The growing popularity of hedge funds means an equities feeding frenzy. Discussion with IROs from National Semiconductor, 2M Invest, Coherent and United Pan-European Communications
Hedge funds attracted attention in the past owing to some spectacular failures. More recently, they have been making the headlines for different reasons. They have outperformed global bear markets and outstripped just about every index there is. Love 'em or loathe 'em, hedge funds are definitely here to stay and play.
Evolved from a group of unconstrained and renegade stock-pickers, the hedge fund industry has grown an average 25.74 percent a year, showing a staggering total growth of 648 percent in the last decade.
Today, the industry is conservatively estimated to be worth $400-450 bn. A further $50 bn is estimated to be in privately managed accounts within hedge funds, and $100 bn more under management with funds that refuse to report to information service providers. The latest TASS Asset Flows Report shows that $8.5 bn in new money poured into hedge funds in the second quarter of 2001, exceeding the total flows of the previous year, which amounted to $8 bn.
To hedge or not to hedge
Investing in alternative funds seems to make sense in the current market slide. Hedge funds supposedly offer returns independent of market direction so they offer the promise of doing well even in today's negative markets. In addition, allocating assets to the hedge fund industry can help diversify portfolios and reduce risk. For example, the CSFB/Tremont Hedge Fund Index - comprising 375 funds out of an international field of 2,600 - rose 3 percent in the first three quarters of 2001. That may not sound so impressive until you consider that the S&P 500 sank 14.1 percent in the same period.
How can hedge funds achieve these results in a bearish market? One answer lies in their name: they can hedge their bets by, for example, short-selling stocks. Sometimes their performance is also a result of trading advantages that other fund managers don't enjoy, even extending to premium information, reduced transaction costs and superior market access. These are possible because hedge funds provide liquidity and speculative functions for the market. 'We're seeing a lot of [hedge fund managers] at sell-side conferences,' says James Foltz, treasurer and IRO at National Semiconductor Corporation. 'Sell-side analysts play to hedge funds as they don't just sit on the money. The sell-side is biased toward those guys who do a lot of business.'
Another reason for the spectacular returns is simply that money follows talent. Hedge fund managers are paid through a performance or incentive fee, which usually amounts to 20 percent of profits. Such potentially lucrative returns lure the brightest investment brains.
Embracing risk
Like oil and water, risk-averse, conservative fund managers could not be more different from the swashbuckling, answer-to-no-one style of hedge fund managers. Yet faced with the demands of an aging population, the pressure is on to perform while diversifying overall portfolio risk. As a result, even pension fund managers are getting their toes wet in hedge funds. In a 2000 survey of 196 continental European pension funds by Indocam and Watson Wyatt, around 30 percent of schemes that outsource to external managers were investing in so-called alternative investments. Swiss plans have the largest appetite, with 1.3 percent of total assets in alternative funds and an average Swiss hedge fund mandate of E36 mn. In the US, the $152 bn Calpers fund is getting heavily into these potentially treacherous waters. Last year, Calpers' board of trustees authorized a $1 bn allocation to hedge funds. Although that's less than 1 percent of the fund's assets, it's clear Calpers intends to take part in the burgeoning trend.
It's not just outsourced funds that are being invested in alternative styles. 'The good [pension fund managers] want to set up their own hedge funds,' comments one hedge fund analyst.
'So in order to keep them as clients, traditional fund companies allow them to develop alternative strategies instead.'
Such is the growth of hedge funds that the likes of The Economist and Morgan Stanley's Barton Biggs have warned of a bubble. Indeed, the last time there was such enthusiasm for hedge funds was just before the Long Term Capital Management (LTCM) disaster. Does it all look like a prelude to another LTCM? According to the Tremont Quarterly Review & Outlook Second Quarter 2001, there is a major difference not revealed in the impressive inflows of new hedge fund capital: many investment banks have scaled back their internal balance sheet risk and instead are creating so-called funds of funds made up of proprietary trading strategies. Basically, they are no longer pouring money into over-leveraged funds.
Nor can a parallel be drawn between the internet bubble and the rapid growth of hedge funds, says Ian Moreley, CEO of Dawnay Day Olympia, an asset management company. 'People in the internet industry were given money and they blew it all away,' he says. 'Hedge funds are about profitable asset management.' As investors learn more about hedge funds, the better they understand that most are not LTCMs. This in turn raises confidence and leads to more - and better-informed - investors heading into hedge fund investments with a more discerning eye.
Churning the water
Hedge funds have always been seen as the sharks of the investment world because of the sometimes vicious habit of short-selling. But the greatest resemblance to sharks lies in the wide variety of species. Sharks include everything from man-eaters to pure plankton-eaters; according to Tremont and TASS, hedge funds fit into ten primary categories: long/short equity; equity market neutral; event-driven; convertible arbitrage; fixed income relative value/arbitrage; global macro; short-sellers; emerging markets; managed futures and funds-of-funds.
Almost half of all hedge fund assets are managed with a long/short strategy, with $2.74 bn flowing into this category in 2001's second quarter. Global macro investment is also popular and represents about 8.5 percent of all hedge fund assets under management. Similar to the long/short equity management, global macro managers also carry long and short positions, but in major capital or derivative markets. Their investments reflect their views on overall market direction as influenced by major economic trends and events.
