Friday, December 22, 2006

Since When Did “Hedge Funds” Stop Hedging?

“Shorts? Listen, my previous fund got hammered on the short side.”

That is a quote from a fellow sitting at a table squeezed next to me in a major metropolitan Starbucks.

The individual in question, who has a few grey hairs like yours truly, is marketing his fund to two younger men who—based on the sophisticated nature of their espresso drinks as well as the unsophisticated nature of their questions—appear to be fund-of-fund investors.

While I don’t know the man with the grey hairs, I vaguely recognize him from company meetings in years past as a fellow hedge fund veteran.

And what I find interesting about the whole thing is that, based on the quote above as well as snatches of conversation I can’t avoid hearing from three feet away, he is quite vociferously playing down his reputation as a hedge fund guy who actually used to hedge his portfolio with shorts.

He is doing so for the purpose of talking up his current, non-hedged hedge fund to his audience, by which I mean the two fund-of-funds managers who, based on their questions thus far, I frankly would not let invest my dog Lucy’s biscuit money, let alone the millions or billions of fund-of-fund money they appear to be investing on behalf of institutions seeking a slice of the hedge fund pie.

I say this not to disparage fund-of-fund managers as an asset class, but when I hear one of these financial middlemen earnestly explain that “the problem with shorting is that your potential gain is limited to 100% while your potential losses are infinite”—as if that insight just occurred to him, and he had to pass it along before his flash of brilliance got lost in the ether—it does not reflect glory on his peers.

Now, what’s the point of all this? you might well ask.

The point is that hedge fund managers appear to be shedding their short-selling identities in order to attract money, precisely at a time when markets are hitting new highs.

I find this a fascinating, particularly now that Iraq has turned into a full-fledged civil war, whatever the euphemism of the day, while cost pressures are rising around the world and we’ve had a currency panic in Thailand, not to mention the forcible appropriation of multi-billion-dollar natural resources from public companies by a thug masquerading as an elected President in Russia, who not for nothing is probably the single most powerful person on earth.

And since we know that what goes around, as they say, comes around, it seems to me that maybe now that grown men are eagerly disposing of their past life on the short-selling side of the hedge fund equation, we might be closer to a time when it could actually be worth looking for shorts rather than longs.

After all, if “hedge funds” don't hedge, they're not “hedge funds,” are they?

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


dkman said...

I have noticed this trend of long-only or "sector" hedge funds slowly emerge over the last couple of years. I thought it reached its peak with the famous WSJ article on hedge funds being pitched aboard planes, with one of the profiled wannabe managers trying to interest someone in a healthcare hedge fund.

The only way I can rationalize it is that these people are former mutual fund managers who don't know much about hedging, but think that by pasting on the "hedge" label they will get a seat on the gravy train of the 2/20 "easy" money.

All of this points to the fact that the hedge fund world today increasingly seems like an asset bubble - trillions of dollars chasing ever decreasing returns - we all know how these parties usually end...

As far as the economy/stock market is concerned, I am afraid you are correct Jeff. The Goldilocks/soft landing scenario that everyone seems to be believing in reminds me of all those bright economists/analysts in late 1999, proclaiming "this time it's different", "the end of the business cycle", "Dow 36,000". Again, we all should know how this party will end too...

Lee_D said...

I consider myself somewhat simpleminded in these endeavors. However, even I understand that the central tenent of a hedge fund is to "hedge" your long position with a short, and vice versa. That's what is supposed to justify high fund costs: the guys running it are supposed to be super-smart and capable of calculating optimal hedges that deliver an extraordinary return no matter what actually happens in the market.

Instead, what we have is overpaid professional gamblers throwing money at positions, and letting it ride. The outcome we have seen is funds blowing up (or at least getting singed) by over-leveraged positions that go sour, and returns that, as someone else said, deliver T-bill returns once your 2 and 20 is deducted.

Now that "everybody wants to be in the act" expect to see more funds careen towards mediocrity or worse.

BDG123 said...

That sounds like one impressive conversation. Could you feel the glow of intelligence eminating from them? Since you were so close, did you get a sun tan?

Gains are limited to 100%? I'd settle for 100% is that is a sticking point to go short.

Happy holidays!

BlackLab said...

I'm curious - you would not let the FoF guys run Lucy's money, but if your fund were open to new investors, would you take money from clients they represent?

whydibuy said...

