Hedge Fund Street

Bayou Group files for bankruptcy

Bayou Management LLC, the hedge fund group that lost hundreds of millions of investor dollars in a massive fraud last year, filed for Chapter 11 bankruptcy protection recently. In a bid to recover profits that it paid, Bayou has filed suit against previous investors in the firm, including UT Medical Group Inc.'s pension plan and 25 others. Reuters.com reports:

The Chapter 11 filing and lawsuits are the latest in a litany of disgraces for Bayou, which raised some $450 million from investors but lost much of it through a series of flawed trading strategies even as it told investors it was making money.

Read more: Bayou US hedge funds seek bankruptcy protection

Knowing your hedge funds

Knowing hedge fund strategies help you differentiate between various hedge funds. Investment returns, volatility, and risk vary largely among the different hedge fund strategies. There are some strategies, which are not correlated to equity markets and are yet capable of delivering consistent returns with extremely low risk of loss. And then, there are others that may be as or more volatile than mutual funds. If you want to have a successful run in the industry, you should be able to recognize these differences and blend various strategies and asset classes together to create a more stable long-term investment return.

Most hedge funds primarily aim to reduce volatility and risk while at the same time preserving capital. And irrespective of the market conditions, they want to consistently deliver positive returns. This is quite a tall order and hence it makes it doubly interesting to know how you can manage the volatile with the stable to ensure consistent returns.

Do we need to worry about regulation?

I guess we all really need to get a grip on this regulation issue. One time you have just about everyone hankering for regulation, then you have U.S. regulators asserting that there isn't a need for further regulation of hedge funds at this time. And then the European companies get fidgety and are wondering if regulation is a good idea after all.

I think we need to know what makes the Europeans so worried. According to certain European executives, it isn't easy to track what hedge funds are doing, in terms of their investments. And this makes them worried. So what does one European government do to assuage these fears? Last month, the German finance ministry said it would force shareholders to make a regulatory filing when their stake exceeds 3 percent. These disclosure rules are tougher than the 5 percent threshold in the U.S. and are tougher than the 5 percent being proposed for introduction across the European Union in January 2007. Meanwhile, the German Bundesbank has called for self-regulation of hedge funds. It wants industry to create ratings for the risk profile of the various hedge funds.

Meanwhile, in the United States, regulators are still not sure if additional monitoring is necessary for hedge funds. Recently, regulators from the Federal Reserve, Treasury Department, SEC, and Commodity Futures Trading Commission testified before a Senate subcommittee that they needed to better understand hedge funds before prescribing additional regulations.

Probably, these increased calls for regulation stem from the fear that given the large amount of money in the business – around $1.5 trillion world-wide – there is a very high scope of indiscretion and even unethical business practices.

Pension funds to invest in European hedge fund market

Mercer Investment Consulting, which surveyed more than 570 European pension funds with $364bn under management found that some 13% of continental European and Irish pension funds invest in hedge funds. This was almost double the number in the UK. Hedgeco.net reports:

“In the UK, 7% of funds invest in hedge funds, spending 6.9% of their assets on average,” Mercer said.

Read more: Pension Funds to Invest in European Hedge Fund Growth

Europe puts hedge funds under scanner

Hedge funds’ popularity seems to have become their undoing. This popularity and high profile is prompting European governments to examine ways to curtail their rising power and to consider new rules for fund investors. The governments' efforts are being championed by influential European corporate executives. These executives are unhappy about the way hedge funds can use relatively small stakes in publicly listed companies to agitate for change.

Historically, hedge funds have been lightly regulated because they were funds for extremely wealthy, sophisticated investors. But now, as there is more money in the business, the pressure to increase oversight has increased. This pressure is visible in both Europe and in the U.S. Post-gazette.com reports:

Earlier this month, U.S. regulators said there isn't a need for further regulation of hedge funds at this time. Regulators from the Federal Reserve, Treasury Department, SEC, and Commodity Futures Trading Commission testified before a Senate subcommittee that they needed to better understand hedge funds before prescribing additional regulations, with some officials cautioning that the current way of regulating funds -- indirectly by focusing on counterparty risk -- is effective.

