Hedge funds are fueling some of the biggest fortunes in history. For evidence of the funds' success, check out their managers' take-home pay: Jim Simons, the founder of Renaissance Technologies, took home $1.7 billion in 2006, according to Institutional Investor's Alpha magazine. Citadel's Ken Griffin made $1.4 billion, and ESL Investments's Ed Lampert made $1.3 billion.
How do they do it? There's no single, simple answer, since hedge funds are like snowflakes. Sure, they appear similar from a distance, but peer closely enough, and you'll see that no two are alike. They're "all evolving in various ways," says Neil Petroff, senior vice-president of tactical asset allocation and alternative investments at the Ontario Teachers' Pension Plan, which has $92.5 billion and is a major investor in hedge funds and private equity.
Hedge fund strategies run the gamut: Some dabble in shares of Thai retailers, while others bet on the next billion-dollar leveraged buyout or the narrowing of two different classes of a company's debt. In essence, there's a nearly endless variety of methods to make—or lose—money.
A good hedge fund strategy can blow the stock market away. During the first quarter of 2007, the Standard & Poor's 500-stock index returned a mere 0.64%, while returns of the 6,000 hedge funds that report such data rose 2.1%, according to researcher Morningstar (MORN). Distressed debt funds rose 4.15%. Returns from emerging funds hit 5.5%, thanks in part to China's growth. "The emerging-markets sector is growing very fast," says Charles Lundelius, senior managing director at FTI Consulting (FCN).
Such market-beating returns are known as "alpha." That's the term that describes a fund that beats the average, or "beta," for its particular sector. That isn't easy to achieve. "The hard reality is that alpha is a zero-sum game. By definition, there have to be losers," says Robert Discolo, head of hedge fund strategies at AIG Global Investment Group (AIG).
Seeking an inside look into how the funds compile their returns, BusinessWeek spoke to hedge fund experts about some approaches the most successful of the 8,000 U.S. funds have used in recent months. Here's a look at a few strategies that have been winning the game:
The Long and Short of It
Traditional stock investors simply buy the stocks, or equities, that they think will perform well in the future. The risk, of course, is that the bet could be wrong. Long-short funds have the ability to bet that particular stocks will go down as well as up. The combination of bets to both the long and short side of a stock's performance reduces a portfolio's overall risk, while boosting returns. Such funds are up more than 3.5% in 2007.
Long-short funds such as SLS Capital Management have done particularly well of late. In recent months, SLS invested about 8% of its capital in a long position in SLM Corp. (SLM), the student-lending company better known as Sallie Mae. The troubled company received a $25 billion buyout offer in April from a private equity consortium led by JC Flowers & Co.
Shares of Sallie Mae soared from $40 to $56, creating a windfall for SLS. "They did very well on it," one fund executive says. That same executive estimates that SLS had $1 billion in assets before the Sallie Mae deal was announced.
The mergers-and-acquisitions market is booming, with a gain of 27% in 2006. Stock buybacks, dividend increases, and other corporate events are rising through the rough, too. Such events can lead to profit (see BusinessWeek.com, 12/19/06, "Deals of the Year, in a Year of Deals").
Hedge funds that specialize in betting on these dynamics are doing well indeed. The strategy overlaps with long-short equity, because M&A and special events are primary drivers of equity prices. But funds that focus on these strategies have done particularly well.
Funds that focus on special corporate "events" such as stock buybacks rose 4.21% during the first quarter, according to Morningstar. Funds that focus on M&A were up 2.9% during the quarter. M&A funds can play both sides of the market: They can buy the shares of companies they expect to be taken over and sell short shares of companies that are likely to buy them. Shares of acquiring companies often fall because deals can boost debt and expenses. "Merger arbitrage has done very well," says Petroff, of the Ontario pension fund.
