The fast-growing world of hedge funds
Love'em or loathe'em, hedge funds are here to stay. In fact, the diverse group of investment assets known as hedge funds is positively exploding. ('If only,' some IROs sigh.) A report released in March by KPMG and RR Capital Management Corp estimates hedge fund assets, pegged at under $20 bn in 1990, will swell to over $1.7 trillion ten years from now.
Today, hedge funds control some $400 bn in assets. Yet for many companies and investors alike, they remain a mystery, conjuring up the shadowy image of a George Soros using leverage and derivatives to bet billions against the Bank of England; of a corporate corsair greasing the skids of emerging markets.
But there is much more to these investors than found in newspaper headlines. The term 'hedge fund' refers to investment vehicles that can use all sorts of complex financial strategies to speculate in global currency, bond and stock markets. They can, for example, use leverage, or go short. On the other hand, some hedge funds do little actual hedging. All seek positive returns regardless of market conditions.
Worldwide, over 1,300 hedge fund management groups run over 3,500 funds. Unregulated and often tiny, their investment strategy can be obscure even should their positions appear on an IRO's radar screen. Understanding their investment goals has become a vital IR skill in an increasingly fast-paced and global capital market.
'It is a mistake to paint all hedge funds with the same brush,' says Kevin Ryan of London-based Financial Risk Management. FRM, an investment services company specializing in hedge fund research, divides the universe into four categories based on their source of return: market neutral, event-driven, long-short strategies and tactical traders.
Market neutral players focus on consistent returns by spotting inefficiencies such as disparities between bonds and swaps. Using mostly quantitative stock selection techniques, they go short as well as long, betting against assets they expect to fall. Like event-driven funds, which make money based on the outcome of mergers, bankruptcies and restructurings, their returns don't mirror stock market performance.
Long-short strategies use models and sometimes a subjective approach to anticipate relative stock movements, and construct long portfolios expected to relatively outperform short portfolios. Trading horizons vary though positions are most often long.
Tactical traders try to predict the future of entire economies and speculate on the movement of currencies, commodities or stock and bond markets. They typically run fast money and can quickly change their market view.
Clipping the hedge
Whatever their label, it is often the short-term, short-selling variety of hedge funds that IROs sometimes wish would disappear. But given growth projections, that remains a wistful dream.
'You have to deal with hedge funds because they aren't going to go away,' comments Maria Quillard, IR director at San Jose-based semiconductor maker Xilinx. 'Obviously, we give them less time than our largest institutional investors. It takes experience to know which hedge funds are important to your stock and which are not.'
Faced with the inevitable, Quillard sees the bright side, pointing out the relationship's two-way nature. 'You can gather lots of information about the Street and your sector from hedge fund managers,' she notes. 'Of course, you must take what they say with a grain of salt. They themselves could be the source of a rumor. Meanwhile, as they give you feedback, they are on the lookout for a reaction. They are often sharp and you must be on your toes when talking with them.'
At Nokia, IRO Audrey McGinnis agrees on the need for appropriate time management. However, she points out that Nokia employs a particularly egalitarian system for shareholder inquiries. 'We return phone calls in the order in which they come in,' says McGinnis. 'If an individual investor calls before our largest shareholder, the individual gets the first call back. All our investors appreciate that.'
In a deal situation, hedge funds may be calling all day. IROs must learn to recognize their names and prioritize time. Snubbing hedge funds entirely is certainly a mistake. After all, in the midst of a merger, they may become the largest group of shareholders - and a key proxy voting constituency.
'People sometimes forget that hedge funds in deal situations create an exit for existing shareholders,' says Kevin Marcus, managing director at the Carson Group. 'Those who handle these deals well are those who treat hedge funds with respect. You can't make yourself available 24 hours a day, but you definitely don't want to cut them out.'
While a proactive approach to targeting short-term holders is probably not in order, keeping an eye on them is. 'They can be a danger signal,' says Richard Wines, managing director at Georgeson. 'Why are you attracting this kind of shareholder instead of the one more compatible with long-term valuation? You may have to adjust your IR message.'
Some hedge funds, however, are simply IR-immune. These include the big macro funds that bet on economies. Companies with operations in emerging markets have been especially affected by these investors. Mexico's Cemex, for example, has a range of investors, including many hedge funds, who buy its stock based on top-down analysis.
'They don't select the company, they select the market,' notes Bradley Johns, IRO at Cemex. 'They typically buy the most liquid stocks so they can move in and out quickly. He believes that the more hedge funds there are in a shareholder base, the greater the chance of stock price volatility. 'If you're looking to thwart short-sellers, few options are open other than trying to surprise the market on the upside and knock them out.'
Once the domain of rich individuals and endowments, hedge funds' potential role in institutional portfolios promises to propel asset growth. 'We are seeing private banks and more larger institutions getting interested,' says FRM's Ryan. 'People have been saying US and European equities look overvalued and wonder where to turn.'
In the meantime, tax rules put into effect last year have opened up hedge funds to a broader group of individual investors. 'If hedge funds can prove their worth in difficult markets, even more investors will be interested,' concludes David Friedland, a lawyer with Bahamas-based Magnum Funds.
Time will tell, but for now it looks like companies can expect their shareholder composition to include an ever growing complement of these complex investors. And if they're out there you better get used to talking to them.