Hedge Fund Street

Fund of Funds & Returns

When choosing between a hedge fund and a fund of funds, one of the most decisive factors is the rate of returns. Just like mutual funds are for people who cannot stand the volatility of the stock markets, fund of funds help investors who don’t have a taste for risk. Since returns are assured, a fund of hedge funds is the preferred investment of choice for many pension funds, endowments, insurance companies, private banks and high-net-worth families and individuals.

What are the benefits? Well, since you get access to a broad range of investment styles, strategies and hedge fund managers, your returns are more predictable than traditional investment funds. Another big time benefit is that it allows you access to a broader spectrum of leading hedge funds that may otherwise be unavailable due to high minimum investment requirements.

Amaranth's Collapse Met With a Shrug

If my going on about the Amaranth collapse worries you, please bear with me. It’s just that I have been writing about huge losses for a long time, but this is the first time I get to experience a really BIG loss and know its effects. There are so many contradictory views about the effect that this fall would have that I felt it was only fair to present all views to you. The frenzy of activity that surrounded the implosion of a large hedge fund in 1998 is strangely missing this time. When hedge fund Long-Term Capital Management (LTCM) imploded, a huge group of Wall Street's most powerful bankers and brokers assembled with the New York Federal Reserve governor to devise a $3.5 billion bailout plan. This was expected to prevent a bout of panic selling in world markets.

I wonder if Amaranth Advisors LLC officials are ruing the fact that the markets just shrugged their losses off and didn’t give it more than a few moments’ thought. No, I’m not being flippant about this huge loss – just wondering how it happened that J.P. Morgan & Co. and Merrill Lynch & Co. just quietly took over and started selling off Amaranth's portfolio of ill-timed natural gas futures.

So, what’s different this time around? Analysts put it down to a belief that the market can absorb this ‘minor hiccup’! One big difference is that LTCM borrowed heavily and its failure threatened the stability of banks. So a fire sale of its assets would have hit securities held by almost every fund and investor. While Amaranth engaged in a similar form of rash trading as LTCM, it borrowed less heavily. Moreover, its positions were smaller and focused mostly in natural gas futures. So, the firm's downfall hasn’t hurt the broader markets.

The future of Hedge fund fees is bright!!

One would assume that with the growing number of hedge funds, there would be some undercutting in the fees charged by the fund managers. This is not what the reality is. Most funds continue to charge 2% of asset as asset management fees and 20% of profits as their performance fees. The fee charged by the hedge fund mangers is often referred to as ‘2 and 20’.

The fund managers find this quite a justified price for the profits that they generate. Industry experts say that this is due to the hedge fund market being more of a sellers market than that of buyers. Also what is witnessed is that hedge funds that have a combination of long and short strategies charge more than their long-only counterparts. In fact Renaissance Technology Corp., charges a 5 percent management fee and 44 percent of the returns for its Medallion fund. This fund is now officially closed for outside investors. Reuters reports:

"They hold all the cards," said Merrill Lynch managing director David Barrett, who introduces hedge funds to investors through the investment bank's $19 billion fund of funds. "There is continually massive demand for consistent performers."

From the Classroom: What is Short Selling?

Short selling is selling of stock by an investor when he expects their prices to drop in the near future. This does not make much sense to those who always believed profit lies in selling when prices go up, in other words in going long.

The difference between short and long selling is that in the former the seller of the stock does not own the shares but only holds it in borrowing from another investor. Here is how it works. You borrow shares from your broker. These borrowed shares are sold and the money is credited to you, but sooner or later you are expected to buy back the shares and return them to your broker.

At the time of buying back you make a profit if the price falls, however you may also lose money if their price rise at the time of buy back. As the stocks are borrowed and sold, any dividends or rights declared go to the lender of the stock. To go for short stocks, you also have to open a margin account since your status remains as that of a borrower and not an owner of the stocks. Investopedia reports:

Short selling is the selling of a stock that the seller doesn't own. More specifically, short sale is the sale of a security that isn't owned by the seller, but that is promised to be delivered.

Hedge Funds: The past and the present!

While we discuss the ups and downs and technicalities of the hedge funds, it would be nice to revisit where the industry came from. A fresh perspective of emergence of the sector and its growth through the years can be useful. So here we are. Hedge funds emerged way back in 1940s after the catastrophic financial movements of the 1030s.

