Why are hedge funds so successful?

With all the talk about hedge funds – the dramatic successes (about 20 hedge fund managers earned in excess of $100 million in compensation last year), and the rising number of flameouts (from the Bayou Group to the Eifuku Master Fund in Japan that lost its $300 million portfolio in seven trading days) – few have focused on the question of how hedge funds are able, so far, to earn higher returns than other investment vehicles. (The largest hedge fund index beat the S&P by about 3% last year, and many of the largest funds earned returns in excess of 30%.)

A couple of hypotheses, some benign and some potentially troubling:

One possibility is the nature of the hedge fund industry – very little regulation, huge pools of equity capital, strategic flexibility, and tremendous liquidity – allows funds to move more quickly to capture value than its primary competitors: the massive, highly regulated, and somewhat stodgy mutual fund industry, or the venture capital and private equity industries, which focus on longer term investments that involve actually running firms instead of being merely investors. In other words, while private equity money is locked up for 5 to 7 years in single firms, and mutual funds are precommitted to single strategies (e.g., emerging markets equity), hedge funds are able to change strategies instantly and with low cost to move money to where returns are good. This is best illustrated by comparing the mix of fund strategies at any two points in time. In the 1990s, for example, about 70% of funds were investors in long bets on various currency or debt markets (“macro” funds), while only 5% were involved in hedging equity securities. Within just a few years, the money found returns better in the equity markets, so the hedge fund mix today allocates about 30% of money to equity hedging and only 10% to the old “macro” strategies. If this hypothesis is true, it should serve as a cautionary tale for regulators who, through increased regulatory costs and oversight, may reduce the flexibility of hedge fund investments.

A second possibility is the ability of hedge funds to create value through so-called “event driven” investments. This strategy involves active participation by funds in takeover battles, mergers, and strategic repositioning at firms. In effect, these funds are the new corporate raiders. While Michael Milken and Ivan Boesky used debt (junk bonds) to finance the LBO takeovers of the 1980s, hedge funds are using their enormous pools of equity capital and the extreme leverage investment banks will give them, to finance takeovers (e.g., Lampert’s ESL Investments acquisition of Kmart and Sears) or to encourage strategic or management changes (e.g., Carl Ichan’s recent letter to TimeWarner’s board and shareholders). The key to superior returns here is that funds are able to actually influence corporate decisionmaking, say breaking an undervalued conglomerate into more valuable pieces, in ways that passive investors like mutual funds cannot. While an exciting development for those of us longing for the discipline of the market for corporate control, this is not likely to explain the industry’s superior returns, since such “event driven” funds still represent less than 15% of the industry, and the verdict is still out on whether these will be successful investment strategies in the long run.

A third explanation is that funds are a talent magnet for the best and brightest on Wall Street. In other words, smarter investors explain the superior returns. It is true that many of the stars at investment banks left to form hedge funds in the past 5 years, primarily because the compensation model at funds – 1-2% annual management fee plus 20% or more of profits – allows managers to earn obscene sums in personal compensation. (For example, a $5 billion fund with a 1%/20% fee structure, that earns a 30% annual return provides profits to the hedge fund manager of $300 million.) While plausible, this is an unsatisfying explanation. Modern financial theory teaches that superior returns are very rarely the product of individual greatness, and that the “best” minds on Wall Street in one year are often duds the next. Instead of brain power or instincts, the more likely explanation is information and access to it. Which leads us to a final, and more nefarious, possibility.

While hedge funds are a relatively small part of the value of equity and debt markets (estimates are in the 10% range), hedge funds are more active traders, on any given day hedge funds can account for 50% or more of the volume in trades on major exchanges. Because many other investors adhere to the buy-and-hold strategy advocated by modern portfolio theory, hedge fund trading is one of the most important sources of revenues (and, it turns out, profits) for investment banks. This bottom line saliency gives hedge funds two advantages over other investors:

One advantage is that it gives investment banks a strong incentive to loan hedge funds tremendous sums against their securities portfolios, which allows funds to achieve leverage ratios of up to 25:1. In other words, banks subsidize funds with low-cost capital (LIBOR plus 50, say), in order to keep them trading. (Think China buying U.S. T-bills to keep American consumers buying Chinese-made goods.) The bottom line is that this leverage enables funds to make bigger, bolder bets, and increase returns far in excess of what their deployed capital could provide. While this extension of credit may be troubling in some cases, as it may raise the systemic risk across financial markets, there is nothing inherently wrong or illegal about funds using their relationships to get more credit from their lenders.

The second advantage is that it gives hedge funds unrivaled access to key decision makers and sources of information at investment banks. This information – a pending merger, a new strategic direction, a new product launch or regulatory development – could explain, in whole or in part, the ability of hedge funds to beat the market. And, if true, this is very troubling. It works like this: a hedge fund calls an investment bank where it does a substantial book of trading business, and chats up various bankers with many pending deals. The fund pressures the bankers subtly (or even overtly) to reveal confidential information that the fund can use to trade to its advantage. The banker is susceptible to this pressure given the fear of losing the trading business, which has very low switching costs. While this practice is unethical and illegal, it is both very hard to eliminate and, according to several investment bankers I spoke with, common. There may be changes to current law that would limit the practice, but more on that later.

Comments

[mjones]

Is there evidence to show that hedge funds pressuring bankers to reveal confidential information is a "common" practice?

[toddhenderson]

Re mjones's question -- I've edited the entry to be more clear about the source for this claim. Finding hard, empirical evidence for this phenomenon would be a great project. I have only anecdotal evidence (off the record of course) from bankers. This may not be the strongest or only explanation, but if it is going on, it raises some difficult issues.

