Hedge Funds Are Hot Again
You might say hedge-fund investor Robert F.X. Sillerman is having a rock `n' roll day. Poring over his 2000 investment results, he has just realized he is up around 20% for the year--a rip-roaring return compared to the stock market. "I'm elated," says the 52-year-old founder and former executive chairman of SFX Entertainment Inc., the world's largest live entertainment company, which arranges concerts for the likes of Britney Spears, Kiss, and 'NSync. "I'm this child of the '60s who happened to strike it big," says Sillerman, who made a bundle last year when SFX was sold to Clear Channel Communications for $4.4 billion. And he's constantly on the prowl for newer, younger managers with "an edge."
But it's not just the newly minted superwealthy baby boomers who are looking for better-than-soggy stock-market returns. Hedge funds, private pools of capital limited in most cases by law to no more than 100 investors, are no longer the exclusive stomping grounds of the rich and famous. The not-so-wealthy are getting into the game, too. The minimum investment used to be $1 million. Now, it can be as little as $100,000 for investors who participate in "pooling" programs at brokerages or even as low as $10,000 for hedge funds that are structured more like mutual funds. Asset managers and brokerage firms are also setting up their own hedge funds and hawking them to their customers.
The cloistered and mysterious world of hedge funds is being transformed and reinvigorated as new types of managers and investors flock to them. This may surprise those who thought hedge funds were dead after last year's notorious demise of Julian Robertson's Tiger funds and George Soros' Quantum funds.
What's so alluring about hedge funds? They can provide much-needed diversification and reduce risk by investing in niche areas such as private equity, commodities, and risk arbitrage or, most important, by shorting stocks--something that typical mutual funds, by law, are restricted from doing. Besides, hedge funds have trumped the average return for U.S. stock mutual funds in 12 of the past 14 years, with 1995 and 1998 the exceptions, according to Hennessee Group, a hedge-fund adviser. With the market showing scant signs of a recovery anytime soon, many investors see hedge funds as the only way to get, or stay, rich.
Hedge funds scored big last year. With the Standard & Poor's 500-stock index down 9.1% and the Nasdaq dropping 39%, the average hedge fund was up 8%, according to Hennessee. That's because they took advantage of an extremely volatile stock market. Managers who shorted, especially technology stocks, struck gold, with short-only funds returning an average of 30%. And risk-arbitrage funds, which typically invest in takeover candidates, took advantage of heavy merger activity to return 14.3%. Sector funds, such as those in health care, hit pay dirt, returning 62% while playing on the extreme ups and downs of biotechs, HMOs, and big pharmaceuticals.
"Hedge funds really delivered, so you've got a lot of money flowing in and incredible interest being shown," says Michael Ocrant, editor at Managed Account Reports (MAR/Hedge), which tracks hedge funds. Indeed, endowments and foundations are investing more and more money in hedge funds, and even large pension funds are starting to get their feet wet. Institutional investors now make up around 25% of the $400 billion in hedge-fund assets, according to Cerulli Associates Inc., up from only 5% in 1993. As institutions increase their stakes in hedge funds, they are demanding more oversight and accountability, possibly putting a damper on their performance.
And hedge-fund investing itself can sometimes prove ruinous. These funds use considerable amounts of leverage, or borrowed money, in order to juice returns, and if they bet wrong, losses can escalate. In the 1998 blowup of Long-Term Capital Management, the $130 billion fund borrowed as much as 30 times its capital. It ended up being taken over by creditors. Soros and Robertson imploded after abandoning their core expertise--macro plays that involved trading currencies and interest rates--for calling the shots on stocks. Robertson stuck stubbornly to value stocks, while Soros bet the farm on tech at the wrong time. When a hedge fund performs poorly, investors can't easily get out. Unlike mutual funds, most require a commitment, or lock-up, of one to three years. After that, they can typically only exit on a semi-annual or quarterly basis.
STEALTH MANAGERS. What's more, because hedge funds are largely unregulated, they're more susceptible to fraud. In fact, as hedge funds multiply and as less sophisticated investors get in, experts say it's likely fraud will only increase. No wonder both investors and regulators want hedge funds to open their books and reveal their strategies and risks (page 90).
