D.E. Shaw, Bridgewater Top List of World's Biggest Hedge Funds

Date: Wednesday, November 30, 2005
Author: Blomberg.com

Nov. 30 (Bloomberg) -- During the past decade, hedge fund managers have emerged as masters of a secretive, $1.08 trillion universe. They rode the 1990s bull market, shorted stocks as the Nasdaq collapsed and made -- and sometimes lost -- vast fortunes. Now, the days of easy money are over. After more than doubling in size since 2000, the hedge fund industry entered the final months of 2005 with almost no hope of reliving its past glories, at least for now. Few investment strategies employed by hedge funds, such as fixed-income arbitrage, convertible bond bets and rapid-fire stock trades, made much money early in the year. By Sept. 30, the average fund worldwide was up 7.4 percent in 2005, according to Hedge Fund Research Inc., a Chicago-based firm that tracks the industry. In October, that return withered to 5.99 percent - - a fraction of the gains posted in the golden years like 1999, when the average manager delivered 31 percent. Generating standout profits will get even tougher. The proliferation of hedge funds and the emergence of megamanagers such as D.E. Shaw & Co. and Bridgewater Associates Inc. will make it harder to spot winning trades. As returns dwindle, the hefty fees that hedge funds charge will cost investors proportionately more, says economist William Sharpe, who won a share of a Nobel Prize in 1990. Funds typically collect a 2 percent annual management fee and take a 20 percent cut of profits. After expenses, hedge funds won't be such great investments. Less Than Treasury Bills ``On average, the clients are going to get less than Treasury bills,'' says Sharpe, chairman of Financial Engines Inc., a Palo Alto, California-based financial planning firm. If Sharpe is right, the repercussions will be felt throughout the financial world. Hedge funds are no longer the exclusive realm of the rich. U.S. public and corporate pension funds have invested billions of dollars in these funds. How wisely -- or unwisely -- managers invest that money will matter to the millions of U.S. baby boomers now nearing retirement age. Which hedge funds might prosper? Bloomberg News has compiled a ranking of the world's best-performing hedge funds in six categories. Our rankings of U.S. hedge funds are compiled from data supplied by Hedge Fund Research. The rankings of non- U.S. funds are based on Bloomberg data. In both cases, the returns cited are for the three years ended on Sept. 30. To make the list, all of the funds, with the exception of convertible-arbitrage funds, must have had assets of at least $100 million as of Sept. 30. For convertible funds, the cutoff was $25 million. Challenges Even the best of these funds face challenges. Fixed-income funds have gotten squeezed in the junk bond market. Convertible bond funds have been hit by an exodus of investor money. Macro hedge funds -- active traders of stocks, bonds and currencies that tend to thrive when markets turn volatile -- have suffered because, for much of 2005, many markets have been anything but wild. A new generation of so-called event-driven hedge funds, meantime, has managed to juice returns by turning shareholder activist. Spiraling energy prices, rising interest rates, spreading bankruptcies, mounting defaults -- these are good times for David Feinman, managing director of Havens Advisors LLC, a New York-based hedge fund firm that invests in troubled companies. Hedge funds that trade distressed assets, typically junk bonds and risky corporate loans, posted an average return of 20 percent during the three years ended on Sept. 30, according to HFR. During the first nine months of 2005, these funds returned 7 percent. `Fertile Ground' ``We are starting to see very fertile ground,'' Feinman says. In this arena, there are plenty of new investments to choose from. Worldwide, 37 companies lost their investment-grade credit ratings in 2005 through Nov. 9, according to Standard & Poor's. Those companies have a total of $511 billion of rated debt outstanding. S&P estimates that 49 more companies, with a total of $73.6 billion of debt, were at risk of losing their investment-grade status as of early November. Lately, some grand old names