A good article in the American Prospect by Barbara Dreyfus gives an overview of the state of play in the hedge fund industry and reviews the causes (considerable) for concern. The article is very much for the generalist reader and misses some points that are important (for example, the role of leverage in most hedge funds’ results these days).
From the Prospect:
Brian Hunter thinks he knows something about hedge fund investing. The 33-year-old Canadian energy trader is starting his own firm and reportedly has already raised nearly $1 billion for the endeavor. No matter that Hunter was largely responsible for risky natural gas investments, which last September lost more than $6 billion for his then-employer, Amaranth Advisors, one of the largest hedge funds, causing it to collapse. No matter that the San Diego County pension fund is suing him for $150 million of the $175 million they invested with Amaranth, saying Hunter failed to deliver the diversified and risk-controlled investment strategy he had promised. No matter that a Senate committee is investigating manipulation of the natural gas futures market related to Hunter’s investments.
Hunter’s investment strategies were already being questioned when he went to Amaranth in 2004, embroiled in lawsuits with his former employer, Deutsche Bank. But because hedge funds operate in the shadows, with scant regulation of their investments or the information they give investors, there’s little to keep Hunter from continuing to recklessly invest other people’s money.
Hunter can maintain his career because hedge funds are money managers that make enormously risky investments but are nonetheless virtually unregulated. Once, hedge fund investors were limited to the very rich, and few political leaders were concerned about what they did. But there’s a new urgency for reform now because that is no longer the case. Increasingly, pension funds, school endowments, and charities in pursuit of easy money are turning to these investments and potentially putting their funds in jeopardy. Currently, about 20 percent of pensions invest in hedge funds. Although, on average, they invest about 5 percent of assets, some invest much more. And a law signed by President Bush last summer makes pension investment in hedge funds even easier. At the same time, nearly two-thirds of endowments, including university and charitable organizations, invest through hedge funds, allocating an average of 18 percent of their invested assets. A Bank of New York study estimated that by the end of the decade, institutions, including pension funds, would account for about one-third of new money to hedge funds.
Even the viability of corporations is being put at risk by hedge fund managers’ demands that they allocate money to shareholders, rather than invest for long-term growth of the company’s plant, equipment, and workforce. And regulators worry, too, that if a large enough hedge fund abruptly collapses, it could broadly destabilize financial markets.
This relatively sudden expansion is receiving new scrutiny on Capitol Hill, in state legislatures, and from international economic organizations. Pressed by German officials, members of the Group of Eight nations held two meetings on hedge funds so far this year, and International Monetary Fund officials have been publicly raising an alarm. On Capitol Hill, just a few months after he took over the House Financial Services Committee in January, Democratic Representative Barney Frank launched a series of hearings on hedge funds. “Many of us are concerned about the effect on workers and employers,”warned the congressman at his March hearing.
In the Senate, Finance Committee member Charles Grassley, a Republican, after failing by amendment to empower the Securities and Exchange Commission (SEC) to oversee hedge funds, formally introduced legislation to do so in May. In Connecticut, home to many hedge funds, state Attorney General Richard Blumenthal warned that “hedge funds remain a regulatory black hole.” He has been working with state legislators to get better visibility into their activities.
There are, however, significant obstacles to reform, not least of which are the millions of dollars that hedge fund managers contribute to political campaigns, including those of nearly every presidential candidate in the 2008 race. The question is whether the cowboys of Wall Street can be reined in before innocent people get hurt.
Ironically, hedge funds were conceived as a way for investors to protect their money by “hedging”the risks of long-term stock investments. Unlike mutual funds, which only invested in stocks and bonds and made money only when prices rose, hedge funds were able to invest in ways that could make money if stock, bond, commodity, and currency prices fell. So they were careful about balancing investments and not exposing clients too much to one investment strategy.
While a few hedge funds existed earlier, they took off in the 1970s and 1980s because new investment opportunities were created in world currencies and in the futures and options markets, which opened up commodity trading and allowed leveraged investing. Investors could make big bets, magnifying their potential wins (or losses), while only putting down a little money.