Read more: Hedge funds get Europe's scrutiny

Campus’ favor Hedge Funds

When institutes of higher education like Harvard and Yale begin to invest in hedge funds, it does give more than just a little respectability to the entire business. It also begins to make people realize that hedge funds are not the disaster-prone financial instruments that most laymen assume them to be. Hedgeco.com reports:

There are also some rising concerns toward this new trend, some endowments that have been trading in hedge funds are reconsidering. Oberlin College in Oberlin, Ohio, is one of them.

Read more: Investing in Hedge Funds on Campus

Are hedge funds aggressive enough?

As the hedge fund industry has grown into a multi-billion industry in the past few years, it has become the focus of increased attention both from investors and regulators. Most investors believe that hedge funds are their ticket to high returns and this belief has led just about everyone to jump onto the hedge fund bandwagon.

Everyone wants to invest in a hedge fund once they are convinced that the term is synonymous with 25 percent-plus annual returns. But this kind of return creates problems with regulators who are not convinced that the extraordinarily high returns that hedge funds earn come the right way. They believe that this mode of earning is either extraordinarily risky or crooked. Hence their eagerness to protect investors and put curbs on hedge funds.

How many investors have actually asked themselves what makes hedge funds so special? Are the high returns on investment due to certain techniques, mode of investment or is it something else. I’m sure most investors are just too happy earning their high ROIs to bother about modes and methods. But to understand how the high returns come, it is important to understand hedge funds.

One of the biggest misconceptions about hedge funds is that it can provide high returns on the invested amount. Yes, the rate of return is quite good when you compare it with mutual funds. However the ability of hedge funds to generate high returns diminishes as with larger asset holdings get larger. Today, hedge funds are estimated to be managing about a total of $1 trillion or about 7 percent of total U.S. financial net worth. And returns to large hedge funds are averaging anything between 10 and 15 percent annually. This may be high when compared to the single-digit returns on US equity markets, but not as high as it used to be when hedge funds were more aggressive.

Hedge funds and monitoring

Simply put, hedge funds facilitate investors who are relatively uninformed, to make portfolio choices that enhance their investment value. The competitive nature of the market ensures that the pricing is relatively efficient. However, it is the volume of money in the market that makes the Federal Reserve and enforcement agencies a bit jittery and that is understandable.

Probably what is needed is a little tweaking of the market rules. While the ability of hedge funds to operate across different market sectors makes them ensure the fairness of prices across different market contexts and various margins for pricing, it probably isn’t enough. There are certain systemic risks that have the ability to cause losses to the partners involved. Hence they need to be eliminated and that can be done by getting the various parties involved in the hedge fund market, to help the authorities thrash out a solution that is acceptable to everyone.

No regulation for hedge funds

Hedge funds have suddenly become the rage all over. What was considered a risky adventure fit for those moneyed few, has suddenly become one of the best methods of making money. And this has led to an explosive growth of this once reviled method of investment. Today the mounting integration of hedge funds into the world financial system has made most industry experts and even central bank policy-makers wary. They believe that hedge funds have increased the risks in the industry and need to be minutely scrutinized.

Sounds more like a doomsday warning. While on the one hand, this industry has got a lot of credibility thanks to institutional investors investing their funds into the hedge fund market, there are others who believe that the growth of hedge funds could have serious implications. However, Federal Reserve Chairman Ben S. Bernanke, like his predecessor, does not think regulating hedge funds is a good idea. Rockymountainnews.com reports:

Bernanke on Tuesday told a hedge-fund conference hosted by the Atlanta Fed that he's skeptical about proposals such as a database of fund holdings that would let authorities monitor risk in the broader financial system. Instead, firms that deal with hedge funds are best equipped to do the job because they have the "best incentives".

