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Goldman Ousts Bridgewater as Largest Hedge Manager

Date: Friday, December 1, 2006
Author: Richard Teitelbaum, Bloomberg.com

(Bloomberg) -- Hedge fund managers can make you rich quicker than just about anyone. Sometimes, they can make you poor even faster.

Just look at Amaranth Advisors LLC, the Greenwich, Connecticut-based hedge fund manager that stumbled over wrong-way bets on natural gas. Going into September, Amaranth was up 26 percent in 2006. By October, it had lost $6.6 billion.

The next Amaranth is out there somewhere. Bloomberg News, using data compiled by Chicago-based Hedge Fund Research Inc. and Bloomberg, has ranked the world's best-performing hedge funds in six investment strategies: emerging markets, distressed, event driven, long/short equity, fixed income and macro.

Since 2000, the secretive world of hedge funds has more than doubled in size. There are now more than 9,000 of these funds with combined assets of $1.34 trillion. Everyone from Wall Street chieftains to the stewards of retirement nest eggs is chasing these funds, which are private pools of capital that allow managers to participate substantially in the investment returns they generate for clients.

Investors poured a record $110.7 billion into these vehicles during the first nine months of 2006 -- more than twice what they did in all of 2005. Since September, Morgan Stanley has bought stakes in two hedge-fund firms and purchased a third outright. And since late 2005, Goldman Sachs Group Inc. has become the largest manager of hedge fund money, with $29.5 billion in assets, according to HFR and Bloomberg.

Goldman passed Westport, Connecticut-based Bridgewater Associates Inc., which has $28 billion in assets, and New York- based D.E. Shaw & Co., which has $23.2 billion.

Returns Sag

So many hedge funds have crowded into the markets that the industry is struggling to generate standout profits. As of Sept. 30, the average hedge fund was up 7.1 percent in 2006. Investors would have made more money buying a mutual fund that tracks the Standard & Poor's 500 Index, which returned 8.5 percent through September. And while hedge funds typically charge a fee of 2 percent of assets and take a 20 percent cut of profits, the Vanguard Institutional Index Fund charges expenses as low as 0.025 percent of assets.

As money pours in and returns sag, Theodore Aronson, a principal of Philadelphia-based Aronson & Johnson & Ortiz LP, sees potential danger ahead. ``You don't have to go back to the tulip bulb mania to see how things could turn out,'' he says. ``It could be ugly.''

Investors are coming to grips with slackening returns. At the California Public Employees' Retirement System, Senior Investment Officer Christy Wood says hedge funds may have a hard time hitting her investment goals because of a rise in U.S. Treasury yields.

Hitting Targets

Calpers, which has invested about $4 billion in hedge funds, targets a return of 5 percentage points more than T-bill rates. In 2003, that figure was 6 percent. On Nov. 8, with T-bills yielding 5.1 percent, it was more than 10 percent.

``It doesn't take a lot of research to realize that you're going to have a harder time reaching that today,'' Wood says.

Which hedge funds will deliver? One place to look for the answer is below. There's no guarantee, of course, that these funds will make the list next time.

``For the rest of our lives, the developing world will be capturing an ever increasing slice of the global economic pie,'' says Scott Peters, co-manager of the $82 million, Sausalito, California-based Tradewinds Fund LP.

That theme, playing out in countries from Peru to Pakistan, has fueled white-hot performance of emerging-market hedge funds.

21 Percent Return

Such funds posted an average annualized return of 21 percent during the three years ended on Sept. 30, more than any other category of hedge fund, according to HFR. During the first nine months of 2006, they returned 12.4 percent. Peters's fund returned 54.2 percent annualized over the three years.

Zeroing in on one market can bring even greater rewards -- and risks. Peters's $132 million Tradewinds Russia Partners I LP returned 80.2 percent annualized over three years.

Peters calls that fund a wager that the political and economic landscape in Russia will continue to improve.

``Our bet in Russia has been that it would go from a really chaotic situation to a less chaotic situation,'' Peters says. ``It's actually done better than that.'' To hold down risk, Peters tends to invest in big companies that often have ties to the government. And he uses no borrowed money.

Other markets have proven almost as profitable as Russia. By the time Workers' Party candidate Luiz Inacio Lula da Silva donned Brazil's presidential sash in 2003, many foreign investors had run for cover.

