Confessions Of An Albanian

Blaming hedge funds only lets the real culprits off the hook

Originally published in the May/June 2009 issue

You may remember ‘Wag the Dog’, the film starring Dustin Hoffman as a Washington spin doctor. In the film, Hoffman seeks to divert attention away from a presidential candidate’s sexual endeavours onto something else. So after a little creative thinking and a few logical leaps, a phony war with Albania suddenly becomes the main threat to American interests. Diverting attention away from the real problem is a time-tested political, as well as managerial, tool.

Working in the fund of hedge fund industry makes me feel rather like an ‘Albanian’. Contrary to popular misconceptions, the hedge fund industry is very small when compared with pension funds and mutual funds, and is unlikely to pose a serious threat to the real economy. In addition, as public anger increases about the use of taxpayer’s money to rescue failing industries, it is worth noting that not one hedge fund has asked for a bail out, nor has any money been offered. So, while the real problem has been promiscuous lending and borrowing, everyone is pointing at the hedge fund industry, which is convenient, but is misguided and inaccurate, a bit like a war on Albania you might say. Let’s look at some of the most common accusations.

With total estimated assets at US$1.3 trillion, the industry is much smaller than mutual funds and pension funds. Even if we adjust the assets with leverage of 1.5 to 2 times, the numbers are still too small to really matter. It is true that some individual managers might use leverage and therefore have a higher risk profile, but investors can easily mitigate this through diversification across managers and strategies. Levels of leverage have also significantly declined with the tightening up of credit markets, reducing this concern further.

The main culprits of high leverage remain the banks, who have been up to 30-40 times leveraged in extreme cases. Furthermore, although banks have been accused of promiscuous lending, it takes two to tango. In other words, it takes a borrower to match the lender. This has been conveniently forgotten in the debate and it is not politically correct to kick one already lying down, namely the American homeowner. What has happened to good old-fashioned common sense? I am a great supporter of the capitalist model, but with this comes responsibility, the responsibility to face-up to the consequences of your decisions.

With performance-related revenue structures, hedge fund managers have made the headlines as top earners. What has been forgotten is that when a manager makes one dollar in performance fees, the client will usually make at least four dollars. Not surprisingly, the clients of such managers are not the ones complaining. Also, even though the fixed fee components in many of these funds are usually higher than for those of conventional mutual funds, it is the performance after fees which is where the money has been made. A side point is that most hedge fund managers are co-investors in the same funds as their clients, i.e. putting their money where their mouths are.

Limited transparency of underlying holdings and opaque mandates are other favoured topics in the debate. As blunt as it may seem, transparency or the lack of it is an inherent characteristic of all investments, conceptually as well as structurally. The whole concept of investing is based on the prospect of a more prosperous tomorrow. Call it hopes, dreams or even earning forecasts… the fact of the matter is that we are putting money to work, after thorough analysis, expecting, but never knowing the exact outcome. Also, no investment vehicle gives its investors full transparency. Mutual funds typically invest in a number of listed companies. Do we know exactly what positions and strategies these companies are pursuing on a day to day basis? No! Do we have a problem with this? No!

Funds of hedge funds typically invest with a large number of underlying hedge fund managers. Do we know exactly what positions all these managers have on their books from day to day? No! Do we have a problem with this? You bet! You might argue that this is not a fair comparison. Listed companies are audited and have to submit annual reports etc. to comply with the rules of the exchange on which they are listed. True, but the fact that companies are listed on recognised exchanges and audited by the most prestigious audit firms in the world has not and will not prevent management making the wrong decisions. If you had any bank stocks of late or tech stocks in the late 90s you will know exactly what I am talking about.

One way to mitigate this problem is to invest with companies or managers whose objectives are aligned with yours, which leads to the second point about opaque structures. Most hedge fund mandates are actually not opaque, on the contrary they are typically very specific. They are not, however, linked to the performance of a specific market or region, which of course is why they make such good diversification tools. They are structured with the aim of increasing wealth incrementally for their investors. And this does not happen automatically, it comes down to the skills of the manager, but at least they are not limited by their mandates in the same way as others are. Long-only managers, on the other hand, might have the same long-term goal, but their mandates are usually to outperform a given market index and are typically restricted to how much the portfolio can deviate from that index. In effect, they are shackled to the restrictive nature of their mandate. They would then be deemed as having outperformed if their fund declines 48% against an index that is down 50%. Don’t blame the fund manager, for they are only doing their job. Instead, the focus should be on investment guidelines, but that is a topic for another article.

So, you might ask, why are hedge funds then labelled as alternatives? And the answer to this is that it is not clear. Accumulating wealth incrementally has been the basis of investing since the beginning of time. Of course, if the hedge fund concept were to grow in importance, it would have an impact of seismic proportions for those working within and around the so-called traditional asset management industry. Moreover the distinction between ‘traditional’ and ‘alternative’ has been diminishing, with traditional mandates increasingly incorporating ‘alternative’ traits, while the alternative industry is increasingly looking to build up more traditional UCITS and mutual fund businesses.

Are all hedge fund managers good? No. But my point is simply that they should be judged on what they do and not what they are rumoured to do. To be sure, real talent is scarce, but that is the same for all industries. Another big misconception is of the parallel universe, for this just does not exist. Hedge funds are operating in the same capital markets as other participants. They are buying and selling the same stocks as mutual fund managers and the same copper futures as an industrial company trying to hedge their raw material costs. Hedge funds do not operate in a parallel universe, but are in fact closely aligned to the real economy. If this is fully understood, it should come as no surprise that some of these funds faced tough times when capital markets stopped working in the third quarter of 2008.

The real question for the future is of course how much money you should invest with those whose objectives are aligned with yours? Only you can answer that question. I know where I have my savings.

The views expressed herein are personal views of the author and should not be interpreted as recommendations or opinions of The Permal Group.


Bo Kratz joined the Permal Group in 2006 and is Regional Director Asia. He was previously Head of Institutional sales Asia for ABN AMRO Asset Management, Hong Kong, and beforehand CEO of ABN AMRO Asset Management, Singapore.