have landed on the junk bond heap, among them Eastman Kodak Co., Ford Motor Co., General Motors Corp. and Sears Holdings Corp. Delphi Corp., Delta Air Lines Inc. and Northwest Airlines Corp., with combined debt of $68.4 billion, have spiraled into bankruptcy. Brendan Campbell, who tracks hedge funds at London-based Allenbridge Hedgeinfo, a research and ratings unit of Allenbridge Group Plc, says corporate pain makes good pickings for hedge fund vultures. Dwindling Returns Lately, however, so many investors have been hunting for high-yield investments that junk bond returns have started to dwindle. Junk bonds returned 28 percent in 2003 and 10.9 percent in 2004, according to Merrill Lynch & Co. They were up 2 percent during the first nine months of 2005. Hedge fund managers will have plenty of opportunity to buy assets on the cheap in the months ahead, Campbell, 30, predicts. Even more companies are likely to default on debt in 2006, he says. Those in the media, entertainment, energy exploration and retail industries are most vulnerable, according to S&P. ``It's not a bad place to be,'' Campbell says of distressed investing. The York Credit Opportunities Fund, managed by New York-based Dinan Management LLC, returned 33 percent during the three years ended on Sept. 30, the best showing among these funds in the U.S., according to HFR. Carl Icahn During the 1980s and 1990s, Carl Icahn was vilified as a corporate raider. Now, the billionaire financier has leapt back into the spotlight -- as a hedge fund manager. Icahn, 69, has opened two funds to invest in companies he thinks need shaking up. Such event-driven hedge funds, which try to profit from corporate events such as mergers and acquisitions and bankruptcies, have become Wall Street's new shareholder activists. These hedge funds posted an average return of 16.6 percent during the three years ended on Sept. 30, according to HFR. During the first nine months of 2005, these funds returned 6.2 percent. ``Shareholder activism is where people are looking in the U.S. because people are seeing returns stagnate here,'' says Jeffrey Altman, managing partner at New York-based Owl Creek Asset Management LP, whose Owl Creek II LP fund returned 28.4 percent during the three years ended on Sept. 30. Making Noise Icahn and several other activist hedge fund managers, such as Daniel Loeb, who runs New York-based Third Point LLC, have been making noise lately. After Icahn agreed to suspend a proxy fight at Kerr-McGee Corp. in April 2005, the Oklahoma City-based energy company promised to buy back $4 billion of stock. Altman's firm has invested in energy companies, too, including Richmond, Virginia-based Massey Energy Co. He sees value in the U.S. after many investors focused on energy stocks and non-U.S. markets in 2005. ``That leaves lots of opportunities in the U.S.,'' Altman, 39, says. The New York-based Jana Partners LLC fund, run by Barry Rosenstein, was among those agitating for the stock buyback at Kerr-McGee. Jana posted a return of 31.8 percent during the three years ended on Sept. 30, the second-best return among event-driven funds, according to HFR. Gary Claar, a managing director at Jana, says that, for now, event-driven hedge funds will keep flexing their financial muscles to fuel returns. Contrarian Streak Not all event-driven hedge funds have turned activist. Many employ more than one strategy. That partly explains why returns vary so much among event-driven hedge funds. No. 1 LaGrange Capital Partners LP, managed by New York-based LaGrange Capital Management LLC, returned 51.2 percent during the three years ended on Sept. 30. When most people bet on stocks, Thomas Claugus bets against them. And when most people sell, Claugus, 54, buys. A contrarian streak has paid off for Claugus, president of Atlanta-based GMT Capital Corp. His Bay Resource Partners LP fund returned 27.5 percent during the three years ended on Sept. 30, according to HFR. Such long/short equity funds -- which buy stocks, wager against them or both -- posted an average return of 12.6 percent during the three years ended on Sept. 30, according to HFR. During the first nine months of 2005, these funds returned 7.9 percent. The original hedge funds, long/short funds make up the largest segment