Still, hedge funds are hotter than ever. Last year alone, their assets jumped $75 billion, and Van Hedge, a consultancy, estimates that hedge-fund assets will reach $1 trillion in five years. Newer, often younger hedge-fund managers have taken the baton from the former industry stalwarts and are racing with it. They are eschewing the macro strategies that made superstars of their predecessors. Unlike Soros and Robertson, who were in the limelight playing the ultimate daredevils who could roil markets, these hedge-fund managers want to remain in the shadows. "There is absolutely no advantage to our investors for us to attract media attention," says one top manager.
That also helps to explain why in hedge funds these days, small is beautiful. Most managers, particularly those who have migrated from such megashops as Tiger and Soros, which at their peaks were managing $23 billion and $22 billion, respectively, are electing to close their funds at $500 million or $1 billion. This way, their strategies attract less attention from other investors, and they can zap in and out of positions. "With more money, you have to come up with more ideas or settle for higher concentration in fewer stocks," says Charles J. Gradante, president and chief investment strategist at Hennessee. For example, Scott Bessent, who worked for Soros, raised $1 billion for his fund in just three months, then abruptly closed the door to new investors. Soros himself had plunked down $150 million in the fund.
"BRAIN DRAIN." Viking Global Investors, managed by a trio of former Tiger cubs, as alums of Tiger are known (page 84), has also elected to remain relatively small. And unlike Tiger, Viking is run by a team. "They have three teams of analysts who are assigned a pool of capital, and they have to come to meetings and justify what they want to do with that money. If they don't have good enough ideas, they have to put the money back in the pool," says an investor. The fund was up 89% last year after fees.
The cream of the crop, say experts, are those managers who have come out of top shops like Tiger or Quantum. "There's been a huge brain drain out of every corner of Wall Street into hedge funds. And many of these guys who are starting hedge funds have just spent three or four years at another top fund. So there's much less of a question about their ability to run hedged money," says Bruce D. Ruehl, chief investment strategist at Tremont Advisers Inc., a hedge-fund consultant. Wall Street's stars are attracted in good part by big money. In a good year, managers at top hedge funds can easily pull down several million dollars, since the fund keeps 20% of profits in addition to a 1% or 2% management fee.
That's why more and more mutual-fund managers have jumped ship to start hedge funds on their own or at their existing firms. Jeffrey Vinik, the former Fidelity Magellan manager, opened his own hedge fund in late 1996 and racked up triple-digit returns through the end of 2000. He recently closed up shop in order to run a smaller pool of money for himself. But Vinik's success seems to be the exception. "It has to do with the Holy Grail of hedge-fund strategies: the ability to short--and mutual-fund managers often just can't do it because they've never done it," says Hennessee's Gradante.
Last year, because most hedge funds beat the market, managers earned their keep. "Nondirectional strategies are the greatest interest right now," says Clark B. Winter, chief global investment strategist for Citigroup's Private Bank Div. Nondirectional, or market-neutral, means that the strategy has little correlation to the stock market--that is, whether the stock market is up or down, the fund should still outperform. Market-neutral funds returned 15.6% last year. But doing even better were long-short equity funds, which gained 16.4%, according to MAR/Hedge. These funds invest primarily in stocks and can go long or short them. Not that this strategy is new. In fact, the first hedge fund, created in 1949, was a long-short equity fund.
How important is shorting to a hedge-fund manager? It can mean the difference between dazzling returns and disaster. Some of the best-performing funds over the past year were technology-focused long-short funds that started shorting the market in the second half of last year when the Nasdaq took its biggest lumps. The three biggies doing this---Pequot Technology, the $5 billion fund run by Arthur J. Samberg in Westport, Conn.; Bowman Capital, the $5.5 billion fund run by Tiger alum Lawrence Bowman in San Mateo, Calif.; and Galleon Technology Fund, the $2 billion fund managed by Raj Rajaratnam in New York--returned 34%, 19%, and 12.5% last year, respectively, according to various hedge-fund trackers. Compare that to the average tech-sector mutual fund, which plummeted 33%.
HAVE IT BOTH WAYS. A long-short stock strategy tends to be less risky, especially when the bets are spread out across a variety of sectors. Maverick Capital Ltd., for example, the eight-year-old fund run by another Tiger cub, Lee Ainslie III, invests in eight different sectors, including media, technology, health care, and retail, and has positions in over 200 stocks. It was up 27.6% last year. And some sector funds other than tech have performed phenomenally (page 86).
