The Problem with Hedge Funds

Hedge funds are the New Big Thing—and that’s bad for the average investor, says professor D. Quinn Mills. An excerpt from Wheel, Deal, and Steal.
by D. Quinn Mills

While investors are still learning what happened to them in the 1990s and are trying to get their money back, they find themselves facing a new set of dangers—in some cases from the same people who victimized them before. And while it's been difficult for all investors, smaller investors have had a particularly tough time. During the 1990s small investors lost out to professional financial firms that manipulated the market; this time they're likely to lose out—if they're not careful—to other sophisticated investors as well.

The Next Big Thing—the Fund Of Funds

Most investors got badly burned in the Internet and telecom bubbles. Those who have money left, or who have new savings coming in and are seeking investments have heard that hedge funds have done well. For example, they've heard that Julian Robertson's Tiger Fund has made money, so they are looking for that kind of smart investment management themselves.

Sensing this demand, which is what they do best, investment banks are now creating funds, which then are invested in other funds. This is the big new thing, the fund of funds. People who managed funds during the Internet and telecom bubble, and then saw those funds go under, now emerge as managers in hedge funds. But investors who lost their shirts in the Internet and telecom funds managed by these people no longer give them their money. So how can the money managers (once of Internet mutual funds, now of hedge funds) get it? The answer is to entice investors to entrust their money to one of the big investment banks or brokerages—Citibank, Chase, Merrill Lynch, or Bear Sterns—which then invests it for them in hedge funds. Funds of funds, the word is on Wall Street, are the next bubble—the next place for financial market professionals to make a killing.

All this the investor has seen before.

In many instances the banks are accepting investments from qualified individuals—people with a net worth of more than a certain amount. But the net worth measure is somewhat elastic, and smaller investors are creeping into these funds. Are these investments suitable for pensions, college savings, IRAs, and 401(k)s? We have yet to see the answers to these questions. The likelihood is that if the investments are laundered, so to speak, through a big bank that pretends to impose some prudence in management on the hedge funds in which investors' money ends up, then until another collapse, funds of funds will be considered suitable investments.

The bank is an intermediary between the investor and the hedge fund. The bank pretends to place a cordon of safety, of conservative investing, around its investors' funds, but in reality it simply transfers them to a hedge fund for management. For a percentage of the assets managed, or a percentage of the investors' gain, the bank places investors' money in other funds for management. The fee the investor pays the bank is for expertise the investor lacks in choosing hedge funds in which to invest, and which the bank claims to have but really doesn't—any more than the mutual funds had expertise in picking dot-com stocks. The banks argue that they have expertise allowing them to pick the better hedge funds in which to invest. And they provide statistical models that supposedly allocate investors' risks properly. But little reliance should be placed in these. Banks might be able to steer investors away from the most fly-by-night of the hedge funds, but beyond that threshold protection, the expertise necessary to impose prudence on the investments being made by a hedge fund is not available to the banks.

All this the investor has seen before. Statistical models of risk and reward, supposedly prudent investment management coupled in bizarre and undisclosed fashion with the most extremely risky investments, were characteristic of the Internet bubble. And here, less than three years later, is the whole concoction emerging again in a slightly different disguise. Again, salespeople for the banks and brokerages are telling investors that they have a safe haven for investments at high returns and are placing investors' money in extremely speculative investment vehicles.

So we are turning full circle. During the Internet and telecom bubble, investors placed money in mutual funds, believing it was being managed carefully, only to discover that it was placed in dot-com and telecom stocks. When the bubble burst, the money was mostly lost. Disenchanted with many mutual funds, for good reason, investors are turning to the banks, which are directing investors' money into places as speculative as dot-com and telecom stocks. But this time the destruction of investors' value isn't likely to take the form of a large run-up in share prices followed by a collapse; that is, of a bubble in share prices that gets punctured in a spectacular bust. Instead, market averages will not move very much, while value is consumed in the hedge funds as they speculate up and down, long and short, on the movement of prices in the markets.

