Secrets Of Success: Hedge funds' heyday may be over

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Not many readers of this page, I trust, will be drowning their sorrows over the spectacular losses that were run up last month by the now infamous hedge fund Amaranth Advisors. Having lost some $6 billion on a series of bets on natural gas prices that went wrong, the fund is, unsurprisingly, looking to wind itself up and return what is left of its assets to its investors.

Amaranth now enjoys the dubious distinction of having lost even more money through a trading mishap than Long Term Capital Management, the hedge fund that went down spectacularly in 1998.

That collapse sent shivers through the entire financial system and prompted the Federal Reserve to organise an emergency rescue by a consortium of banks.

It is by no means a coincidence that both Amaranth and LTCM are based in Greenwich, Connecticut, the quiet and ultra-wealthy enclave that has become the unofficial capital of the hedge fund industry.

Losing $6 billion in the space of two weeks is certainly going some, but on this occasion, although the losses have wiped out up to 70 per cent of Amaranth's capital, there have been few repercussions on the wider financial system.

This may be partly because the losses were concentrated in a large but specialist market and partly also because the financial world is better equipped these days to handle trading accidents on this scale.

After pressure from investors and bankers, the loss-making natural gas positions that Amaranth and its "star trader" Brian Hunter had taken were swiftly sold on to JP Morgan Chase and a rival hedge fund. Investors in the fund are now waiting to see how much of the remaining assets they can recover.

Like most hedge funds, Amaranth imposed a series of "lock-up" clauses that effectively mean its investors can only redeem their money after a period of notice (in its case, three months, though the lock-up can often be for as long as a year).

Even these restrictions, according to press reports, could be overridden in the case of Amaranth if a rush of investors all tried to redeem their money at the same time.

The lack of liquidity, while understandable, is one of the features that make hedge funds less than ideal investments for private investors. Having said it will suspend the redemptions due at the end of September and October, it looks as if Amaranth now plans to try to find a single buyer for its remaining assets, rather than allowing itself to experience death by a thousand redemptions.

While Nicholas Maounis, the founder of Amaranth initially said that he wanted to stay in business, there was never any realistic chance of that happening.

Once a fund of any kind incurs losses on this scale, investors always pull the plug, however great the profits that the fund may have made before (and Amaranth had done extremely well in the previous two years).

What I find interesting about the Amaranth saga is that it so neatly sums up the best and the worst features of the hedge fund business. It is true that generalisations can be dangerous, because the strategies that hedge funds pursue are so wildly different.

While some funds are high-risk endeavours that make hugely leveraged bets across a range of markets (the George Soros model), other funds take so little risk that they appear to be almost comatose.

The only things all hedge funds have in common are a distinctive fee structure (typically a 2 per cent management fee and a 20 per cent share of any profits made) and a willingness to pay lip service to the idea that what they are interested in is absolute returns.

Only a minority, in practice, pursue the classical hedging strategy that AW Jones, the inventor of hedge funds, employed and which gives hedge funds their name.

Nevertheless, what can be said with confidence is, first, that the way that hedge funds are marketed does not always square with the reality of what they do; and second, that their lopsided fee structure, while ostensibly aligning the interests of investors and managers, in practice often does the opposite.

The big selling points that have drawn increasing numbers of pension funds into hedge funds are the talent they attract, the absolute returns they promise and the limited correlation of hedge fund returns with those of equities and other mainstream asset classes.

In many cases these advantages are genuine. In the right hands, as Yale and other institutions have shown, hedge funds can make a consistently useful contribution to both the returns and risk profile of an investment portfolio. However, the real risk in many hedge fund strategies is hard to establish, and in practice investors often fail to appreciate quite what they are getting into. Past performance figures for hedge funds, in particular, are notoriously unreliable for a range of reasons.

One notable feature of the Amaranth case is that a number of fund of hedge funds, including ones run by Goldman Sachs and Morgan Stanley, held positions in Amaranth.

While a fund of funds structure is a safer way to invest in hedge funds, it clearly does not totally eliminate the risks. And as fund of fund managers charge an extra layer of fees for their services, it is legitimate to ask what they are being paid to do, if not to monitor and supervise what funds such as Amaranth are doing.

In the past two years alone, well over 2,000 new hedge funds have been set up and more than 1,000 have closed down, sometimes because of losses, occasionally because of fraud, but often because they simply cannot attract enough money to remain viable.

Having been given a huge boost by the 2000-2003 bear market, which made the concept of absolute returns look very attractive in comparison, it will be no surprise if the whole hedge fund bandwagon finally now starts to slow down.

There is too much money chasing too few opportunities and the flaws in the hedge fund model are becoming all too apparent.

jd@intelligent-investor.co.uk

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