowments typically pay 40-50 basis points. By contrast, hedge fund managers get paid a management fee between 1% and 2% and a performance fee of 15% to 20% of the profit. When net returns are in excess of 20%, investors may not worry, but recent industry performance has caused some to pause for thought. ‘High water marks’ are universally adopted but rather miss the key point. If gross returns are merely in single digits then the combined management and incentive fee charges result in a high total percentage payment to the manager – even when performance has been distinctly mediocre. What is needed in addition to high water marks is a hurdle rate or hurdle return over which the performance fee is charged - a structure growing in acceptance by smarter hedge fund managers.
Hedge funds have a high mortality rate. According to data compiled by HFR the average life span of a hedge fund is less then five years. This is in some part due to the mechanics of the performance fee charging structure. If a manager loses money he will not receive performance fees until those losses have been recouped and with reduced fees it becomes difficult to retain staff. In other cases it is simply a lack of money management talent or a failure to understand the importance of marketing to achieve critical mass. Certainly as the stigma associated with failure is much diminished these days, so the personal risks to the manager are reduced while the rewards are as attractive as ever. This is no bad thing but does mean that the lower hurdle to entry opens the doors to mediocrity and that characterises part of the recent population growth in hedge funds.
Fund of Hedge Funds
Along with hedge funds, funds of hedge funds have become very popular. Using their knowledge and expertise, these funds construct portfolios of hedge funds. Typically their approach is to look back at historical track records, select the best performance, perform a due diligence process to filter that set and finish by constructing a portfolio out of the remaining hedge funds. Investing in hedge funds from the big brand name firms is widely regarded as a good approach because performance is expected to be better and the fund is perceived to be safer from mis-management and blow-up risk. Interestingly, empirical data doesn’t support either of these notions since numerous research papers now show that smaller hedge funds consistently outperform their peers and all of the blow-ups have been in large firms.
The Future
The industry is evolving. Standards across the board are rising. Acceptance and adoption is rising too. Big brand names will go on providing comfort to investors in need of that sort of thing, but remain unlikely to deliver exciting returns. Niche managers will continue to apply their processes to extract outstanding performance but will eschew size and therefore brand recognition. Not only is the universe of choice growing but depth and breadth is growing too. Hedge funds have joined the mainstream of investment management, are gaining increasing representation in all investors’ portfolios and are here to stay.