During the bubble, it was easy to see where an investor's money went—it was invested in stocks or in a mutual fund, and as stock prices rose so did his or her account, and when they fell, so did his or her account. With hedge funds money is going to be made, and lost, in arcane positions trading with or against the market, sometimes in so complex a fashion that not even the fund managers will know exactly what caused an investment to be a success or a failure. From the point of view of most investors, including the banks that claim expertise when they intermediate investors' money, invested funds go into a black box at a hedge fund in which it's not possible to see why the fund grows or declines. The investor is further away from the actual management of his or her fund than during the Internet bubble. The outcome is not likely to be much better.

Despite the temptation to think so, an investor can't protect him- or herself in this market just by finding a way to join a hedge fund. There are now thousands of them, and most perform very badly. In a period of starvation, some wolves get eaten by the others. This is happening among the hedge funds.

Hedge Funds

The increasing number of small investors who have entered the market now face the hedge funds, the big, new sophisticated players in the investment world into which not only wealthy individuals but large pension funds and endowments have poured money. Big investors such as hedge funds are secretive, and small investors aren't sufficiently protected. It's a setup for a small investor to get killed.

Hedge funds, like venture funds, do not reveal performance. But they should be required to do so.

Hedge funds don't really hedge; mainly they sell short as well as buy long; and they are very aggressive in the marketplace, taking strong positions and moving money very quickly. A news report is issued at noon; moments later hedge funds are buying or selling. They've added a new dynamic to the market that is reflected in the enormously increased volume of stock transactions and in the very greatly shortened period of time for which shares (on average) are held by investors. The market is made much more volatile; there are spikes of trading on any news.

It is important for investors to realize that the stock markets in the first years of the 21st century are not just down, but down in a particular way, as a result of the new forces at work in the market, the most important of which is the hedge fund. A hedge fund investor must have at least $1.5 million in net worth to invest. The funds are regulated little and do not report their activities, trades, and balances. The smaller investor cannot play this game successfully. He or she can only go long in the market, hoping for sustained rallies, while through the hedge fund a richer investor is free to go either long or short. The ordinary investor can make money in only one way—an up market—while the larger investor can make it coming or going, up or down.

Hedge funds are a much bigger part of the market than they used to be. They follow a herd mentality, as do most fund managers of any sort. When they all go long, the market rises—when they all go short, it falls. They tend to go one way, then the next—and the market experiences violent shifts from day to day, but in a narrow range without much of a trend. Hedge funds have increased in number in the past decade from about 2,000 to 6,000, and assets managed have risen from about $69 billion to about $600 billion. 278 Funds differ in investment strategy—some go long, some short, some both; some use leverage, some don't. Europe has about 450 hedge funds managing the equivalent of some $65 billion and their number and the amount invested are growing quickly (more than a fourfold increase in the past 3 years) 279 More funds mean more competition, and some funds are now closing.

Investment banks run sessions for investors (high net worth individuals and pension funds) to introduce them to hedge funds. Here's a description of one such session. "Suddenly the lights went out and two Morgan Stanley hedge fund marketers appeared on giant television screens. The comely pair—both men—sported blunt-cut blonde wigs and cheerleader outfits with pleated skirts.... This pep squad launched into an arm-waving cheer, `Chilton, Chilton, he's our man; if he can't short it, nobody can!"' This is an account of the Morgan Stanley hedge fund conference held at the Breakers Hotel in Palm Beach in January 2002. The pep squad's reference was to Richard Chilton of Chilton Investment Company, a Connecticut-based hedge fund.280

Banks rarely take a fee for this sort of entertainment. They make their money on trades and other services that are now a big source of revenue to the banks.

Hedge funds began in 1949, and were fashionable in the late 1980s, then were tarnished by the failure of Long Term Capital Management, then in the late 1990s became major drivers of the market, having grown enormously. They are often close partners to the investment banks, because the funds are small money-management units with no credit ratings and little infrastructure, so they need to rent the clearing and settling capabilities, the stock loan inventories and balance sheets of the banks.