Sandell Asset Management, a $7 billion fund that also goes by the name Castlerigg, has succeeded with a combination of both strategies, with a good measure of shareholder activism thrown into the mix. Last year, the firm, which is run by Bear Stearns (BS) veteran Thomas Sandell, decided to take a run at gas company Southern Union (SUG). Sandell urged Southern Union to raise its dividend and put itself up for sale, ultimately making returns in the neighborhood of 15%, according to one person familiar with the investment. Sandell issued a statement in March, saying it supported Southern Union's new strategic plan to boost shareholder value through dividends and other means.
Profiting from someone else's misery is a favorite play on Wall Street, as much a part of New York as yellow taxicabs or a bagel with cream cheese. Investing in distressed debt is almost always in season. While the actual level of defaults is at historically low levels, distressed-debt funds nonetheless rose 4.15% during the first quarter, according to Morningstar.
Distressed-debt investors can take a passive tack, buying bonds in hopes that they will benefit from a turnaround or restructuring. "That's a passive approach, with no way to directly influence the outcome. Its success depends upon sophisticated analysis of the securities and the situation," says Andrew Scruton, a senior managing director and restructuring specialist at FTI Consulting. One popular approach is to invest in credit default swaps, or insurance policies that protect bond investors from a drop in the value of their investment (see BusinessWeek.com, 4/17/07, "Little Risk, Big Rewards in Buyout Deals").
Hedge funds are taking more active roles in restructuring too, according to Scruton. "Sophisticated hedge funds are buying enough debt in distressed companies to give them a seat on a bankruptcy-restructuring committee, where they have access to special information supplied by the company," Scruton says. That active approach is best applied to large bankruptcies, where the potential payoffs can justify the labor-intensive approach.
Hedge funds such as Appaloosa Management and Cerberus Capital Management made a fortune buying the debt of WorldCom when it was in bankruptcy. Both funds had positions on WorldCom's creditors committee, allowing them to influence the case's outcome. WorldCom eventually was sold to Verizon Communications (VZ), in a deal that's widely believed to have generated enormous profits for the hedge funds. As WorldCom went into bankruptcy in 2002, its debt was trading in the neighborhood of 47¢ on the dollar. Verizon's acquisition of the company ensured payback of the debt and allowed credit investors to double a well-timed bet.
Sowing discord in a bankruptcy case is another profitable approach. Why bring all parties together and settle things fairly when you can grab as much money as possible for yourself? A capital-structure arbitrage is a bet on which creditors will make out best in a bankruptcy reorganization. The strategy hasn't been in favor during the last few years, but there are indications that it could be useful in certain situations.
In the Northwest Airlines (NWACQ) bankruptcy, hedge funds such as Owl Creek Asset Management have bought Northwest equity and shorted the bonds, a reversal of the common assumption that equity holders are the losers in bankruptcy cases. Owl Creek is betting that Northwest, which filed for bankruptcy protection in 2005, will be acquired, giving it another shot at life and boosting the value of its stock. The shares, which now trade over-the-counter, once traded above $50. Last week, they hit a low of 8¢, and finished at 16¢ on May 7. Owl Creek declined comment.
Suing for Fun and Profit
Many people argue that the U.S. economy is burdened by too many lawyers and lawsuits. If so, why is that? Because it's profitable! In the bankruptcy of the former Adelphia Cable, hedge funds including W. R. Huff Asset Management and Appaloosa bought the company's bonds on the assumption that Adelphia would be able to recover money by suing former auditor Deloitte & Touche. Deloitte and a group of banks agreed in December, 2006, to pay Adelphia investors $455 million to settle the case. Deloitte was responsible for $210 million of the agreement.
The pursuit of alpha isn't for the faint of heart: An estimated 83 U.S. hedge funds went under in 2006, eliminating $35 billion in assets, according to Absolute Return magazine, which tracks the sector. "To produce alpha, you have to take risks," says Discolo of AIG Global Investment.
Wipeouts notwithstanding, the outlook remains strong. The U.S. hedge fund sector crossed the $1 trillion mark in 2006 for the first time, according to Absolute Return. It looks like this poker party is set to last a while.
Click here for a roundup of the U.S.'s 10 top hedge funds.