[slevmore]

Todd's question as to why hedge funds do so well is intriguing. Is the outpeformance reliable, or do many underperformers simply disappear from the market, change their mission (so they are not counted as hedge funds), or otherwise ruin the study of average hedge fund performance? And as for the dark story, should we worry that the investment bank insiders are not simply holding on to good customers, but even investing privately, themselves, in the hedge fund?

[Tim]

Do you have systematic data that hedge funds outperform the broader market? This article:

http://www.usatoday.com/money/markets/us/2004-11-21-hedge-funds_x.htm

suggests a couple of reasons hedge fund indexes could be misleading if they're not constructed carefully.

[ardent_capitalist]

Todd -- Let me get this straight: You are at a loss for an explanation as to why hedge funds outperform the market (if indeed they do), and conclude that there must be illegal and unethical bahavior. That is a rather drastic, unsupported conclusion.

Stock buying and selling is still subject to the the scrutiny of watchdog groups (public and private) and trends would develop; such as buying and selling before events.

Perhaps you should dig a little deeper for a reasonable explanation as to why the top funds make money. Have you asked anyone at top hedge funds? Or did you stick with "off-the-record" quips from (bitter?) bankers?

[Henry Mohrman]

Sorry I only picked up this topic from The Law School Record now. I hope you are still interested.

An important point is that many hedge funds are "private" and therefore either can make higher returns or can claim to make higher returns with very little ability to be challenged until something goes very wrong (e.g. business failure) or very right (e.g. liquidation at a huge profit).

It will take many years to get a good empirical handle on real returns versus claimed returns. Long-Term Capital Management gives us real information because it liqidated at a very modest profit, and there is a case report telling us so.

The behavior of investment bankers (both legal and illegal) is an agency cost experienced by both private hedge funds and public mutual funds. It is possible that that cost is disproportionately borne by the public mutual fund, but again it would take the release of a lot of private information to get a handle on that. In the Long-Term Capital Management case, the investment bankers killed them with kindness, using their trading information to replicate Long-Term Capital Management's trades, ultimately creating a temporary illiquidity in Long-Term Capital Management's trading positions that the investment banks had to resolve by acquiring 90% of Long-Term Capital Management's equity.

There is a wealth of published information on the case. I would be pleased to send you citations by conventional means.

[Henry Mohrman]

Sorry I only picked up this topic from The Law School Record now. I hope you are still interested.

An important point is that many hedge funds are "private" and therefore either can make higher returns or can claim to make higher returns with very little ability to be challenged until something goes very wrong (e.g. business failure) or very right (e.g. liquidation at a huge profit).

It will take many years to get a good empirical handle on real returns versus claimed returns. Long-Term Capital Management gives us real information because it liqidated at a very modest profit, and there is a case report telling us so.

The behavior of investment bankers (both legal and illegal) is an agency cost experienced by both private hedge funds and public mutual funds. It is possible that that cost is disproportionately born by the public mutual fund, but again it would take the release of a lot of private information to get a handle on that. In the Long-Term Capital Management case, the investment bankers killed them with kindness, using their trading information to replicate Long-Term Capital Management's trades, ultimately creating a temporary illiquidity in Long-Term Capital Management's trading positions that the investment banks had to resolve by acquiring 90% of Long-Term Capital Management's equity.

There is a wealth of published information on the case. I would be pleased to send you citations by conventional means.

[Henry Mohrman]

A further thought on hedge funds, if you are still listening. At very high leverage ratios (say, 20:1 or above)the investment bankers really own the funds as its bondholders, with the managers and the investors holding different options on the residual value of the fund. The high compensation to the managers comes from both the investment bankers and the investors. The investment bankers pay the managers to formulate strategies that will (1) attract the investors' capital to buy the investors' option, (2) utilize the investment bankers' lending capital at the rates charged for secured borrowed money by the investment bankers, and (3)implement trading stragies generating brokerage revenue to the investment bankers. The investors pay the managers for the option to the residual after the investment bankers have been paid in the proprietary trading strategy of the managers.

One commentator has found investment in a hedge fund to be most like investment in a private entrepreneurial company. The investor is basically buying the management and the idea, in a very high risk private capital arrangement. Carefully vetted and with some luck, these very high risk investments earn returns comensurate with the risk or greater.

The word "fund" in hedge fund might be misunderstood if the investor thinks the hedge fund is like a mutual fund. They are very different, particularly with respect to leverage. Very few mutual funds use leverage (or much leverage), and therefore mutual fund managers do not work for their lenders in the same way that hedge fund managers do.

In any leveraged firm, the managers must work for the lenders as provided in the lending agreements. If they did not, they would not be in business, because the lenders would not lend to them. There is nothing illegal, immoral or fattening about that, it is just capitalism.

[Joan A. Conway]

Seeing a really big picture of the structure of different industries and what makes them a bust or a boom belongs to a relatively few men, and it is inconsistently seen by them as well! Uncertainty exists in their perception, like it usually does in ours, but they have a much deeper understanding about the nature and reactions of the global economy. Hedging your bet with the right Hedge fund managers puts the advantage on your side, but remember it isn't a sure thing either.

[Hedge Fund Consultant . Richard Wilson]

Many if not most hedge funds use no leverage at all. Anyone have a statistic on the % of funds that employ leverage? Something reliable to point towards?

- Richard

[Hedge Fund Consultant - Richard Wilson]

p.s. Nice post. I referenced your blog posts here in within my blog.

- Richard