Experts even say that macro strategies could make a comeback in the next year or two. "Trends like a strengthening euro and yen against the dollar and falling interest rates in the U.S. are new opportunities for macro strategies," says Hennessee's Gradante. Some younger macro players such as Stanley Druckenmiller, Soros' former top lieutenant who now runs Duquesne Capital, are getting investors' attention. But these funds are quite different from their macro predecessors'. For one, they are more diversified, having branched out into domestic equities. They are also far less leveraged, use more sophisticated risk-management tools, and are smaller. Druckenmiller's fund has only $3 billion, compared with Quantum's $22 billion at its peak.
The megatrend starting to rock the industry is the invasion of pension funds, foundations, and the like. Hedge funds have been attracting bucketloads of institutional money, a phenomenon that most likely will continue to mushroom. The California Public Employees Retirement System, the largest U.S. pension fund, with $117 billion in assets, recently decided to put $1 billion into hedge funds for the first time and is looking to put more of its money into alternative investments.
There's a catch: Pension funds, because of their fiduciary responsibility to their investors, put dramatically different demands on hedge funds. Pensions, and increasingly those who lend capital to hedge funds, insist that hedge funds be much more open about their strategies, disclose how leveraged they are, and follow strict risk-management measures. They even try to negotiate fees. "Hedge funds don't want any corollary, additional requirements imposed on them that would take their focus away from making money," says Kenneth M. Raisler, a Sullivan & Cromwell lawyer who represents hedge funds.
The inflow of pension and endowment money and the growing popularity of hedge funds among individuals explain why financial-services companies are clamoring to get into the act. They are starting their own funds, setting up funds of funds, or taking equity positions in hedge funds. "Pension money is far more likely to go with a hedge fund with institutional standards," says Carrie McCabe, a hedge-fund consultant.
To cater to institutional investors, in the past year Merrill Lynch & Co. formed an alternative-investments division. Its first hedge fund, Merrill Lynch Equity Arbitrage, has $1 billion in assets. Merrill now has six hedge funds worldwide. The Bank of New York Co. purchased Ivy Asset Management last year, a firm that specializes in funds of funds. Donaldson, Lufkin & Jenrette, now Credit Suisse First Boston, got into hedge funds in 1994 and is now ramping up its offerings.
LOST EDGE. But there are drawbacks to funds run by brokerages, mutual-fund companies, and the like. The managers aren't as likely to have much of their own money tied up in the fund, as opposed to indie funds, where the bulk of the manager's money is typically invested. "The manager simply isn't on the line in terms of performance," says Tremont's Ruehl. And many don't know how to hedge. Also, a corporate parent can interfere too much and insist on group decision-making so that hedge funds lose that maverick-like quality that has often allowed them to reap superior gains. What's more, the tendency of these funds is to grow larger and larger, much like mutual funds, making money off asset fees rather than focusing on top-notch performance. Says Jim Berens, managing director at Pacific Alternative Asset Management Co., a fund of funds in Irvine, Calif.: "The whole lure of hedge funds is that they provide a break from the traditional asset-management business, where often there's more of a focus on getting money to manage than actually managing money."
Not only are brokerages and fund companies going after the big guys, they are beginning to tailor hedge funds to the smaller investor. PaineWebber, CIBC Oppenheimer, and others now have programs where investors pool their money, investing as little as $100,000 in hedge funds. PaineWebber now manages $2.5 billion in pooled hedge-fund investments, up from just $220 million in mid-1999. "If a PaineWebber client has, say, half a million in U.S. equities, we will introduce hedging strategies to reduce overall portfolio volatility," says Gregory Brousseau, co-head of PaineWebber's alternative-investment group, who says it provides clients access to top managers that they otherwise wouldn't have. And mutual-fund companies like MFS and Strong Capital Management have started hedge funds. In fact, there's a whole new crop of hedge funds that are structured more like mutual funds: They have restrictions on the amount of leverage or short positions they can use, require as little as $10,000 to get in, generally don't require lock-up periods for investors, and don't impose hedge-fund fees.
All this sounds inviting. And with the market in the doldrums, investors may be tempted to give hedge funds a try, especially considering their track record. But as individuals and institutions pile in, demanding more oversight and stricter standards, hedge funds may end up little more than exotic, superexpensive mutual funds. And investors like Sillerman may not find those hot new managers with an edge after all.
By Marcia Vickers, with Debra Sparks and Heather Timmons, in New York