The world of hedge funds is secretive and sometimes shadowy. But the image of the freewheeling hedge fund gunslinger is more the stuff of fiction than reality.
"I have always believed in the long-term," said Todd Harrison, partner and head trader at Cramer, Berkowitz & Co., a New York-based hedge fund with $350 million in assets under management. "I don't want to hurt the people I trade with [on the sellside]. I call them all through the day telling them what I'm seeing and doing. That's a mutually beneficial arrangement."
Trading for a hedge fund is a mostly conservative profession and ranks high among the career aspirations of trading pros. Market neutral strategies, short selling, leverage. These are the flesh and blood of many funds.
Hedge funds, unregulated pools of capital for rich people and institutions operated as limited partnerships, allow traders to dabble in a panoply of instruments – from stocks and bonds to currencies and commodities.
Hedge funds give managers and top traders a strong incentive to grow profitably. They often have a sizable portion of their own wealth invested in the funds they run.
Gunslingers, hedge fund traders definitely are not.
Hedge funds are growing in popularity, propelled by an increase in the number of rich Americans. The price tag: One million dollars in investable assets or an annual income of at least $200,000 over three consecutive years. An estimated 2.5 million Americans qualify.
The prize money is attractive: Hedge funds have a record of big double-digit risk adjusted returns (An average of 37 percent through the 1990s.) The chances of an investment failing are often neutralized, or 'hedged,' by offsetting transactions. In theory, that means foolproof.
But as Wall Street has learned from painful memory, the industry is littered with spectacular failures.
The industry was shaken by the liquidation of all six hedge funds run by Tiger Management, as well as the big losses of George Soros' Quantum Funds earlier this year. Their enormous size and contrarion style of investing contributed to the image of the hedge fund as an untamed
beast. Mahathir Mohamed, prime minister of Malaysia, blamed hedge funds for the collapse of Asian currencies two years ago. Soros' big bets pummeled the British pound in 1992.
There is a controversial side to the smaller funds as well. Some critics say these have a reputation for trading ahead of big mutual or pension fund orders, on information the smaller funds receive about the big funds' positions.
Whatever the full truth, the more than 6,000 hedge funds worldwide are performing comfortably and showing renewed signs of vitality. The CFSB/Tremont hedge fund index posted a 3.7 percent return in June. That pushed the alternative investment benchmark to 1.8 percent year-to-date, positive territory for the first time since April's market shivers.
"You won't read about the number of funds coming into existence," said Steve McMenamin, a fundraiser for Indian Harbor Associates, operator of several hedge funds in tony Greenwich, Conn. "You won't read about the ones that make a lot of money."
Hedge funds are among the most glamorous, the most secretive and the most profitable investments on Wall Street. Usually they charge a fee of one percent of the assets under management and 20 percent of the profits. Mutual funds, by contrast, typically charge a management fee of 1.25 percent of assets under management.
"Hedge funds have the ability to make money under various market conditions in contrast to traditional mutual funds, which only make money when markets are going up," said David R. Friedland, general partner with the Magnum Funds, a family of hedge funds in Miami with about $600 million under management.
Hedge Fund Hotel
The growth in the number of hedge funds is breathtaking. New York City, with its enormous concentration of wealth, has seen a spike upwards in the number of funds. About 700 operate in Manhattan, up some 15 percent in the past 12 months, according to the Hennessee Hedge Fund Advisory Group in New York. Altogether these funds have $67 billion in assets under management. In the U.S., hedge funds have an estimated $300 billion in assets, according to Hennessee. That's projected to grow at an annual rate of 20 percent over the next ten years. About 80 percent are small (unlike the headline-grabbing Soros kind), managing less than $100 million in assets.
Along ritzy Park Avenue, in an area known as Hedge Fund Row, is nestled dozens of small hedge funds. The upscale office space is leased by prime brokers and rented out to established, as well as newly formed, hedge funds. One building, located at 237 Park Avenue, houses so many hedge funds that some of its tenants call it the Hedge Fund Hotel.
These funds are coveted by prime brokers. They make their money providing clearance and settlement services and it is a lucrative business. "We like to have them send us 20 to 30 percent of their [trading] business. The rest they can send to wherever they want," said Stephan Vermut, chief executive of Banc of America Prime Brokerage Services. "We clear and settle all of the trades from their executing brokers."
The most common types of hedge funds are macro, black box or quant funds, and pure equity funds. Macro funds, the type made famous by George Soros and Julian Roberston, place bets on currencies and global economic fundamentals. Quant funds are driven by complicated computer-driven models.
While a large number of funds are invested heavily in equities, others are focused on other areas as well, such as interest rate or convertible arbitrage, noted George Crapple, chairman of the Managed Fund Association in Greenwich.
"Some have nothing to do with the direction of the stock market," added Crapple, whose group has about two billion dollars in assets under management. "This kind of market activity will be bad for some and good for others."
Macro funds, once stellar performers, have seen their star dim. By one estimate, macro funds comprise only 40 percent of the world's hedge funds but control roughly 10 percent of the more than $386 billion in hedge fund capital.
Size Hurts
Many analysts say the enormous amount of assets held by macro funds caused them problems. Size, not lack of brainpower, seemingly hurt Roberston.
"Julian Robertson has a mindset for numbers that is unbelievable," recalled David Saunders, a former head trader at Tiger in New York and now a partner at a fund that invests in hedge funds. "He could add up a string of numbers faster than you could put them into a calculator. Julian is a genius."
Genius or not, Robertson's sizeable positions made it difficult for him to maneuver and to deliver consistent double-digit returns. "I can buy 500,000 shares of a stock and make several million dollars," said Harrison at Cramer, Berkowitz & Co. "That will impact my performance."
"But the bigger your fund becomes the easier it is to run into problems," he added. "You have to be able to scale the trade in. If you get caught in a blow up with 15 million shares, you have nowhere to go."
Soros is vowing to take fewer risks and speculative positions in Quantum, relaunching it as the Quantum Endowment Fund. One analyst says recent market volatility caused a change of heart for Soros. "In these volatile market times the smart person, and we have to believe that Soros is one of the smartest money managers who ever lived, is saying the markets are just too crazy," said Daniel A. Strachman, author of Getting Started in Hedge Funds (John Wiley & Sons, 2000). "There's not the opportunity that there used to be, so he's stepping aside," Strachman added.
Small hedge funds like Foxhound Fund LP of Clearwater, Fla., which was heavily invested in technology stocks, also experienced substantial losses during the Nasdaq meltdown in April. Foxhound lost about $160 million of its nearly $200 million in assets within just two days.
Alex Eckelberry, fund manager at Bulldog Capital, parent of Foxhound, blamed out of control volatility. The fund is not about to throw in the towel, however. In a letter to its investors, Foxhound said it will continue to trade with its remaining $40 million in assets. "Hedge funds were created for the purpose of hedging in the market," Strachman said. "If these funds are having terrible returns, then one needs to question if they are really hedge funds or just expensive mutual funds."
Seasoned pros said well-run funds are prepared for the worst. "If you don't have the right methodologies in place, you are putting yourself at risk," Harrison said.