Read more: Fed chief wary of regulating hedge funds

Pension funds still wary of hedge funds

Despite hedge funds being touted as the next big thing, and quite a few institutional investors now trying them out, pension funds are still wary of hedge funds. A recently released study shows that pension funds invest only a small fraction of their assets in hedge funds even as these lightly regulated portfolios pull in billions of dollars in new assets every month. Reuters.com reports:

Some of the industry's best performing hedge fund managers have turned away pension fund money both because trustees often want more transparency and because they would have to invest pension funds' big chunks of money which might make the hedge fund less nimble in trading.

Read more: Pension funds not big hedge fund investors-report

Hedge funds resemble mutual funds?

The total amount estimated to be managed by hedge funds stands at $1 trillion today; or about 7 percent of total U.S. financial net worth. And returns to large hedge funds, those with over $3 billion under management, are averaging between 10 and 15 percent annually. This is a far cry from the 40 and 50 percent that hedge fund managers used to get for their investors a few decades ago. Hedge funds began making money through their aggressive inclination to invest in more rapidly rising foreign stock and bond markets. However, as institutional investment in hedge funds increases, there is now a call for hedge funds to be less risk-taking and provide a more stable rate of return over a long period of time – something like a mutual fund.

Then what pray is the difference between the two types of funds now? Well despite the need to restrain more aggressive activity, hedge funds can still pursue a more unconstrained investment approach than most mutual funds. They can still employ leverage by going short, and pursuing multiple strategies. However, that does not deter from the fact that hedge funds ARE slowly beginning to resemble mutual funds. And the most obvious similarity is the structure.

Hedge funds are increasingly being structured more like mutual funds. Investment strategies that depend on long-only equity have allowed more institutions to expect a fixed rate of return on their investments annually. However, the downside of this effect is that despite hedge funds resembling mutual funds, their fee structure is still on the high side. Most hedge funds employ a two-and-twenty fee structure wherein the hedge fund manager gets 2% of the investments to operate the fund for the first year plus 20 percent of the upside of anything he earns. This fee structure often leaves small investors with returns no greater than, or sometimes less than, returns on mutual funds.

Merger arbitrage helps stabilize returns

Hedge funds by their inherent nature involve risks. If you are dealing in the market, you are expected to make a few profits and losses. However, there is one tool that is designed to ensure profits regardless of the direction the equity market takes. Sounds intriguing? Called merger arbitrage, this strategy takes advantage of the expected price movements or arbitrage opportunities that occur after the announcement of a merger or acquisition offer.

Now that you know what a merger arbitrage is, let’s examine how it works. Once a company makes an announcement of its intent to acquire another firm, the price of the target company's stock will go up. If you notice carefully, it does rise but usually not to the full offering price. And since there is a risk of the deal not closing on time or at all, the target company's stock may sell at a discount to its value at the merger's closing. This discount usually increases with the expected length of time until closing and the perceived risk of the deal. Now wit the merger arbitrage strategy, you can lock in this spread.

Hedge funds rise in April

According to new data released by research and ratings firm Standard & Poor’s, hedge funds rose 1.01 percent in April, recording the sixth month of straight gains. Hedge funds now manage nearly $1.2 trillion as pension funds. Reuters.com reports:

"Six out of nine hedge fund strategies performed well in April," said Justin Dew, senior hedge fund analyst at S&P. He cited rising interest rates plus the skyrocketing commodity market as reasons for the slightly regulated asset class' strong performance.

Read more: Hedge funds gain ground in April-S&P

‘Hedge funds could cause problems in case of a financial meltdown’

Around last month, Europe’s financial regulators simulated a continent-wide financial crisis. This was just to check the veracity of claims that they are ill prepared to stop a problem in one country spreading across borders. And one of the areas that could be troublesome is the hedge fund sector. News.ft.com reports:

However, the report warned that hedge funds and credit derivatives were sources of concern “as related risks remain opaque and they have become extremely relevant in assessing financial stability both across borders and across all financial sectors”.

