Problems of Hedge Funds

Hedge funds deal in a paradoxical private language worthy of the worlds of Lewis Carroll or George Orwell. Words seem to be able to mean whatever managers want them to mean: market-neutral positions can bankrupt a fund; long-term capital means a small amount of short-term capital leveraged to the hilt; and to hedge means to take wildly risky positions. Sometimes, even the investors do not know what strategies their funds are using. The rules of LTCM, for example, forbade investors asking what it was that gave the fund its promised edge, ostensibly because of fears of secret investment strategies leaking to competitors.

What is more, it is often not clear if, when hedge funds perform spectacularly well, their high returns owe more to investment judgment, to leverage or to the chance outcomes of purely speculative bets. After all, when a bet is risky, it will make a lot of money if the outcome is as hoped; but when it is relatively safe, the profit is meager unless the bet is big.

Hedge funds claim to be arbitrageurs rather than speculators. But it is generally agreed that there are relatively few real arbitrage opportunities even LTCM returned money to investors in early 1998 claiming lack of opportunities so when you find them, you have to bet big. And when the bets go wrong, you need enough capital or credit lines to stay at the table. Of course, the richer and more powerful a fund becomes, the greater its ability to influence the market in which it deals, often leading to self-fulfilling prophecies. As has been pointed out about Soros, it is not that difficult to move markets when you back your bet with $2 billion and can ride roughshod over markets and governments.

Indeed, hedge funds offer potentially high returns for the lucky few but considerable dangers when their heavy borrowing can damage a whole financial system, and their trading strategies can destabilize whole countries and markets that are not equipped to cope with mass selling of their currencies and equity markets. There is some dispute about the real impact of hedge funds but it seems indisputable that they are powerful and dominant in many markets, including emerging markets, high-yielding debt and mortgage derivatives. And the LTCM bailout suggests that there were real fears that its collapse and the fire sale of its positions would send the global markets into a tailspin. Soros himself provides this counterpoint to some degree in his 1998 book, where he argues that markets have grown so large and powerful they can destroy countries; and markets have become so frightened that they will withdraw capital from most countries in the world. He calls for more international regulation of markets, perhaps through an international central bank or an agency to guarantee loans a cry from the heart that MIT economics professor Paul Krugman has amusingly if harshly translated as "stop me before I speculate again."

In a different article, this one carried by Slate magazine, Krugman discusses LTCM and the possibility that hedge fund compensation arrangements create the incentives to take inordinate risks since managers share in the upside but not the downside. He points out that if someone lends you a trillion, they have effectively given you a put option on whatever you buy: since you can always declare bankruptcy and walk away, it is as if you owned the right to sell those assets at a fixed price whatever happens to the market. He argues that the rational way to maximize the value of the options is to invest in the riskiest, most volatile assets since if you win, you win massively, and if you lose, you merely get some bad press and lose the money you yourself put in.

George Soros and Hedge Funds

A number of energetic people fled from behind the Iron Curtain in the years after World War II. One, George Soros, carried with him a European's sense of philosophy that he applied to understanding markets. Although not trained as an economist or accountant perhaps because of this gap Soros took a psychological and cultural approach to predicting markets. Through his flagship fund, the Quantum Fund, registered outside the United States for flexibility, he would take major positions for or against foreign exchange, derivatives, emerging markets, bonds, private markets or almost anything. Any market was fair game for his group. And he would use leverage to amplify his wagers when called for. Results were outstanding although the volatility was not for the faint.

More recently, he has been writing about his investment style. Coverage in news reverses his trading desk mentality never to discuss his trading positions. And his model book on reflexivity, The Alchemy of Finance, explains his investment approach, which factors investment expectation into structure to make things that seem obvious actually occur. Indeed, the Quantum Fund's name is a reference to Heisenberg's Uncertainty Principle, which describes our inability to predict the behavior of sub-atomic particles.

But Soros's main skill is as a guerrilla investor willing to explore any market, study it more than others, strike with style and quietly withdraw, most often with a profit. In 1992, he became known as "the man who broke the Bank of England" after his attack on sterling forced its exit from the European Union's fixed exchange rate system and reputedly netted the Quantum Fund $1 billion in a day.

George Soros is a complete person and public figure, described variously as hard-nosed financier, philosopher-king, and latter-day Robin Hood. The activities of his charities are well-covered and substantial, especially in the former Soviet sphere, where his Soros Foundation has been more generous than all but two other entities, both of which are big countries. He claims that over half his time now is spent giving money away. So his life is making the transition to that which could be called a private statesman.

