On The Hedge

Radio 4's In Business programme profiles hedge funds

Peter Day, Presenter, BBC & Stephen Chilcott, Editor, in Business
Originally published in the November 2006 issue

Last month hedge funds were the topic of conversation on Radio 4’s In Business programme. Presenter Peter Day discussed the fears and fascination of hedge funds with a distinguished panel of guests. Apart from Day himself, they were:
Hector Sants Managing Director, FSA
Peter Montagnon Director of Investment Affairs, Association of British Insurers
Stanley Fink Chief Executive, Man Group
Theo Phanos Director, Trafalgar Asset Managers
Doug Shaw Managing Director, Blackrock Investment Management
Bernard Opetit Chief Executive, Centaurus Capital
Peregrine Riviere Director of Corporate Affairs, Carphone Warehouse
Professor Colin Blaydon Tuck School of Business, Dartmouth College New England
Rich Blake Senior Editor, Trader Monthly

DAY: Hedge Fund. The phrase sounds friendly, like a garden gnome. Ten years ago these were rare beasts in the financial jungle. But today there are thousands of them, sprung up all over the world. Their clients are mostly very rich and they make their profits by doing clever things more traditional investment funds don’t do. They’ve attracted huge sums of money, including portions of many people’s pension funds. Maybe yours. They have big powers. Hedge funds play a significant role in takeover bids – maybe changing the ownership of the company you work for. The financial news pages are full of them: official probes into their activities, Germany tabling hedge funds as a subject of concern for the next G8 global summit conference; one big American fund Amaranth losing five billion dollars in days. People worry about them: huge pay cheques for hedge fund managers, big risks, tough guy intimidation of companies they invest in, waves of failure if a bunch of them were to go under. This programme tries to find out what they are and what they’re doing. And their influence is growing fast.

PHANOS: Hedge funds are still, in terms of the amount of capital they manage, relatively small. However, the capital they manage is more nimble and it’s more activist. They do make a lot of noise and they do make things happen as well. So I would say increasingly powerful.

DAY: They are certainly in the money.

BLAKE: Let’s say you’re out at a bar, you’re 25 years old and you’re chatting up a lovely lady. You know what you want to do is drop that H-bomb. It used to be, “I went to Harvard”. Now it’s “I run a hedge fund”. That’ll get their ears up and it’s becomes synonymous with a fabulously wealthy way of life.

DAY: And some observers are afraid of them.

BLAYDON: They’re very private, very unregulated, and people have been concerned that no one quite knows what they’re doing and is there an amount of risk in the capital markets that could come together under some emergency or crisis, circumstances that would create a perfect storm that could cause a major financial crisis.

DAY: Before we hear more from those voices, a basic question for Hector Sants, one of the regulators at the organisation that supervises the whole finance industry in Britain, the Financial Services Authority. What exactly, Hector Sants, is this thing called a hedge fund?

SANTS: Firstly, in general, they tend to be partially based offshore or in more lightly regulated areas. Secondly, in terms of their investment techniques, they’re quite aggressive in the way that they trade, utilising leverage – i.e. borrowing money to enable them to make bigger bets than they would otherwise do; and also in many cases utilising derivatives markets, which enables them to buy and sell instruments that they may not actually own.

DAY: Yes it sounds complicated, but if you still want a definition, well essentially hedge funds seek to make money whether markets are rising or falling; traditional investment managers think they’re doing well if they outperform the marketplace as a whole. But where did they come from? Professor Colin Blaydon has been following them closely for the past 10 years at the Tuck School of Business at Dartmouth College in New England.

BLAYDON: The huge rise of the hedge funds came really as a result of the big bust of the Internet economy and telecommunications bubble.

DAY: Shares can go down as well as up in a big way?

BLAYDON: Right. And people realised that if you were a flexible investor and you could make financial bets on things going down as well as financial bets on things going up, you could use sophisticated financial investments to hedge your risk; that you could have someone perform better as an investor on your behalf than you could if you simply invested in long investments in equities in a mutual fund.

DAY: What do the huge traditional investors, the insurance companies and the pension funds, think of these pushy newcomers? With some reservations, they welcome them, says Peter Montagnon, Director of Investment Affairs at the Association of British Insurers.

MONTAGNON: The world has rather changed now. The days are passed when the long-term institutions like insurance funds and pension funds simply owned companies and they were the biggest players around.

DAY: And they were very conservative investors: they on the whole took a position in a company and stayed with it.

MONTAGNON: Sometimes they actually were able to influence what happened because they had this long-term interest. But these days, as I say, have disappeared or are disappearing. The market is more fragmented; you’ve got these new players. They’re using techniques which are also new where they can build up stakes without necessarily anybody else seeing that because it’s contingent. It means you’ve got an option, you can exercise it, and suddenly there you are on the share register.

