Hedge Funds Hold More Appeal Than Their Managers

Date: Tuesday, December 15, 2009
Author: Matthew Lynn

As investors make a year-end review of their portfolios, they will see that after all the predictions of the demise of the banking industry earlier this year, most financial stocks have done pretty well.

Except for one group: hedge-fund management companies.

While the rest of the financial industry has largely recovered from the credit crunch, the small group of publicly traded hedge funds is in the doldrums. They have about as many friends as Tiger Woods at a convention of marriage guidance counselors.

There is a lesson in that. Once markets tank, as they did a year ago, and once a fund stops making money, then it is very hard for it to earn decent returns again.

Investors should invest in hedge funds. Many of them will do very well. But they probably should steer clear of the companies that run them.

Two of the most dynamic hedge fund managers in London, RAB Capital Plc and Charlemagne Capital Ltd., have both seen their shares soar this year. But when you consider how beaten down they were, that isnít much consolation.

RAB was one of the most successful of Londonís new breed of hedge funds. At the peak in 2007, its shares touched 126 pence. Now they are worth less than 20. During the worst of the credit crunch they went all the way down to 6 pence.

Shares in Charlemagne, which specializes in emerging market funds, climbed to more than 100 pence at their peak in 2006. They are now trading at 16 pence, after reaching 7 pence when the market was at its worst.

Across the Atlantic

Over in the U.S., GLG Partners Inc. hasnít fared a great deal better. Its shares peaked at almost $15 back in 2007. They are just over $3 now, having dipped below $2 when the market tanked. At their peak they touched $14.97.

Even the big daddy of the industry, the giant Man Group Plc, isnít the star it once was. Its shares have declined from a peak of more than 700 pence in 2007 to a little more than 300 pence now. That isnít a disaster given what has happened to the market. But it does suggest the company isnít the automatic money-making machine it once was.

Contrast that with some of the big, mainstream financial firms. The banks have largely recovered since the crash. So have many of the traditional fund managers and insurers.

Consider Edinburgh-based Standard Life Plc. Its shares now trade at a little more than 200 pence, down from their 2007 peak of 357 pence in 2007. But on the whole they havenít witnessed the catastrophic collapses that have hit the smaller hedge funds.

Market Slump

True, any hedge-fund manager is going to do badly when the markets slump. In a bull market, your assets under management grow and grow without you having to do very much more than watching the money pile up in your bank account. You rake off bigger fees automatically. In a bear market, that virtuous circle turns vicious. Your assets are going to shrink no matter how hard you are working.

So what is up with the hedge funds? And what lessons can be learned about how the industry operates?

It would be wrong to pick on the four companies that happen to have stock market listings. In reality, their performance is not likely to be much worse than any of their private rivals. They are staffed by bright people. They may well come through with a terrific, market-trouncing performance next year that will see their shares spinning to fresh highs.

Even so, there are three broad lessons that can be drawn.

In a Hole

First, the way many funds are structured makes it very hard for them to make money after a crash. The big money in hedge funds is made from the performance fee, not the charge on assets. Once a fund is underwater, it might take years to get it back into profit, even with the most successful managers in charge. There may be years when you are only covering the cost of the rent and receptionists without the fund itself making a bean.

Next, there may well be a gradual attrition of talent. Hedge funds depend crucially on a few brilliant individuals who can read the market, or design the software that exploits a pricing wrinkle somewhere. Those people are guns for hire: they work for whoever pays best. If a fund isnít making money any more, and has to worry about getting its share price back up before it rewards the staff, donít be surprised if the best brains start to drift away.

Watch the Founders

Finally, watch the founders. When a hedge fund lists its shares, it isnít because it needs capital to expand. All a fund needs is a ritzy address in Londonís Mayfair, a bolt-hole in Zurich (in case the British taxes get even worse), and one of those really fancy espresso machines. If the guys who set up the fund have cashed in a lot of their chips during the initial public offering, are they really committed to the company? Probably not the way they once were.

Three years ago, it looked like we might see a wave of hedge fund IPOs. Firms such as RAB and Charlemagne were the advance guard. If they had gone well, we probably would have seen dozens of hedge funds join the stock market.

And now? Forget it. The lesson of the few funds that have sold shares to the public is that hedge funds are better off staying private. The record isnít good enough for outsiders to want to invest in them.

(Matthew Lynn is a Bloomberg News columnist. The opinions expressed are his own.)

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To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net.