Read more: Europe simulates financial meltdown

Hedge Funds are the flavor of the season on Campus

When institutes of higher education like Harvard and Yale begin to invest in hedge funds, it does give more than just a little respectability to the entire business. It also begins to make people realize that hedge funds are not the disaster-prone financial instruments that most laymen assume them to be.

In June 2005, Harvard and Yale invested 12 percent and 25 percent of their respective endowments in hedge funds. Their success in the field has encouraged many of the nation’s biggest schools to follow the Ivy League into hedge fund investment. The statistics tell the tale: Reed College in Portland, Oregon, has 58 percent of its endowment in hedge funds, and Hobart and William Smith Colleges is at 54.7 percent. And then there are schools, which have also invested in hedge funds. And then there are some small schools that are known to have hedged more aggressively than their larger counterparts. Hedgeco.com reports:

There are also some rising concerns toward this new trend, some endowments that have been trading in hedge funds are reconsidering. Oberlin College in Oberlin, Ohio, is one of them..

Read more: Investing in Hedge Funds on Campus

‘Hedge funds not as risky as private equity’

Well, if you ever needed confirmation, here it is. ABN Amro recently admitted that lending to hedge funds was not as risky as exposure to leveraged buyouts by private equity funds, which like corporate borrowing a few years ago poses a bigger risk to investment banks. Reuters.com reports:

Hedge funds mostly trade listed stocks, fixed income securities, currencies and commodities. Private equity firms buy companies they think are cheap and pay for the transaction by loading the firm's balance sheet up with debt, using leveraged loans and high-yield bonds, which can become a problem when interest rates rise and growth slows.

Read more: Hedge funds less risky for banks than private equity

Hedge fund strategies

Today, I will continue on the topic of hedge fund strategies, their types and differences. Now there are some among you who are probably wondering why we need to know about hedge fund strategies. Well, one of the simplest and most basic reasons to study them is because it helps you know the difference between various hedge funds. Investment returns, volatility, and risk vary largely among the different hedge fund strategies. There are some strategies, which are not correlated to equity markets and are yet capable of delivering consistent returns with extremely low risk of loss. And then, there are others that may be as or more volatile than mutual funds. In case you want to have a successful run in the industry, you should be able to recognize these differences and blend various strategies and asset classes together to create a more stable long-term investment return.

Most hedge funds primarily aim to reduce volatility and risk while at the same time preserving capital. And irrespective of the market conditions, they want to consistently deliver positive returns. This is quite a tall order and hence it makes it doubly interesting to know how you can manage the volatile with the stable to ensure consistent returns.

And one final thing. There is a common belief or should I say misconception that hedge funds are volatile by nature. People who don’t know much about these funds believe that hedge funds use global macro strategies and use lots of leverage to place large directional bets on stocks, currencies, bonds, commodities or gold. Sadly, the reality is not so romantic. Less than 5 percent of hedge funds can claim to be global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all. And most importantly, many funds use no leverage.

Hedge fund strategies

This one’s for those who are interested in hedge funds but don’t know much about them. Let me give you a little tutorial about two hedge fund strategies.

There is a popular misconception that all hedge funds pursue an aggressive growth policy. Nothing could be further from the truth. Of course, there are those who do adopt this policy. A hedge fund that has an aggressive growth strategy, invests in equities that are expected to experience acceleration in growth of earnings per share. These equities usually Includes sector specialist funds such as technology, banking, or biotechnology. When using this kind of strategy, the hedge fund manager will hedge by shorting equities if the earnings are not up to mark or by shorting stock indexes.

Then there is the distressed securities strategy wherein the hedge fund buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Next time, we will discuss more strategies.

Hedge Fund guilty of investor fraud, chief held

You know what is the worst part about a fraud of any kind – innocent investors losing a great deal of money and something more important, their faith in the system. Recently Keith G. Gilabert, the founder of an investment firm that operated a hedge fund called the GLT Venture Fund has agreed to plead guilty to federal charges that may have cost investors nearly $14 million. He has admitted to lying to investors about the fraudulent operation. Hedgeco.net reports:

The Justice Department said Gilabert stole at least $2.5 million of investor money for his own use. And he continued marketing his fund throughout 2004, officials said, even though Capital Management’s investment advisor registration had been revoked by the California Department of Corporations in 2003, Gilabert declined to comment.