Nevertheless, in 1998, Soros suffered some serious setbacks. Not only was his new book on global capitalism poorly received and the Quantum Fund forced into restructuring, but his August letter to the Financial Times on the economic chaos in Russia seemed to trigger the country's debt default and currency devaluation. As the Moscow Times noted, Soros issued what was perhaps the most humiliating statement of his career: "The turmoil in Russian financial markets is not due to anything I said or did. We have no intention of shorting the currency. In fact our portfolio would be hurt by any devaluation." But it was too late: the theory of reflexivity played a cruel joke on its creator and on the ruble.

Understanding Hedge Funds

Highwaymen of the global economy was Malaysian prime minister Mahathir Mohamad's description of hedge funds after the devastation of his country's currency and stock market in 19978, which he blamed on them, particularly the fund led by George Soros. The near-collapse and $3.6 billion bailout of John Meriwether's Long Term Capital Management (LTCM) by fourteen Wall Street banks and brokerage houses in the late summer of 1998 did little to restore the reputation of these shadowy investment vehicles. What are they all about?

Hedge funds typically pool the capital of no more than a hundred high net worth individuals or institutions under the direction of a single manager or small team. Their name originally comes from the fact that unlike most institutional investors, they were able to deal in derivatives and short selling in theory to protect or ''hedge" their positions. But having begun as a way of minimizing risk, the conservative activity of hedging has become the least important of their pursuits.

Usually based in offshore tax havens like the Cayman Islands to escape the regulators and the standard reporting requirements of mutual funds, hedge funds use their freedom to borrow aggressively, to sell short, to leverage up to 20 times their paid-in capital (though LTCM had somehow borrowed over 50 times its capital base) and generally to make big but highly risky bets. They tend to focus on absolute rather than relative returns, aiming simply to make money rather than to beat an index.

But the only real difference between hedge funds and other funds are their compensation strategies. Hedge fund managers tend to be paid for performance, with a modest management fee but a substantial share of the profits the fund makes typically 15-20% though LTCM charged 25%. Otherwise, hedge funds are a diverse grouping of independent asset managers pursuing a variety of investment strategies, usually with minimal disclosure to investors and regulators, and most operating in a niche where they feel they understand the "rules of the game" better than anyone else. Consultancy Financial Risk Management categorizes them into four main groups in a comprehensive overview of the hedge fund market produced with investment bank Goldman Sachs.

First, there are the macro-funds of which Soros's fund is a leading example. These indulge in tactical trading, one-way speculation on the future direction of currencies, commodities, equities, bonds, derivatives or other assets. Their most-publicized activities involve speculation on exchange rate movements, usually shorting the currencies of countries whose economic policies look questionable and whose ability to maintain an exchange rate peg is weak (see Short Selling). Macro-funds constitute the most volatile hedge fund sector in performance terms and their correlation with traditional bench-marks is low.

Second, there are the market-neutral or relative value funds, the kind of fund LTCM described itself as. These funds are supposedly low risk because they do not depend on the direction of market movements. Instead, they try to exploit transitory pricing anomalies, regardless of whether markets rise or fall, through an arbitrage technique called convergence trading: spotting apparently unjustified differences in prices of assets with similar risks and betting that the prices will revert to their normal relationship. For example, LTCM was betting that historically wide spreads between emerging market and US assets and between corporate bonds and US Treasuries would narrow. Of course, as it turned out, history proved no guide to the future as spreads widened and everything moved in the wrong direction at once.

Third, there are event-driven funds, which invest in the arbitrage opportunities created by actual or anticipated corporate events, such as mergers, reorganizations, share buybacks and bankruptcies. Merger arbitrage, for example, involves trading in the stocks of both bidder and target on the assumption that their prices will converge if the deal goes ahead.

Lastly, there are long-short strategy funds, which combine equities and/or bonds in long and short positions to reduce market exposure and isolate the performance of the fund from the asset class as a whole.

Given the lack of a strict definition of hedge funds and the fact that they file no reports, it is difficult to estimate the extent of their activity. Figures for 1998 from the Hedge Fund Association suggest there are between 4000 and 5000 funds with total assets in excess of $250 billion; while according to TASS, a performance measurement firm, there are only 3000 funds but with over $300 billion in assets. But as the experience of LTCM shows, the total assets may not be a true representation of the amount of money dedicated to short-term trading activity since the funds frequently borrow substantially in order to make leveraged bets.