DAY: Peter Montagnon at the Association of British Insurers, representing the familiar and traditional big investors who buy shares and hold them. Going “long” on equities is the market phrase. By contrast, one of the main things hedge funds are allowed to do is to exploit bad news (or potential bad news) by selling shares they do not own, hoping to book a profit by buying them later at a lower price. It’s called short selling and it helps hedge funds to make profits even when markets in general are falling. Now what do companies make of these activities? Here’s a business which often appears to catch the attention of hedge fund activists: there’s always an air of intense activity at the headquarters of the mobile phone group Carphone Warehouse in West London, and it’s often in the headlines: only the other week Carphone Warehouse shares tumbled 16% in two days on the news they were losing an important Vodaphone contract. At Carphone Warehouse, Peregrine Riviere is Director of Corporate Affairs, and here’s what he thinks about the hedge funds.

RIVIERE:They are highly influential. Firstly, they are now (because of the amount of money that can be made) populated by highly intelligent individuals who have often come from a more traditional institutional background but are attracted by the much higher personal wealth that they can create by running hedge funds. Secondly, they tend to (in some cases) form close-knit associations or kind of splinter groups of people who’ve worked together previously and are now running separate pots of money but do talk to each other. And, thirdly, at the shall we say less salubrious end of the market, they are, I would say, not averse to perhaps talking their own book from time to time. So that when you know a lot of hedge funds are interested in your stock, there tend to be more unsubstantiated rumours in the market about trading activity, M&A activity, etcetera.

DAY: It means you’re subject to even closer scrutiny than you would be by the traditional City of London?

RIVIERE: I would say that. I think these are people who are looking for an edge in a very small number of circumstances. If they can’t create an edge by their own due diligence and intelligence, they might try and create one through a slightly more subversive approach, shall we say.

DAY: You have to be on hedge fund alert all the time in a way that maybe you didn’t quite as much in the old world?

RIVIERE: That’s certainly true, but it’s all about how you deal with these issues and our approach has always been that dissemination of information was the way to get rid of speculation.

DAY: Now long side and short side – that’s if they’re actually buying the stock or if they’re selling the stock in the hope that they can buy it back later and make a profit because it’s gone down; and selling short is particularly nasty to a real company because it’s people betting your stock is going to fall even more maybe than it has done already, so it leaves a nasty taste in the mouth of people getting on with the business of running their own companies, doesn’t it?

RIVIERE: That’s true. And I’d love to sit here and claim that you know we take an all-comers approach to our investor base and it does create a certain amount of ill will if we know that people are betting on our failure, but actually we find it extremely motivational and very often what gets us out of bed in the morning is to say let’s lose these people a whole load of money.

DAY: By sending the shares up rather faster than they expected?


DAY: Do you think it’s bad for the economy in Britain, the rise of the hedge funds?

RIVIERE: No, absolutely not. It’s part of London’s credentials as probably the second most important financial centre in the world, and I get slightly irritated when a lot of UK plc tries to lay the problems of their performance at the door of hedge funds.

DAY: One of the many tactics in the hedge fund armoury is to seek out companies in trouble, needing change or maybe a takeover bid. Theo Phanos is co-founder of Trafalgar Asset Managers, and he’s got a small team of people constantly looking for these kind of investment opportunities.

PHANOS: Having an alternative view is the single most important skill set of a hedge fund manager. I had the opportunity to focus on a company; they were in the oil exploration field. I started calling people literally round the world to get more information, to get behind the scenes. I even literally met ex-Kroll investigators to explore the possibility of sending them to a certain part of the world to review if the assets actually existed. This is the new world of hedge funds, it is getting behind the scenes, being investigative like journalists.

DAY: You’re putting pressure on them and you’re investing in them?

PHANOS: Absolutely. We invested a couple of years ago in Alves, which is a tank manufacturer. There was a bid from a US defence company called General Dynamics. We were aware that British Aerospace had a major stake in Alves, so we actually invested and we then went to British Aerospace and said, “You should outbid General Dynamics”. And that’s ultimately what happened, and we were instrumental in making that happen, working with the advisors of British Aerospace. So having an intention, investing and then acting on it, is a perfectly legitimate way of investing.

DAY: And that’s what your team out there does all the time – they keep on looking for ideas, which are details, imbalances, imperfections or possibilities in companies?

PHANOS: That’s exactly right. You know I met a company today. I asked the CEO who his top five customers were and he struggled to answer that question, which told me that you know he’s a boardroom type of CEO, and I was kind of astonished to be honest.