This was the time of legendary commodity and currency traders such as George Soros, Bruce Kovner, Julian Robertson, and of enormous hedge fund profits, ranging from 50 percent to 100 percent. These traders were very good at making money for their investors, and many wealthy people sought them out. They were so good that investors were willing to give them 20 percent of profits, along with 2 percent fees. John Makin, a scholar at the American Enterprise Institute and a principal at a major hedge fund, Caxton Associates, told a forum two years ago that “in the first 10 years of the industry, they were all superb risk managers.”
Hedge funds were allowed to be exempt from the securities laws regulating mutual funds because their clients were limited to the very wealthy: Only people with a net worth of more than $1 million or with $200,000 in income could buy in. Rich investors were considered sophisticated enough to evaluate their managers. And if they lost money, nobody was too worried. In the 1980s, the largest hedge funds managed several hundred million dollars. They had a limited number of investors, and were concerned with building long-term relationships with them. Due to their successes, the number and size of these funds grew dramatically, and by the early 1990s the largest managed more than a billion dollars.
But success created problems. As more and more hedge funds were set up, there were not enough stellar managers who could earn returns of 50 percent or more. And as the hedge funds received more money to manage, there was just too much money chasing too few opportunities. In the late 1990s, some funds actually reduced their size, returning money to investors.
The problems of low-performing managers and too much money under management grew worse in the early 2000s as the stock market bubble — and stocks such as Enron’s — collapsed. With mutual fund earnings tanking, individual investors, pension funds, and endowments started pulling out of them, looking for better returns. Money poured into hedge funds and new ones popped up everywhere. In 1990 there were 610 hedge funds trading in U.S. dollars, according to Chicago-based Hedge Fund Research (HFR). The number increased to 3,873 by 2000, and to 9,462 today. Assets grew as well, and today HFR says hedge funds manage nearly $1.5 trillion. The top three hedge funds today manage more than $30 billion each, and at least a dozen have more than $10 billion in assets.
Many of the new funds were started by former mutual fund managers whose funds and salaries had collapsed, and many of these managers were unprepared for the fast-moving and complex world of hedge fund management. This inexperience, coupled with enormous growth in the assets of hedge funds, set the stage for many of the problems that are surfacing today. Hedge fund managers are under pressure to replicate the huge returns of the 1980s, but today’s conditions mean that is very difficult. This has led many of them to try riskier ways of making money. Hedge fund managers, under pressure from their clients, watch returns “daily, even hourly,”says Jeff Wiggins, a recently retired money manager who worked for pension funds, a hedge fund, and a mutual fund. If they see losses, they “have an incentive to take on higher risk to get into the black.”
Many hedge funds have abandoned hedging altogether because it eats up some of their returns. They are branching out into many areas and trying to be experts in all of them. “Hedge funds no longer focus mainly on stocks, bonds, and currencies,”longtime hedge fund manager Jeffrey Matthews told a House hearing in March, adding that many no longer actually hedge against market declines. Instead, he warned, they have “branched into subprime debt, distressed securities, real estate, uranium ore, and even grain sales” — areas that are more complex, and in some cases more inherently risky, than more traditional investments.
Fund managers are also willing to take big risks since they don’t lose money themselves if their investments tank. Under the current system, they get 20 percent of any earnings, but pay nothing if their investments fail. It is only their clients who lose. “If a hedge fund manager racks up a nasty loss, he or she can just walk away … and leave the losses to the clients,”says Wiggins. And so hedge funds are quick to come and go. Of about 40 firms one job-hunting manager says he interviewed with four years ago, none are in existence today. In 2005 there was an attrition rate of 11 percent, according to HFR. That year there were 8,661 funds; 2,073 were brand new and 848 closed up shop.
The frenzy for returns is raising the possibility that hedge funds will do whatever it takes, including manipulating the market, to profit. As officials of the British financial regulatory agency have warned, today’s hedge fund managers are “testing the boundaries of acceptable practice with respect to insider trading and market manipulation.”
