Despite a Rough Year, Hedge Funds Maintain Their Mystique

Date: Monday, November 28, 2011
Author: Azam Ahmed

Hedge funds, the golden children of finance, are having a very rough year.

For one, they are not making money the way they used to. Returns for a number of funds, including those of star managers like John A. Paulson, have fallen by as much as half this year. And that poor performance comes just as these investment partnerships are coming under increased regulatory scrutiny.

Yet the money keeps pouring in, even for Mr. Paulson.

This year alone, more than $70 billion in new money has gone to hedge funds, mostly from pensions and endowments. A recent study by the industry tracker Preqin found that 80 percent of investors were weighing new allocations to hedge funds, and 38 percent of investors were planning to add to existing ones.

One bad year for hedge funds can be written off. But most investors rarely enjoy a bounty of returns even over the long run. The average hedge fund investor earned about 6 percent annually from 1980 to 2008 — a hair above the 5.6 percent return they would have made just holding Treasury securities, according to a study published this year in The Journal of Financial Economics.

So why would large investors pay hedge funds billions of dollars in fees over the years for those returns? The answer highlights the financial problems at the country’s largest pensions.

As waves of workers prepare to retire, pensions find themselves in a race against time. Short of what they need by an estimated $1 trillion, according to the Pew Center on the States, public pensions are seeking outsize returns for their investments to make up the gap. And with interest rates hovering near zero and stock markets gyrating, the pensions and others are increasingly convinced that hedge funds are the only avenue to pursue.

“Even with the short-term ups and downs, at the moment there is not a credible alternative with the same risk profile for pensions,” said Robert F. De Rito, head of financial risk management at APG Asset Management US, one of the largest hedge fund investors in the world.

Hedge Fund Investments Rise

Hedge funds, once on the investing fringes, have become a mainstay for big investors, amassing huge amounts of capital and accumulating more of the risk in the financial system.

The effect of this latest gold rush into hedge funds is unclear. Some argue that the hedge fund industry’s rapid growth — it has quadrupled in size over the last 10 years — has depressed returns. Others, meanwhile, wonder whether the bonanza in one of the most lightly regulated corners of the investment universe will have broader, less clear implications.

“I worry that institutions are betting on an asset class that is not well understood,” said William N. Goetzmann, a professor of finance at the Yale School of Management. “We know that the real long-term source of performance is not picking someone good at beating the market, it’s taking risks on meat and potato assets like stocks and bonds.”

The growth has been fed in part by more sophisticated marketing — most funds now have employees whose jobs are to manage relationships with investors and to seek out new ones, jobs that were uncommon a decade ago. And there is still a mystique: funds that have had at least one spectacular year have excelled at raising and keeping money.

Despite the appeal of a blowout year, however, performance tends to peter out after investors jump into a hot new fund. Yet even with the lackluster returns of late, many investors have resigned themselves to sticking with hedge funds. The financial crisis taught them that even more important than making money was not losing the money you had.

Reflecting that perspective, hedge funds have started to change how they sell themselves. For decades, funds have marketed themselves as “absolute return” vehicles, meaning that they make money no matter the market conditions.

But as more and more money crowds into them, the terminology has started to change. Now, managers and marketers increasingly speak of “relative returns,” or performance that simply beats the market.

“In general, they’re probably not going to have the blowout returns of the ‘80s and ‘90s,” said Francis Frecentese, who oversees hedge fund investments for the private bank at Citigroup. “But hedge funds are still a good relative return for investors and worth having in the portfolio.”

Gauging by the inflows, pensions seem to agree.

This year, major pensions in New Jersey and Texas lifted the cap on hedge fund investing by billions of dollars. The head of New York City’s pension recently said its hedge fund investments could go as high as $4 billion, a roughly tenfold increase from current levels. Illinois added another $450 million to its portfolio last month, which already managed about $1.5 billion in hedge fund investments.

About 60 percent of hedge funds’ total $2 trillion in assets comes from institutions like pensions, a big shift from the early days when hedge funds were the province of ultra-wealthy individuals.

As the investor base has changed, hedge funds themselves have grown into more institutional businesses. The biggest firms have vast marketing, compliance and legal teams. They hire top-notch accounting firms to run audits, and their technology infrastructure rivals that of major banks.

They make money even off mediocre returns. A manager overseeing $10 billion, for instance, earns $200 million in management fees simply for promising to invest the assets. Investment returns of 15 percent, or $1.5 billion, would translate into another $300 million in earnings for the hedge fund.

By contrast, a mutual fund that invests in the shares of large companies charges less than half a percent in management fees, or less than $50 million.

Psychology plays a meaningful role in hedge fund investing. Investors often pile into the hottest funds, even well after their best years are behind them.

This year’s must-have manager is John A. Thaler — despite having closed his fund to new investors last year in the face of a flood of money. While little known outside Wall Street, Mr. Thaler and his stock-picking prowess have been the talk of the hedge fund world. A former star portfolio manager at Shumway Capital Partners, Mr. Thaler developed a reputation early on as an astute analyst of media and technology companies.

His hedge fund, JAT Capital, had done well since its founding in 2007, and this year, as returns climbed to 40 percent amid the market upheaval, investors clamored to gain entry.

Then, last month, two of his biggest holdings, Netflix and Green Mountain Coffee Roasters, took a bath. His fund fell by nearly 15 percent in a few short weeks, a reminder that even high-flying managers can quickly fall back to earth.

But few hedge fund managers have risen and fallen so quickly and so publicly as Mr. Paulson, the billionaire founder of the industry giant Paulson & Company.

He made his name after earning billions of dollars in 2007 and 2008 with a prescient bet against the subprime mortgage market. Afterward, investors clamored to get money into the fund, and by the start of 2011 assets had swelled to $38 billion.

This year, Mr. Paulson has lost gobs of money on an incorrect call that the United States economy would recover. One of his major funds was down nearly 50 percent, while others fell more than 30 percent. Investors who poured money into Mr. Paulson’s hedge fund after his subprime bet have given back gains from 2009 and 2010, according to an investor analysis.

But last month, when investors had the opportunity to flee the fund that had suffered the worst losses, most instead chose to stick around. Some even put more money into Mr. Paulson’s funds, despite losing almost half of their holdings this year.