The rising stars in the hedge fund world are short-sellers. Although they only represent 3.7 percent of funds now, their popularity has jumped enormously in recent times. The Hennessee Hedge Fund data shows that funds focusing on short-selling, effectively betting against upward performance, were up 10.72 percent in September, the best performers for the month. These funds rose 15.77 percent in the year to September.
Although hedge funds do go long on stocks for long periods in order to hedge the risk of short positions and more volatile holdings, most hedge investments are short-term regardless of the fund's style. They are also more likely than others to take large positions as they are usually well-capitalized and hungry for returns. And when large funds turn over their books often, this can dramatically impact stocks over the short term.
However, Pelham Smithers, a hedge fund manager at London Oxford Capital, says stock volatility can't be blamed on hedge funds. 'Most hedge funds look for sensible opportunities and are not trying to create a scarce situation,' he explains.
'In some cases, IROs are scared that hedge funds are in the stock so they create a self-fulfilling prophecy and drive the shares down themselves.' Certainly human psychology plays a part in every market, exacerbating volatility.
Setting up the nets
Following the much-publicized debacle of LTCM, there were worldwide calls for the investigation of hedge funds and tighter regulation of the market. So in 1999 pace-setting legislation was introduced by Richard Baker (Baker's Bill) in the US. The bill is aimed at preventing another LTCM affair by making extreme leverage and risky investments more visible to investors and to the banks making loans to hedge funds. The bill would require hitherto unregulated hedge funds to make quarterly reports to the Federal Reserve, with the Fed making portions of those reports available to the public. It would apply to only the biggest hedge funds with $3 bn or more in capital. To date no further formal action has been taken on Baker's Bill, after a mixed reaction when it was heard in front of the House Banking Committee, so its future is uncertain.
In the UK, Sir Howard Davies, chairman of the Financial Services Authority, has been a strong proponent of the regulation of highly leveraged institutions following recommendations by the Financial Stability Forum (FSF) working group which he chaired. The FSF was set up soon after the LTCM disaster to look at systemic risk in financial markets.
In Asia, both Singapore and Hong Kong are keen to use regulation to promote investment in hedge funds rather than to rein them in. Singapore has recently issued guidelines for hedge funds that enable them to solicit investment more easily, while the Hong Kong Securities & Futures Commission has said it is also moving to provide greater access to hedge funds for retail investors.
Swimming to safety
So how are IROs dealing with hedge funds given their rise in popularity and increasingly mainstream approach? Are they looking to swim to safety? 'If you choose to avoid hedge fund managers, this can work against you as they might choose to make up stuff,' says Foltz of National Semiconductor. 'The best inoculation against rumors is to make sure everyone is saying the same thing.' Indeed, a recent roadshow saw National Semiconductor executives going door-to-door to talk to hedge funds. 'There is more incentive to inoculate yourself against their rumors than with mutual fund managers,' Foltz says. Even short-sellers don't faze him; his company has at any one time 4 mn shares shorted out of the 175 mn on the NYSE (excluding stock options). Foltz says being shorted is just a part of liquidity management.
'In this environment, nobody could afford to deny a hedge fund's interest in their company,' comments Lynge Blak, vice president of investor relations and communications for 2M Invest, a Danish technology venture capital company. 'They are able to lift a low price and maybe take a company from a dangerous situation like a takeover threat, and add liquidity.'
Even arbitrageurs have an upside, observers agree. 'Some companies do hate hedge funds as they can make a stock volatile,' comments a European hedge fund analyst. But during a merger process, an arbitrage fund can make a stock more liquid without making it necessarily more volatile, he says.
Generally, however, it is volatility that draw hedge funds to their prey, like blood luring sharks. 'They will look for catalysts, positive or negative,' says Peter Schuman, director of investor relations at Coherent Inc, a Californian laser manufacturer. He points to short-selling newsletters, written for a hedge fund audience, that prey on rumors. Certain hedge funds then 'see the opportunity, smell the blood and go for it.'
Schuman says that the trick to managing rumors and therefore volatility is to be proactive in all relationships, especially those with the media. 'Maintaining a good relationship with the media can be to your benefit,' he says. 'The media are exempt from Reg FD, so you can sometimes use them to quash rumors.' With two hedge funds among Coherent's top 30 shareholders, Schuman recommends a direct confrontation when there is a suspected rumor and subsequent selling. 'I would call them up and say, I haven't heard from you lately. Either you're not in the stock or you've been on vacation,' says Schuman. 'And they usually haven't been on holiday, so I know they were the ones who have been selling. Hedge funds usually call up a lot.'
Are hedge fund managers more demanding of management time? 'They do demand more than most investors,' says Blak of 2M Invest. Adds Claire Maloney of United Pan-European Communications, 'In terms of time frames, they want a lot of information in a short amount of time.' But Maloney says IROs cannot afford to bury their heads if hedge funds buy into their stock. 'You must understand their strategies. Then you can understand when they will exit and smooth it over.'
Maloney recommends treating hedge fund managers like any other fund manager. After all, the bulk of them have come from successful long-only careers where they may have built relationships with IROs of companies they traded in.
However, Andrew Clearfield, managing director at TIAA-Cref, the US pension giant, recommends a more cautious approach. 'They are not interested in establishing a relationship with a company; they are there to make a return,' he says. 'They are looking for the big pay-off and can be right less often than they are wrong. They visit a company usually only to see if a sell-side analyst is feeding them a line.'
This approach, however cautious, may be appropriate following the disturbing financial shocks of the past, but it would seem that most IROs have jumped into the water well-equipped.