Betting on Brazil

Greg Lesko, manager of Deltec Emerging Market Equities LP, a $41 million New York-based fund, and his colleagues instead poured 10 percent of the fund's assets into Brazilian bonds that were trading for as little as 40 cents on the dollar.

``It was clear to me that Lula was not going to be a traditional leftist,'' Lesko says.

In general, Lesko focuses on a dozen or so markets benefiting from what he sees as stable political situations, responsible economic policies and healthy competitive environments. He began unloading the Brazilian debt a year or so later at 85-100 cents on the dollar -- when he was confident enough to shift more heavily into equities.

Today, 20.3 percent of Deltec is in Brazilian stocks. The fund has also built up holdings in Taiwan, at 15.2 percent of assets, and the Philippines, at 7.4 percent. Deltec was up 29.5 percent annualized over the three years.

Going against the crowd is the key to market-beating gains. Richard Mashaal opened Senvest Israel Partners LP in April 2003, during a wave of violence between Palestinians and Israelis. ``Many stocks were trading below their cash holdings,'' says Mashaal who also runs a long/short equity fund. ``We felt this was the deal of a lifetime.''

Vultures Swoop

The fiasco at Enron Corp. has been good to Alan Cohen. Since Enron went bust in 2001, Cohen, a senior managing director at York Capital Management LLC, has made a fortune on its bonds.

New York-based York Capital, run by Jamie Dinan, has emerged as one of the most-successful hedge-fund vultures. Its York Credit Opportunities Fund, which Cohen manages, posted an average annualized return of 23.6 percent in the three years ended on Sept. 30, according to HFR.

In 2001, York bought bonds and shares of Adelphia Communications Corp., Tyco International Ltd. and WorldCom Inc -- and got hammered when accounting scandals rocked those companies. York's main fund lost 7.1 percent in 2002. The firm held on to many of those investments and posted a 33.3 percent return in 2003.

``Many of these companies have continued to recover and grow,'' Cohen says. ``We expect more positive developments down the road.''

Troubled Industries

Hedge funds that trade distressed assets, typically junk bonds and corporate loans, posted an average annualized return of 14.6 percent during the three years ended on Sept. 30, according to HFR. During the first nine months of 2006, these funds returned 9.8 percent. So many hedge funds are chasing distressed investments that returns have withered from 18.9 percent in 2004.

Sam DeRosa-Farag, president of New York-based Ore Hill Partners LLC, says he's keeping a close eye on the troubled airline and auto industries. Cohen says he's watching them, too.

``You have 80 percent of the industry in trouble. That is quite unusual,'' DeRosa-Farag says of both. ``If you compare that to the 1980s or 1990s, the pain threshold is much, much higher.''

As of mid-November, the biggest bond market casualty of 2006 was Toledo, Ohio-based Dana Corp. The auto parts maker filed for bankruptcy on March 3, with $6.8 billion of debt.

Fallen Angels

More companies are likely to run into trouble soon, according to S&P. As of early October, 38 companies around the world had lost their investment-grade credit rating in 2006. Forty-one more, with a combined $77.6 billion of debt, were at risk of landing on the junk-bond heap.

Bay Harbour 90-1 Ltd., managed by New York-based Bay Harbour Management LLC, returned 34.6 percent during the three years ended on Sept. 30, the best showing among distressed-asset funds in the U.S., according to HFR.

When Mirant Corp. made a $7.86 billion hostile bid for NRG Energy Inc. in May, Barry Rosenstein, founder of Jana Partners LLC, went to work. Jana and several other hedge funds that bought shares in Atlanta-based power producer Mirant denounced the acquisition as overpriced.

The hedge funds won. Mirant eventually dropped its bid and, to placate investors, agreed to buy back $1.25 billion of stock.

Over the past few years, hedge fund managers like Rosenstein have made headlines -- and lots of money -- by buying stocks and then pushing for change.


Event-driven funds such as Jana Partners, which try to profit from corporate events such as mergers, acquisitions and bankruptcies, posted an average annualized return of 12.7 percent in the three years ended on Sept. 30, according to HFR. During the first nine months of 2006, they returned 9 percent.

As the S&P 500 Index rallied in November, some event-driven managers predicted investor activism might wane. When stock investors are making money, it's often hard to rally them.