Read more: Hedge Fund Chief to Plead Guilty to Investor Fraud

Hedge funds beware: Big bro’s watching

Here is the latest update on the regulations imposed on hedge funds by the Securities and Exchange Commission (SEC). I recently wrote about how the SEC was getting serious with hedge funds. In February, the Commission asked most hedge funds to register as investment advisors. Now as a follow-up, the SEC is targeting funds that have weak internal controls for regulatory action.

As part of its new compliance regulations, the agency plans to conduct audits at least every three years. This will be especially for funds that meet their ‘high-risk’ criteria. In my opinion, while some amount of regulation is good, at the end of the day, market forces will make these funds become self regulatory. Of course, a little nudge from the authorities never did any harm. Latimes.com reports:

Factors related to a fund's "internal control environment" are at the center of what constitutes high risk, said Elizabeth Jacobs, deputy director of the SEC's Office of International Affairs.

Read more: Regulators to Scrutinize 'High-Risk' Funds

Hedge funds come under federal supervision

As per the new rules from the Securities and Exchange Commission, any hedge fund which has more than $30 million in assets, 15 or more investors and a lock-up period of less than two years will have to register as investment advisors under the Investment Advisors Act of 1940. Thanks to this mandate, there are quite a few new requirements that must be addressed immediately. Some of them include appointing a chief compliance officer, improving record-keeping practices and submitting to periodic audits from the SEC.

But there are some things no hedge fund will compromise on. Secrecy of investments is still of prime importance to the industry. So, though hedge funds must register with the SEC, they do not have to disclose their investments or investment methods, unlike mutual funds managers. And the hedge fund industry is not going to let go of this privilege. They are committed to fighting further regulation because according to them, maintaining the secrecy of investments and strategies allows it to exploit market anomalies. Looks like this is one area the SEC cannot breach.

Hedge funds try to limit risks

Yesterday, I wrote a short piece about how hedge fund managers seem to be reluctant to make risky investments. Doesn’t this sound a bit odd? I mean hedge funds are supposed to make money the risky way so how do these managers hope to make big money without taking adequate risks. Their argument is that their customers don’t want them to deal in such investments. So, for fear of losing these customers and more importantly, their fees, which can only be called exorbitant, hedge fund firms are now learning to play safe.

This sudden change in what is essentially a risk-taking business came about slowly. As fund managers realized that they were making a killing by raising money from pension funds, endowments, insurance companies and other institutional investors, their taste for the dangerous diminished. And the clincher was the 2 percent per annum management fees from large amounts of assets. With all these benefits, it didn’t take long for caution to become the new byword for hedge fund managers.

The sector's profile witnessed a change after institutions poured money in and drove worldwide hedge fund assets to more than $1,000bn. This large amount of money has weighed heavily on hedge fund performance and has led to ‘overcrowding’ in many strategies. Then there were institutional investors like pension funds which have asked the hedge funds in which they invest, to reduce their risk levels.

However, any which way you look at it, hedge fund firms seem to be the gainers. As they reach critical mass, these firms begin to slowdown their aggressive activity and try to appease their major clients. This strategy of caution allows other investors to repose more faith into these firms, which then translates to more business and more money.

Are hedge funds trying to be risk-free investments?

Are hedge funds refusing to hedge bets on risky investments? It would seem so if GAM, the world’s biggest hedge fund firm is to be believed. According to GAM, it is hard to find managers who are prepared to take the levels of risk needed to produce the high returns wealthy investors demanded. News.ft.com reports:

David Solo, chief executive of GAM, which manages $55bn for private clients including $23bn in hedge funds, said the change in managers' risk appetite stemmed from their success in raising money from pension funds, endowments, insurance companies and other institutional investors

Read more: Hedge funds try to limit risk to avoid losing fees