of the industry. They oversee $318.9 billion of assets, 29 percent of the industry total, according to HFR. Golden Era The 1990s bull market was the golden era of long/short funds. They posted an average return of 44.2 percent in 1999 alone, according to HFR. Nowadays, investors have been slower to pump money into these funds. A net $9.4 billion flowed in during the first three quarters of 2005, putting these funds on course for one of their slowest years since 1997. Claugus occasionally makes big bets. In early 2005, his Bay II Resource Partners LP fund had about 35 percent of its assets in energy stocks, Claugus says. He says he's since pared that figure to about 20 percent net, because he expects oil prices to fall to $45 to $50 a barrel in coming months, from more than $60 on Nov. 4, before prices head higher again. J. Michael Johnston, co-founder of Seattle-based Steelhead Partners LLC, has made some big wagers, too. His JK Navigator Fund LP returned 71.4 percent during the three years ended on Sept. 30, the best showing among U.S. long/short funds, according to HFR. In 2001 and 2002, the fund bought the predecessor to Mittal Steel Co. for about $2 a share. By August 2004, Mittal stock had soared to more than $20 and the company accounted for more than 35 percent of JK Navigator's assets. Thriving on Volatility Since then, the fund has cut its stake to 14 percent of its assets. In 2002, Johnston sank one-third of JK Navigator's assets into technology and telecom stocks such as 3Com Corp. and LSI Logic Corp. Hedge fund manager Paul DeRosa thrives when world markets turn volatile. DeRosa, a partner at Princeton, New Jersey-based Mount Lucas Management Corp., trades stocks, bonds and currencies around the globe and counts on big market swings to generate fat returns. Such so-called macro hedge funds posted an average return of 10.4 percent during the three years ended on Sept. 30, according to HFR. During the first nine months of 2005, these funds returned 4.5 percent. Macro managers had a tough 2005 because financial markets have been relatively calm, DeRosa, 64, says. Mount Lucas's Peak Partners LP fund returned 23.9 percent during the three years ended on Sept. 30, according to HFR. ``For hedge funds to do well, you need large movements,'' DeRosa says. Markets Becalmed Many markets have been becalmed lately. The S&P 500 Index rose just 0.68 percent in 2005 through Nov. 4; the Nasdaq Composite Index was down 0.28 percent. A Bloomberg/EFFAS index of U.S. Treasuries maturing in 10 years or more has bobbed between a low of 294 on March 22 and a high of 323 on June 27; it was up 2.3 percent for the year through Nov. 4. Mount Lucas made some good calls in late 2004, DeRosa says. His fund bet on U.S. petroleum and oil-services stocks, which have soared along with energy prices. It also bet against the euro, which fell 12.8 percent against the dollar in 2005 through Nov. 4. And DeRosa bought Japanese and European equities, profiting from a 22.5 percent rise in Japan's benchmark Nikkei 225 Index through Nov. 4 and a 15.7 percent gain in the Bloomberg European 500 Index. Energy Stocks Robert Holtz, a principal at Greenwich, Connecticut-based Wexford Capital LLC, says macro funds had few standout trading opportunities in 2005. Among them were energy and U.S. utility stocks and equities in emerging markets such as South Korea. ``In general, you did lousy this year unless you were overweight energy,'' Holtz says. WexfordSpectrum Fund LP returned 28.9 percent during the three years ended on Sept. 30, according to HFR. DeRosa says that many investors are sticking with macro funds. Funds of funds, in particular, need to invest in a variety of strategies. ``Nobody who has a brain is going to be dismayed by a subpar year or so,'' Holtz says. ``A perfect storm.'' That's how Jerome Abernathy, managing partner of Stonebrook Structured Products LLC, a New York-based hedge fund firm, characterizes the environment lately for hedge funds focusing on the $48 trillion global bond market. Fixed-income hedge funds posted an average return of 9.5 percent in the three years ended on Sept. 30, according to HFR. During the first nine months of 2005, these funds returned an average of 4.3 percent. Rising Interest Rates Rising