The year of the hedge fund

24Dec05

2005 has taught us that hedge funds are not going anywhere, anytime soon. The rise of hedge funds has caused ripples throughout the financial world. Most financial observers would argue here is nothing inherently wrong with the hedge fund structure. However the massive influx of capital into the hedge fund industry (yes, it is now an industry) has made a number of analysts anxious about how this abundance will affect hedge funds and the greater financial economy.

Alan Abelson in Barron’s aptly notes that 2005 was a news year dominated made by, and about, hedge funds. While hedge funds are not a new phenomenon they have in the past few years become increasingly popular and increasingly powerful.

On several counts, we find the spreading popularity of hedge funds and their ever-greater influence on markets of almost every kind a mite disturbing. Rather than the more the merrier, we suspect the explosion of funds will prove a case of the more the messier. And since the genre largely lives and — it’s easily forgotten — dies by leverage, the potential for disaster is all too often a tick away.

The amount of institutional assets rushing into hedge funds in search of high single digit returns is frightening to some. What may be more scary is that the nature of hedge funds is changing, and not for the better. Hedge funds were designed and run for decades as nimble, go-anywhere, investment vehicles. But Abelson echoes comments by Seth Klarman of Baupost Group on hedge funds.

There’s also, he points out, a “change in the very nature of hedge funds — from nimble vehicles focused almost exclusively on investing to marketing organizations with well-staffed investor-relations teams.” What that means, among other things, is that where once hedge funds accepted new capital pretty much only when they spotted reasonable opportunities to put it to profitable use, today, all too often, marketing is the driver and the hope is that somehow the new money will be fruitfully employed down the road.

So it may not be bloated assets, estimated at $1 trillion, that sink the hedge fund boom, but rather the effects it has on the nature of hedge funds themselves. Abelson quotes Stephanie Pomboy of MacroMavens on the increasingly desperate tactics that hedge funds use. Her fear is that overleveraged hedge funds will eventually be the source of a financial “accident” that harms the credit markets.

Come the New Year, Stephanie speculates, the hedgies may resolve to reduce their leverage, unwind their bets and allow the markets to follow their natural inclinations. But if, more likely, they decide to continue their feckless ways, she reasons, their risky behavior is bound to come home to roost and their positions will be unwound for them the “hard way.”

breakingviews in the Wall Street Journal notes the effect the hedge fund boom has had on investment banks. In a sense hedge funds (and private equity funds) have become so important that investment banks have changed the nature of their business to capitalize on the inflows into these alternative asset classes. Indeed they have become too important to ignore.

The reason is simple: They can’t afford to lose out on the juicy fees flowing from the huge trading volumes the hedge funds generate, and the leveraged deals private-equity firms engineer.

Hedge funds account for more than 40% of brokerage-firm revenue at Wall Street’s large securities firms, and private equity accounts for about 25% of the investment-banking fee pool, according to Dealogic, a research firm. Miss out on too much of either and the risk is that your business swiftly drifts into the second tier. This is fueling an investment arms race on Wall Street and in the British financial district, the City of London. Banks are putting money into trading systems and prime brokerage operations to serve hedge funds, and chucking capital at their lending business to squeeze more revenue from private equity.

They are also increasing the scope of their businesses in order to be able to offer hedge funds the ability to trade all the instruments, however exotic, they are interested in. And as hedge funds get more eclectic, that’s a costly undertaking.

They speculate that this will lead to another round of consolidation in investment banking in order to create shops that can handle all of the intricate needs of these new financial powerhouses. The challenge increases as hedge funds become in a real way competitors to investment banks.

Lawrence C. Strauss in Barron’s notes that the middling performance of hedge funds in 2005 has started causing frustration among both hedge fund managers and their investors. This may be causing some managers to veer from their original mandates in a chase for returns.

This includes increasing leverage and a higher exposure to the world equity markets. The question is whether investors will become disillusioned with the middling returns of hedge funds or the seemingly anomalous strategies used by these managers. This is taking a toll on hedge fund inflows.

Net cash inflows into hedge funds diminished this year. Third-quarter inflows of $9.4 billion were down sharply from $17 billion a year earlier, according to Hedge Fund Research. “That’s a good thing,” says Jaeger. “There has been too much hype about hedge funds.”

Karen Richardson in the Wall Street Journal covers a high profile hedge fund manager who always seems to be at the center of various financial dramas. David Rocker of Rocker Partners is one of a dying breed: a dedicated short-seller.

Short-selling, by its nature, is a controversial practice. Especially to those companies who find themselve targeted by short-sellers. The greatest profits are generated by the most egregiously overvalued companies. Often these companies are involved in some sort of financial shenanigans that when uncovered cause the company’s stock price to plummet.

This profile is an interesting introduction to investors who are not familiar with the short-selling game. It is worth a look.




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