Stock price manipulation by hedge funds has been rumored in corporate corridors for years. Hedge funds retorted that companies were just trying to prevent exposure of their problems. Indeed research done by hedge funds has helped expose corporate corruption, such as at Enron. But the frenetic Jim Cramer, who ran a major hedge fund, Cramer, Berkowitz & Co., for more than a dozen years, recently boasted publicly that market manipulation is indeed how the system works. In a December 2006 appearance on Wall Street Confidential, an Internet show that is part of his financial news, commentary, and video conglomerate, Cramer detailed how easy it is to manipulate stock prices. Suppose, said Cramer, his investments were tied to Apple’s stock tanking, and suppose that stock began to rise. In such a case, he said, he would, “pick up the phone and call six trading desks”at brokerage houses and tell them people at Verizon were panning Apple. “That’s a very effective way to keep a stock down,”he chuckled. “I might also buy January puts” — stock options that anticipate a stock going down. This, said Cramer, creates an image that bad news is coming. And, he added, you then call investors and reinforce that image. “The way the market really works is you hit the nexus of the brokerage houses with a series of orders that can be leaked to the press, and you get it on CNBC, and then you have a vicious cycle down.”
Today some corporations are so convinced that hedge funds are trying to destroy them they are going to court. Last July, Fairfax Financial Holdings, a large Canadian insurance company, filed a $6 billion lawsuit charging that a group of hedge funds ran a vicious campaign to discredit the company and drive its stock price down in order to reap millions in profit. The lawsuit claims that the hedge funds sent emails and made phone calls to employees, investors, regulators, and the press implying that the CEO had embezzled church money, cooked the firm’s books, and lied about the company’s business successes, among other actions, to send the stock price down. Lawyers for the hedge funds refused to comment.
Two other companies, Biovail and Overstock.com, have filed lawsuits charging hedge funds with conspiring with independent research analysts to issue false reports that would drive down their stocks. The research company has denied this, as have the funds. But three employees of the research firm submitted sworn affidavits in the lawsuits giving support to the charges.
The independence of research companies may also get continued scrutiny, given that hedge funds are often the main buyers of their products. Even if they don’t control what is written, hedge funds want inside information about when reports will be issued or what they might say, both of which can move stocks. One former hedge fund employee says she was urged to date investment analysts so she could learn such information.
There is also widespread worry that hedge funds are using their enormous clout with brokers and investment banks to get inside information about mutual fund trading activity. Hedge funds have become the most important clients of Wall Street brokers and bankers like Merrill Lynch, Bear Stearns, and Morgan Stanley. When they trade their $1.5 trillion in assets, they pay these banks and brokers high fees, usually much higher than mutual funds. Hedge funds account for about 30 percent of all stock trading. That means a lot of trading fees, plus more for the many other services the banks and brokers provide to them. “They are the biggest clients on Wall Street,”says Stan Schifman, who recently retired after 35 years working for brokerage houses as a senior institutional salesman. “Wall Street caters to these people.”Last year SEC Commissioner Roel Campos, a former federal prosecutor appointed to a second term at the SEC by President Bush, warned that “broker-dealers may place the interest of hedge fund clients over the interest of other clients.”
SEC chairman Christopher Cox told leaders of the SEC’s regional offices in March that policing possible insider trading by hedge funds would be a top regulatory priority for the agency over the next two years. The SEC is currently investigating reports that hedge funds get advance word from brokers about mutual fund trades. The investigation was prompted, in part, by the Investment Company Institute (ICI), which represents mutual funds. “A major concern of the Institute is the leakage of mutual fund trading information,”says Ari Burstein, senior counsel of the ICI. “This is a critical issue for mutual funds and their 94 million shareholders.”Brokerage firms and hedge funds have already paid hundreds of millions of dollars in fines over the last several years for unlawful joint activities in the purchase of mutual funds. Last year, for example, the SEC fined Bear Stearns Securities $250 million for a pattern of illegal late trading of mutual funds over four years. An SEC official warned at a hedge fund conference two years ago that the agency had identified 400 hedge funds they believed were participants in these schemes.