``The market is doing things on its own now,'' says Jeffrey Altman, founder of New York-based Owl Creek Asset Management LP, whose Owl Creek II LP fund returned an annualized 16.3 percent in the three years ended on Sept. 30, according to HFR. If the good times last, investors may start to frown on hedge fund rabble- rousing, Altman says.

Activists may have a harder time making money because so many hedge fund managers are piling on, says Rosenstein, whose fund posted a 19.5 percent annualized return over three years, according to HFR.

``You have a lot of people combing over the same companies, and stocks can be run up too high,'' he says. The plus is that the new breed of hedge fund activist has provided a shareholder base that supports corporate change, Rosenstein says.

Activist Action

Rosenstein has teamed up with some of the most-prominent activists around. He joined billionaire corporate raider-turned- hedge fund manager Carl Icahn in a failed bid to break apart Time Warner Inc. in 2006. Time Warner stock rose 12.6 percent in 2006 through Nov. 8.

At Owl Creek, Altman looks for companies that are restructuring, spinning off units or struggling to boost their stock price. He made money betting that auto industry suppliers and health insurance providers would ride out turbulence in those industries. He also bought shares of AMR Corp. and Continental Airlines Inc., figuring the airlines would benefit from lower oil prices and recent concessions from labor unions.

``Airlines are generating tremendous amounts of free cash flow,'' he says.

The Original Hedgers

In a world of rapid-fire traders, Richard Mashaal buys, holds -- and wins.

Mashaal, manager of New York-based Senvest Partners LP, began buying shares of Msystems Ltd., a Kfar Saba, Israel-based maker of flash drives, at about $6 in 2001. Mashaal, 41, didn't sell when the stock doubled to $12 in 2003 or when it sailed past $30 in 2005. Today, his $118 million fund still holds some 85 percent of its original stake in Msystems, whose shares traded at $35.38 on Nov. 8.

``When you find a good management team with a good product attacking a growth market, you stick with it,'' Mashaal says.

Long/short equity funds, which both buy stocks and wager against them, posted an average annualized return of 10.3 percent during the three years ended on Sept. 30, according to HFR. During the first nine months of 2006, these funds returned 6 percent.

Industry Giants

Investors poured more than $30 billion into long/short funds during the first nine months of 2006. These funds now sit atop a combined $379.3 billion in assets, more than a quarter of the industry total.

Mashaal garnered a 25.7 percent three-year annualized record by sussing out beaten-down technology stocks with low price- earnings multiples, fat cash cushions and attractive prospects.

``We'll buy something that has a 40 trailing P/E, but if we look at where we see it going, it'll have a forward P/E of 10,'' Mashaal says.

The long/short arena accommodates a variety of investing styles. Bryant Riley, founder of Los Angeles-based SACC Partners LP, is an activist whose fund returned 33.3 percent annualized over three years.

``We take a private equity approach,'' Riley, 39, says. SACC often demands board seats after building a position in a company. The $118.8 million fund is represented on the boards of 10 of SACC's 15 core holdings. All of them are microcaps with market values of less than $300 million.

Winning Board Seats

SACC bought shares of Alliance Semiconductor Corp., a Santa Clara, California-based maker of computer memory products, after the company's shares had tumbled to less than $1.60 in May 2005.

After winning five of seven board seats, Riley and his partner, John Ahn, ordered management to sell off Alliance's operating businesses and concentrate on a portfolio of investments it owns. Alliance shares rose to $3.65 on Nov. 8.

Its success is such that the fund is changing its name to Riley Investment Partners LP, which will put an end to people confusing the fund with Stamford, Connecticut-based SAC Capital Advisors LLC, which was founded by legendary trader Steven Cohen.

``He's unfairly capitalizing on the reputation we've been building,'' Ahn jokes.

``It's hard to make a buck.'' That's how Donald Brownstein, founder of Stamford, Connecticut-based Structured Portfolio Management LLC, sums up life these days for hedge funds focusing on the global bond market.

Bond funds posted an average annualized return of 7.8 percent during the three years ended on Sept. 30, according to HFR. During the first nine months of 2006, they were up 5.9 percent.