When did hedge funds stop hedging? The question should be have hedge funds really ever hedged any position? Another example of people expecting a free lunch. Heads I win, tails somebody else loses. Outsized gains without outsized risks. Yeah, sure. A hundred shares long and a hundred shares short equal a perfect hedge...and a 0% return. T-bills give 4.8% risk free ( outside of inflation, dollar risk and a coup in the gov ). After that SP500 index gives maybe 6-7% over long spans. Bigger gains only come with big risks. But that doesn't sell real easy. " Well guys if you want big returns, we're going to have to utilize huge leverage and incurr some bone chilling risk. You could get a monster return but you may also get stomped". No, they want to hear how they're an institution superior to lowly mortals and can make you rich without risk. Thus the fine print in commodities advertisments " you may lose part, all or more than your initial investment". Of course that sure doesn't sound like a free lunch.

Jeff Matthews said...

BlackLab: The short answer is "No."

People who invest in fund-of-funds are, generally speaking, trend-followers with no clue what they're buying, and those are not good investors to have.

(There are some very very good fund-of-funds with long term track records, but I'd bet it's not a big percentage of the total.)

The reason I say f-o-f investors are not necessarily bright is this: if you invest in a f-o-f that charges 2% plus a 5% override, and they invest in a 2-and-20 hedge fund, and if that hedge fund does 20% gross, the f-o-f investor sees only 12% before taxes.

And if the hedge fund generates short term capital gains, which is generally the case, the f-o-f investor nets only 8% after taxes.

And that's if the hedge fund does 20%.

Now, the cynic in you might say, "what a great investor--they have no clue how they're getting taken."

But that's not my thing.

BlackLab said...


I have consulted to the long only world and worked in the hedge world, and I can say beyond a shadow of a doubt that the goal is not to manage assets, but to gather assets.

Rare is the manager who limits himself in that regard. Rarer still is the manager who insists on intimately knowing his clients and insisting that his clients intimately know him.

Happy Holidays, Jeff.

ae_trading said...

Jeff and readers, I am surprised at your response.

The term "Hedge Fund" is actually a misnomer. They are called such because they have the ability to open short postiions, not because they hedge all bets(although of course some do hedge somewhat.)

For even the simplest explanation check out wikipedia.

Brad Meikle said...

2006 goes down in the books setting records in many aspects including the $ involved in LBO deals. One of the most absurd LBO rumors was that Micron might be a takeover candidate. In terms of being a steady cash flow business DRAM couldnt be more opposite. LBO investors have diverged from their typical mandate fueled by excess available capital and desire for big returns.

This is fueled by the f-o-f trend as they invest huge money in 200 of the 10,000 hedge funds out there, and total assets surpass 1.5tril. There are still many hedge funds out there doing it the traditional way and working hard for 20-25%, but unless youre managing 200-500mil(really 1bil+) f-o-f investors have no interest.

These decision makers invest based on a limited scope of considerations, and the majority(late comers, certainly not all) lack the ability to contemplate the qualitative aspects of an investor. Beyond that their time frame is very short - one bad quarter and the whole investment is reversed. Building a business on these investors is not a great position to be in.

The result is that young and up and coming hf managers have two choices. Go work for one of the top 200 funds, or go small and try and do it your own way. It takes longer, but its also true that running a hedge fund is usually a very decent business, so no tears should be shed.

The current result of too much f-o-f money is a market which is totally myopic without much consideration for valuation. The Thai crisis is very likely the beginning of the reversing of speculative excesses in emerging markets - take a look at the morgan stanley emerging market index.

pondering said...

Happy Hollidays Jeff, your deadpan wit had me laughing out loud and is reminicent of that great comedian Steven Wright. As for hedges, I just cut mine down for the winter and the view of the other side isn't pretty.

Andy Hall said...

I heard a man from a highly successful, conservative mutual fund give a talk recently. He mentioned offhand during an answer to some meaningless question that it was "obvious" with the advent of wireless everything that wired phone companies were on the decline. I then asked why he doesn't short such companies, and he answered with just the same "infinite loss" theory in the same tone and manner you describe. It's funny how everyone in the industry uses the same canned answers and buzz-speak all the time. As you suggest, it does not speak well for them.

market crasher said...

I am looking forward to 2007 when these "hedge" funds can't crush it as usual. I figure they will get in such a hole early in the year that plenty of chatter on the IM circuit will be "a large hf liquidating...". Speaking of which has anyone heard about a large NY fund who attracted a large amount of money at inception is in trouble?