The man responsible for designing hedge funds was Alfred Winslow Jones who created the first hedge fund primarily aimed at eliminating market risk. The core idea that he worked on was to enable investors to enjoy equity upswings but ensure that they were simultaneously protected against the risk of share price falls. Thus the world saw the emergence of long/short hedge funds. He combined a stock-picking philosophy which invested in undervalued companies. This was done primarily when the share prices were expected to rise. Overvalued operations were also identified and he sold them short. He was convinced the prices of these operations would ultimately fall and hence he borrowed stock and sold it with the hope that the prices would fall and he could buy them then.

Though the industry has capitalized on the core philosophy, things are quite different today. Today the market is not only grown in size but also has several strategies that never existed earlier. The dynamism of the field is such that it seems to be evolving continuously. Newer and yet newer strategies seem to be emerging every day, further complicating the arena. Therefore even the savviest of the investors, are quite often clueless of how their money is being invested.

The secrecy in using the oft utilized but less understood strategies further adds to the chaos. So what exists today is either the crowding of existing strategies trying to profit from the very same opportunity, or use of strategies that even some of the managers are not very familiar with. The hedge fund manager never wants his client to know that he is not sure of how the strategy will work or how much it might fetch. Thus there is no dearth of funds that thrive under the shrouds of mystery. 

To top it all, the industry itself is very mildly regulated. US is now implementing some blanket rules that aim to reduce the risk to investors. FSA in Britain on the other hand seems to have a tighter control on the industry. But even that is not sufficient for funds that are based off shore. So what we have today is a lot of collapsing funds and lot of funds that are involved in big time frauds. Scotsman Business reports:

“Is the FSA being overly jumpy? Probably not, given the sector's history. These here today, gone tomorrow funds have a record of being risky and racy, and have been at the centre of a long line of headline-grabbing scandals.” 

CGM Focus Fund: A mutual fund that looks like hedge fund

We have been told time and time again that mutual funds are safe when compared to Hedge funds. We have also been told that mutual funds are unidirectional and make money when the market is on an upswing alone. And we are absolutely sure they cannot sell stocks short. Well all this may well be proved wring by the time you reach the end of this write up.

Introducing - CGM Focus Fund (CGMFX), a no-load mutual fund that invests in a blend of growth and value stocks--mostly mid-caps and the best part of the story is that the fund is also permitted to sell stocks short. The fund comes from the stable of Capital Growth Management. CGM Focus Fund has a glorious history of triumphs with the most recent year-to-date through Sept. 9 returns of 28.5%.

The reporting of returns in case of mutual funds is relative as compared to absolute returns reporting of hedge funds. The fact is still not altered with the fund reporting an effective annual compound rate of return is 21.4% since its inception in 1997. Compare this with the dismal 3.7% compound annual growth rate of the S&P 500 Index over the same period. The success of the fund may be attributed to both the inherent flexible nature of the fund as well as the skill of veteran manager G. Kenneth Heebner.

Mr Heebner also manages at least three other funds from the same group - CGM Capital Development (LOMCX), CGM Mutual (LOMMX) and CGM Realty (CGMRX). He is known for his bold stance on changing portfolios which he thinks will not work, in a blink. He recently unloaded home builders and steel firms and instead picked up energy firms and raked in huge profits.

All this looks too good to be true. There have been some down hill rides for the investors of this fund but overall the funds performance has left them quite pleased. While some bets might pay off, some might not. Therefore it may be wise for the weak hearted to stay away. Forbes.com reports:

“The attraction of putting money into a hedge fund is that you're not betting on the direction of the market, as much as you are the skill of the person who's managing it.”

Read More: A Mutual Fund That Goes Both Ways

Short Sellers Prove to be Top Performers

The Chicage-based firm that tracks hedge funds, Hedge Fund Research, has put out a report that illustrates that short sellers were the top performers when looking at all different funds. According to the report, short sellers returned 2.78 percent on average the previous month. From January to August of this year it was up 7.07 percent as well. Information compiled by the New York based company, Hennessee Group, also showed that short sellers average return was 10.49 percent through August. Second only to European Stocks, short sellers were the top performers this year. According to Reuters:

"Short sellers generally perform in inverse proportion to the Standard & Poor's 500 Index, and in August these short sellers were on the better side of the trade," said Joshua Rosenberg, president of Hedge Fund Research. Most major stock indices posted losses in August.

Read more: http://today.reuters.com/investing/financeArticle.aspx?type=bondsNews&storyID=2005-09-14T185229Z_01_N14656725_RTRIDST_0_FINANCIAL-FUND-HEDGES.XML