Fed Headache

The U.S. Federal Reserve has been a big headache for bond investors. Since 2004, the Fed has pushed overnight interest rates higher in an effort to head off a new surge in inflation. It left the benchmark federal funds rate unchanged at 5.25 percent on Oct. 25.

As the funds rate has climbed, so have U.S. Treasury yields. Two-year Treasury yields reached 4.75 percent on Nov. 8, up from 3.07 percent in late 2004. Ten-year yields have climbed less, to 4.64 percent from 4.22 percent. As a result, investors who borrow at short-term rates to buy bonds make less money on their investments.

``There's been a significant inversion between the overnight rate and the 10-year note,'' Brownstein says. ``It's very hard to make money in that kind of environment. It's hard for banks. It's hard for everybody.''

Bond managers who focus on mortgage-backed securities have outdone many of their peers. Brownstein's $476 million Structured Servicing Holdings LP fund, which specializes in these securities, posted an 8.7 percent average return in the three years ended on Sept. 30.

Housing Market

Mortgage bonds are getting riskier now that U.S. home prices have begun to decline. Banks fashion these securities out of mortgages and home equity loans. If enough people default on the loans, the securities' credit ratings could suffer.

``The key trend is navigating this slowdown in housing and finding good opportunities,'' says Tony Lembke, portfolio manager at New York-based MKP Capital Management LLC. The firm's MKP Credit LP fund, which invests in residential-mortgage-backed securities, posted an average annualized return of 11.7 percent over the three years.

Mortgage Opportunity Fund VI and the Galena Street Fund, both managed by Denver-based Braddock Financial Corp., led fixed- income hedge funds during the three years, according to HFR. Mortgage Opportunity logged an annualized return of 22.2 percent during that period; it was up 15.4 percent during the first nine months of 2006. Galena, which specializes in mortgage-backed securities, posted an average annualized return of 15.2 percent over three years and was up 7.1 percent in 2006 through Sept. 30.

The Globalists

What a comedown. The old masters of the hedge fund universe -- macro funds -- can't even beat the S&P 500 Index these days.

Macro funds, which trade just about anything, anywhere, posted an average annualized return of 6.7 percent during the three years ended on Sept. 30, according to HFR. During the first nine months of 2006, these funds gained 3.2 percent -- less than the S&P 500, which rose 7 percent.

World markets have been too calm for many macro managers, who tend to thrive on volatility.

``The glory days of macro are over,'' says Paul DeRosa, a principal at Princeton, New Jersey-based Mount Lucas Management Corp.

DeRosa's Peak Partners LP, which posted an annualized three- year return of 13.4 percent, has managed to call recent turning points in the markets. The S&P 500 rose 5 percent during the first four months of 2006, dropped 2.6 percent through July and advanced 8.5 percent through Nov. 8. Crude oil started 2006 at $61 a barrel, rose to $78 in July and then retreated to $60.

Commodities Play

``We had a good chance in commodities with the run-up in spring and the run-down after July,'' DeRosa says. ``And there was a chance to catch the rebound in equities.''

James Passin, who manages Firebird Global Fund LP, did even better. Firebird led macro funds in the three years ended on Sept. 30, with a 43.6 percent annualized return for its U.S. fund, according to HFR.

``Our theme for the last three years has been natural resources and the rise of commodities,'' Passin says.

New York-based Firebird has been trading everything from uranium stocks to gold. It's invested in companies with oil or gas concessions in Africa, Iraq and North Korea, and Passin has traveled to Papua New Guinea to check oil assets there.

Uganda Oil

One pick, Calgary-based Heritage Oil Corp., wants to pump oil in Lake Albert, between Uganda and the Democratic Republic of the Congo. Another, South Korea-based Finetec Corp., makes cryogenic insulation used in liquefied natural gas tankers.

As investors crowded into commodity trades in 2006, Passin pulled back and loaded up on Japanese construction and technology stocks. Now that North Korea has nuclear weapons, Japan is likely to embark on a military buildup that will spur industry and the economy, he says. Japanese stocks, among them Tokyo-based Mitsubishi Heavy Industries Ltd., accounted for 15 percent of Passin's holdings in late October. Only 5 percent of the fund's assets were in U.S. stocks.

To contact the reporter on this story: Richard Teitelbaum in New York at rteitelbaum1@bloomberg.net .