How to run a hedge fund…poorly

Date: Friday, May 9, 2008
Author: Arnold Joe, GuruFocus

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There were reports out today that Drake Management LLC (a hedge fund) is shutting down its largest hedge fund and may plan to start another. This is a classic example of what exactly is wrong with hedge funds.

A hedge fund manager is paid an incentive bonus if the fund that is being managed is able to achieve returns greater than some benchmark. In other words, the fund manager shares in the profits when profits are good but doesn’t share in the losses. This type of incentive program encourages risk taking as the fund manager will do very well if the risk pays off but doesn’t suffer the pain of a big loss.

If I was running a hedge fund (and didn’t have any morals), I would do exactly what many of the hedge funds are doing. First, maximize the leverage of the fund by borrowing the maximum amount of floating rate debt. Second, take the equity and debt proceeds and invest in something with a high yield. If nothing changed for the worse, the fund would be very profitable and I as the manager would get a huge bonus check. Investors would be very pleased with their above average returns and won’t think twice about my huge compensation. The typical investment strategy would be to invest in some high yield debt while borrowing at a lower floating rate debt. Another investment alternative is to borrow in a currency where interest rates are low and invest the proceeds in a currency where the interest rates are high e.g. borrow in Japanese Yen where the interest rates are near zero and invest in Latin America where the interest rates are much higher. If the foreign exchange rates don’t move too severely against the fund manager, the strategy will be very profitable as some returns in Latin America are in the double digits.

Of course there are lots of risks with these strategies; for one, the assets could go bad e.g. funds that invested in sub-prime loans, CDO etc. As the value of the assets go down, the banks that lent the money to the fund will demand a margin call (to protect their loans) forcing the fund to sell assets in a poor market. Secondly, the short term rates could go up or the banks could refuse to renew the loans (especially when they are trying to conserve their capital after taking some massive losses themselves). Third, Hedge funds that exposed themselves to the foreign exchange rate have to worry that the currency that they borrowed in strengthens against the currency that the fund invested in. In normal times these strategies work as the positive carry (the investing rate is higher than the borrowing rate) provides a cushion. But when hedge fund managers get too greedy and employ too much leverage on very risky assets that don’t provide enough cushion, it’s much easier for the fund to experience very large losses compared to a fund that is managed more conservatively.

So what does the over-levered fund manager do when there are large losses? He simply closes down the fund, mutters an apology and starts up a brand new fund. New investors unfamiliar with the fund manager fund might not know that the previous fund run by the same manager had just blown up.

So who wants to invest in Drake’s newest fund?…so far the fund hasn’t had any losses even during all the market turmoil. You’d think they must be doing something right.

How do I get a job managing a hedge fund?