Another major concern is that the huge growth in assets that hedge funds manage now allows many of them to buy enough shares of corporate stock to control even large corporations. The fear is they will seek radical changes that might bring them quick profits, but ruin the company. Campos recently warned that this activism raises the specter of “the corporate raider”of the 1980s. “Hedge funds may attempt any number of measures to extract the maximum financial benefit from their investment, including trying to force a sell-off of assets and restructuring remaining operations,”he warned. “During the 1980s, this often meant plant closing, mass layoffs, demands for wage and benefit concessions from workers, and seizure of pension plan assets. Despite the passage of time, the same concerns may be legitimate today.”This concern is echoed by Ron Blackwell, the chief economist at the AFL-CIO. Hedge funds, he warns, may get huge returns on their investments in companies by “reorganizing them, often at a disadvantage to the people who work for them, or in some cases, to the survival of the company itself.”
Recent events at Algoma Steel show there is reason to worry. The management and union at the Canadian company waged a long fight against demands by a hedge fund, Paulson & Co., which recently bought 19 percent of the company. Paulson, the largest shareholder, wanted an immediate return on its investment in the company, and demanded that Algoma distribute $400 million Canadian of its cash reserves to shareholders. Paulson also wanted to replace Algoma’s board because it had rebuffed earlier efforts for a payout. Company management refused, saying steel and raw material prices were fluctuating and the money might be needed if prices went up. The United Steelworkers union argued the money should be used to pay for a needed blast furnace upgrade, to meet pension benefit and debt obligations, and to ensure the long-term viability of the company. But the continued demands from the hedge fund finally forced the company to cave, though they were able to reduce the payout to shareholders to half of the original demand.
Although world leaders, international and U.S. regulators, and members of Congress are all raising concerns about hedge funds, regulatory oversight is not likely to happen soon. On the international front, German efforts to implement greater oversight of hedge funds have been met with resistance from U.S. and British officials. Domestically, the modest effort two years ago by the SEC, under its previous chairman, to require funds to register with the commission and to keep auditable records, was struck down by an appeals court last year, prompting Grassley’s recent legislative efforts. While Barney Frank has taken up the issue in the House, it is not yet clear how far he wants to go or what support he will get. A recent report by a presidential advisory group, headed by the Treasury Secretary, concluded that the current oversight structure was adequate.
So far, there is little indication that things will change in the next administration, given the support hedge fund managers are giving to presidential aspirants of both parties. Democratic hopefuls, including Hillary Clinton, Barack Obama, Christopher Dodd, and John Edwards, as well as Republican hopefuls Rudolph Giuliani, John McCain, and Mitt Romney, have all raised tens of thousands of dollars from hedge funds. Clinton, Giuliani, and Obama all count hedge fund executives as important fund raisers for them. Giuliani considers Paul Singer, founder of the $7 billion hedge fund Elliott Associates, a major policy adviser. Edwards worked for a year as an adviser to the hedge fund company Fortress Investments, but quit when he launched his presidential bid. So far there is little talk among the candidates about hedge funds, except how much they will contribute to campaigns.
In 1929 stock manipulation, insider trading schemes, and massive speculative investments, brought down Wall Street and led to the Great Depression. But it was only after the damage was done that these schemes came to light. In 1933, after the election of a Democratic president, Franklin Delano Roosevelt, and a Democratic Senate, a stalled investigation into what had happened came to life. The findings of the investigation, dubbed the Pecora Commission after commission leader and Senate Banking Committee chief counsel Ferdinand Pecora, shocked the country and led to the securities laws that oversaw most of Wall Street’s activities.
Oversaw most of Wall Street, that is, until now. Today a huge chunk of Wall Street’s assets and much of its activities are once again shrouded in secrecy and unregulated. In his memoirs, Pecora wrote that the Wall Street schemes that led to the 1929 collapse could “not long have survived the fierce light of publicity and criticism.”The question is whether Congress will forcefully investigate, now, what is happening in the murky hedge fund world, or whether it will take a major blow-up to force action.