The hedge funds claim to be able to provide substantial returns regardless of the direction of the market. Like mutual funds and traditional money managers, most hedge funds probably can't beat a market index, but a few do very well. Hedge funds are now becoming respectable investments for pension funds, as did venture capital firms about fifteen years ago. Major colleges and universities have 20 to 30 percent of their endowments in hedge funds, and so have become major contributors to the way in which the market is changing against the interest of most investors.281 In 2001 the California Public Employees Retirement System, America's largest pension fund, put $1 billion into hedge funds. It was a major stamp of approval. Yet this is an industry about which Institutional Investor writes, "Secretive and far from pristine, the industry [hedge funds] has long been notorious for providing scant information (if any at all) and for suspect fundraising practices."282

Research indicates that long-term investors should reduce their portfolio allocation to equities when volatility increases, as it has recently. But it also shows that there isn't sufficient volatility to justify a big increase in demand for stocks for hedging purposes.283 In today's market, long-term investors should be pulling out of equities and have little need for buying stocks to hedge volatility.

There is thus no justification for the enormous growth of the hedge funds. It follows that the hedge fund mania is simply the latest of the securities industry's new, new things" for investors—another sales gimmick.

Regulating Hedge Funds

Hedge funds, like venture funds, do not reveal performance. But they should be required to do so. They should be required to report activities and positions to regulatory authorities frequently so that the regulators know what is going on. When the Long Term Credit Management crisis broke, it caught the Fed flatfooted because the Fed hadn't known of the developing problem. Yet years later the quality of the information available to the government to avoid even larger crises has not improved at all, although the number of hedge funds and their significance in the markets have increased dramatically.

The investor is further away from the actual management of his or her fund than during the Internet bubble.

We need a study as to the impact of the funds to see what, if any, new regulations are required. On July 26, 2002, the SEC wrote to major hedge funds asking them to fill out a questionnaire about such things as background of fund managers and valuation processes. The SEC seems concerned about conflicts of interest (such as mutual funds owning hedge funds) and possible fraud and the increasing availability of hedge funds to retail investors. The SEC may be getting ready to regulate hedge funds.284

The Impact Of Hedge Funds On The Market

Hedge funds sell short. Short selling is always speculation, not investment. The growth of hedge funds thereby injects a much larger speculative element into the market. This makes the market much more dangerous for investors who are trying to finance pensions and retirements, college tuition, and so on, by appreciation on their stock market investments.

Some speculation via short-selling is necessary and appropriate; it adds liquidity to the market and limits excessive optimism. But too much speculation turns the markets from an investment vehicle into a casino. Hedge funds most likely affect the performance of the market by making it more volatile and limiting its upside potential (via much larger amounts of short-selling). Most commentators about the market ignore this. When the market suffers big losses on a single day, they find some small piece of bad economic news and attribute it to that. When the market gains a lot on a day, they look at the overall upward direction of the economy and attribute it to that. When the market stalls and seems to move aimlessly, they say the American economy is stagnating like that of Japan. The point is that even though the market is behaving in unfamiliar ways, it is explained as if it were behaving in traditional ways. Nowhere is the change in the players in the market recognized. The change in the means by which large players seek to profit and the greater role of the hedge funds and of speculation via short-selling is ignored.

Hedge funds had their origin in speculating in international currency markets. Currencies have trends, crises, and turnabouts, all of which makes them ideal for speculation. But rarely does one invest directly in currency markets expecting long-term appreciation. Currency markets are speculative markets, not investment markets. The same is true of commodity markets. Hedge funds are now very active in equity markets and are making equity markets much more like currency markets; that is, speculative markets rather than investment markets.

Talking Points

Hedge funds are the emerging giants in securities markets. Most sell short as well as buy long. Until recently they were the arena of wealthy individuals, but now college endowments, corporate pension funds, and moderately wealthy people have much money invested in them.

The best hedge funds are very sophisticated investors, and they make it even more dangerous today for an individual investor trying to pick stocks. But there are many more hedge funds than there used to be, and many don't seem to have a good investment record. There is little known about the funds because by and large they do not yet report to regulators.

The big new thing in investments for many people is the fund of funds, by which an investor pays a bank to find hedge funds in which to place the investor's money. The fees for investing in this way are high, and the banks that take a fee for placing investors' money rarely have any expertise in the selection of hedge funds, so the investor is again taking a large chance with his or her capital, whatever the promised return.

About the Author

D. Quinn Mills is the Alfred J. Weatherhead Jr. Professor of Business Administration at Harvard Business School.