U.S. interest rates have hurt many fixed-income funds. Since the U.S. Federal Reserve began raising interest rates in June 2004, two-year U.S. Treasury note yields have climbed, reaching 4.47 percent as of Nov. 4, up from 3.07 percent at the end of 2004. At the same time, 10-year Treasury yields have risen less, to 4.66 percent from 4.22 percent, so funds that borrow money at short-term rates to buy Treasury notes make less money on their investments. It's getting harder to make money trading corporate bonds, too. So many investors are hunting for high-yielding securities these days that the premium that corporate bonds pay relative to Treasuries has dwindled. The yield gap between investment-grade corporate debt and Treasuries fell to 0.92 percentage point on Nov. 4 from 2 points in late 2000, according to Merrill Lynch. In the junk bond market, spreads between BB-rated bonds and Treasuries have fallen to 3.48 points from 9.16 points in that time. Low Spreads ``In the fixed-income marketplace, particularly in the high-yield universe, spreads are at some of their lowest in 10 years,'' says Lorraine Spurge, managing director at Los Angeles- based Post Advisory Group LLC. The firm's Post High Yield Plus Composite Fund, which focuses on BB-rated junk bonds, returned 20 percent in the three years ended on Sept. 30, according to HFR. Investors are still pouring money into fixed-income hedge funds. About $5.2 billion flowed into these funds in the first nine months of 2005, according to HFR. With so much money chasing bond investments, making money won't get easier anytime soon, Abernathy, 46, says. ``It's just going to get worse before it gets better,'' he says. The Galena Street Fund, run by Denver-based Braddock Financial Corp., topped Post High Yield among U.S. fixed-income funds in the three years ended on Sept. 30, returning 20.4 percent, according to HFR. Galena specializes in mortgage-backed securities. `Death March' John Wagner has two words to describe his style of hedge fund investing lately: ``death march.'' Wagner, a managing partner at Los Angeles-based Camden Asset Management LP, oversees two hedge funds that focus on convertible arbitrage, which typically involves buying corporate bonds that can be swapped for stock while betting against those underlying shares. Convertible arbitrage hedge funds posted an average return of 4.2 percent in the three years ended on Sept. 30, according to HFR. That was the weakest showing among the six hedge fund categories in this survey. During the first nine months of 2005, these funds lost 2.7 percent. Among convertible arbitrage funds, Wagner's Yield Strategies Fund II ranked third during the three years, with a 4.3 percent return. ``We're still standing, I guess,'' Wagner, 48, says. He says research -- and luck -- helped him avoid convertibles issued by companies that ended up being downgraded by credit rating companies or taken over, such as Mandalay Resort Group, which was acquired by MGM Mirage in April 2005. Convertible Arbitrage Convertible arbitrage funds have stumbled because so many managers were hunting for investments in the convertible bond market, which totals about $260 billion in the U.S. ``There is a finite number of convertibles,'' says Brett Barth, a partner of New York-based BBR Partners LLC, a family office with about $2 billion in assets. ``Between 60 and 80 percent of that is owned by hedge funds.'' From the end of 1999 through 2004, investors plowed $34.4 billion into convertible arbitrage funds, according to HFR. As money poured in, returns began to shrivel. Michael Rosen, CEO of Context Capital Management LLC, which runs several convertible arb funds, says the flood of investor money drove the prices of convertibles to unsustainable levels. Lately, investors have been bailing out of convertible arbitrage hedge funds. They pulled $5.8 billion out of these funds during the first nine months of 2005, HFR says. That depressed convertible bond prices and pushed the Goldman Sachs Bloomberg Global Convertible Index down 3.5 percent in 2005 through Nov. 4. ``When there's a big boulder rolling down the hill, it's pretty hard to escape,'' Rosen says. To contact the reporter on this story: Richard Teitelbaum in New York at rteitelbaum1@bloomberg.net.