The Unknown Broker said...

Jeff is wise (although sadly he may also have fewer assets under management as a result of this wisdom) not to accept fund-of-fund money. I say this not only because of the performance-draining math he outlines above but for another reason:

Fund of funds (and other consultant-driven monies) have notoriously short attention spans and quick trigger fingers. As one fund manager expressed it to me, "Living and dying by the fax machine is a sure ticket to underperformance." His point was that if as a hedge fund manager your first activity in the morning is to approach the fax machine with fingers crossed - hoping that the fund-of-fund manager or consultant didn't become disenchanted with you and yank away a big slug of money - your investment decisions are impacted. You are forced to keep more cash on hand to meet redemptions and more importantly you become more short-term performance driven and less able to stick with positions that may ultimately be outsized winners, simply because they aren't contributing to the Quest to Impress the Consultant and/or FOF Manager.

It's alluring money, it seems too good to turn down. But for certain hedge managers with certain approaches - particularly those for whom holding periods are measure in months rather than in nanoseconds - it can actually be counterproductive to be on the receiving end of the FOF money train.

Jeff Matthews said...

"AE Trading" is wrong to say hedge funds are called "hedge funds" because "they have the ability to open short positions."

They are called "hedge funds" because the original hedge fund, established by A.W. Jones in 1949, used short-selling and leverage to attempt to generate positive returns in both bull and bear markets.

Jones charged a 20% profit participation based on, as I recall the story, Portugese ship captains who got a 20% share of whatever profits they generated for their owners as compensation for getting the ship back safely to port--the idea behind Jones' pioneering concept that he would try to make money for his investors no matter how good or bad the stock market.

That 20% profit participation is what distinguishes "hedge funds" as we know them--including funds that never write a short ticket in their lives--from investment managers who get a simple percentage of assets as their annual fee, regardless of whether or not they make their investors a dime.

It has nothing to do with the ability to short, as we have seen from the way so many hedge fund managers have abandoned shorting altogether.

"Pondering" made my day: being mentioned in the same sentence as Steven Wright is too kind to me and too rude to Steven Wright, but I'll take it.

taylorfedrates said...

Jeff, one the blindest spots in the entire hedge fund universe is the source of the leverage. How about discussing the terms the typical hedgie faces from their main broker to provide that capital? You don't have to provide anything from your own situation, but I am sure you are propped by the competition on a regular basis.

I would be interested to be behind the scenes in something like Amaranth when the liquidity provider pulls the chain. Now- did their liquidity provider perhaps contribute to their demise?

I have my doubts about "chinese walls", but then those huge bonuses at Goldman were for being super nice... After all Amaranth's nat gas positions would be about $2billion to the good today, now wouldn't they...

I think hedge funds are mostly going to be a dying business, as the returns die because of the crowded trade problem. Why pay for huge risks and capped returns? Fund of funds strikes me as the old Investment pools of the 1920s returning for another run at shearing the maximum number of sheep.

Housewife said...

I've just gone to the garage and brought a brand new hack saw to the bedroom.

When I get done posting this comment I'm be slicing a hole in the back of my closet where I'll put our life savings.

Some of what you say really scares me.

Aaron Koral said...

Jeff: If more and more hedge funds are "going long", could the move be an indication that hedge fund managers anticipate another rise in the stock market (i.e., large cap indices like the DJIA and the S&P 500) in 2007, and are thus shunning the "risks" (i.e., higher costs for borrowing shares to short as well as increased costs for leveraging their short equity positions to "juice" returns) associated with going "short"? Just wondering, and I could be wrong in my analysis.

P.S. - Here's hoping that Santa brought every reader and poster to your board profitable returns (with minimal risk, of course) and left the lumps of coal with companies like Arch. Happy holidays, everyone!

jimmy z said...

question: If I short a stock at $100 and bring in $100 for the effort and later cover the short at $10 (hey, what can I say...I'm good), then theoretically I am paying out $10 to buy back the stock. So $10 went "out" of my fund to cover the short, and $100 came "in" to my fund to originally short the stock?

Then what is my return on the trade?

By the way there will always be room (even with 9000 hedge funds out there) for a manager who can deliver alpha returns for his limited partners. Cheers and here's to a great 2007. Focus on the return on the money you are currently managing instead of being pre-occupied by going out looking for new $$$ all the time.

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