DAY: An opportunity there for you then, is there?

PHANOS: Most definitely an opportunity and it’s one that is increasingly the focus of hedge funds.

DAY: Aren’t you interfering in their long-term strategy for temporary short-term advantages, which you take advantage of?

PHANOS: I question a long-term strategy. I mean I remember when I was interviewing for jobs and people would say, “What will you be doing in 10 years?”, and I thought this was the biggest joke of a question. I would say, “Look, I think I know what I want to do in the next six months, maybe 18 months, but long-term is a series of short-term strategies”. No one knows what the tastes of people will be in two, three, five, or seven years, what market conditions will be, so too much longterm planning, I don’t think is a good thing.

DAY: Despite their reputation, some hedge funds can also take much longer views. So says Bernard Oppetit, the French Chairman and Chief Executive of Centaurus Capital based in London, on the lookout for what he calls “special situations”. For example, Centaurus has a big stake in two Dutch companies: the troubled international supermarket group, Ahold, and the engineering conglomerate Stork.

OPPETIT: We do like special situations, which includes things like mergers, bankruptcies, takeovers. This is where we can add value. We are not very short-term orientated. We are not buying and selling the same thing in a few hours. Our time horizon is very often a few months, sometimes a few years.

DAY: So you have a strategy …


DAY: …which doesn’t just emerge at a morning meeting and off you go; it’s much more long-term than that?

OPPETIT: Yes. We sometimes sit on the same positions for four or five years.

DAY: As long as that? I thought three months was an eternity for a hedge fund, but it isn’t necessarily?

OPPETIT: For some, for some it is.

DAY: And can you make money if you sit on a holding for five years?

OPPETIT: Yeah, you can.

DAY: What happens at the end of the five years?

OPPETIT: Well once the story is out, you get out of your positions. Many things can happen in five years.

DAY: Stork and Ahold, you were involved there. Ahold is still in play.

OPPETIT: Ahold is in play – indeed, yes.

DAY: Still interested in it?

OPPETIT: Yes. We still think that there’s a lot of value to unlock in this company.

DAY: So you wait. Five years? It’s been in play for a long time actually, Ahold.

OPPETIT: We’llsee. Stork is a bit of a different case. In Stork, together with another investor, we own 32% of the company.

DAY: You want something done?


DAY: What? Break up?

OPPETIT: We want the company to focus on its aerospace business, which is a very good business, very promising.

DAY: Are your views expressed more robustly than the traditional investment funds are?

OPPETIT: We don’t mind voting the way we want to vote or express our disagreement if we disagree.

DAY: But this kind of activist change-making investment strategy is just one of the many ways that hedge funds make their money. Listen to the man called “the godfather of the European hedge fund industry”, the softly spoken Stanley Fink, Chief Executive of Man Group.

FINK: If you and I have the same golf handicap, when we go out on the golf course tomorrow and you have one club and I have 14 clubs, who’s going to win on the round of golf – the 17 handicapper with one golf club or the 17 handicapper with 14 golf clubs? And as a hedge fund industry, we’ve got 14 golf clubs.

DAY: Man Group is a two hundred year old city broking business which under Stanley Fink has become Europe’s biggest hedge fund group. It’s the largest publicly quoted company managing hedge funds in the whole world. It’s got £50bn under management – that’s fifty billion – in a cluster of three different businesses. One of them is an intriguing fund manager called AHL. Its main investment tool is a computer.

FINK: We programme the data into a computer, so the computer does it unemotionally and absolutely remorselessly in a way that no human being ever could because most human beings would think this time it’s different.

DAY: And you have programmes that are better than people at doing this?

FINK: Yes, we had a debate in our company 20 years ago nearly when I joined about whether black boxes could be better than traders. In those days it was our sugar traders who were deemed to be very good and Man was a sugar commodity business. And 20 years later we’ve got the black box and we’ve not got the sugar traders any more, so it would suggest that black boxes can be better than sugar traders

DAY: Stanley Fink’s Man Group is best known as a “fund of funds” operation, picking a selection of other people’s hedge funds in which to place rich investors’ money, depending on the amount of risk they want to take.

FINK: We were trying to identify 400 managers, which are multi-style, so they compliment one another and the risks of each style offset one another, so it’s a very diversified portfolio.

DAY: So you’re hedging against the hedge funds?

FINK: We’re hedging against certain styles coming in and out of fashion.

DAY: As the number of hedge funds grows so rapidly – what, we’ve got nine, ten thousand of them in the world now – isn’t there a danger that what they’ve delivered over the past 10 years is much less likely in the next 10 years?

FINK: That’s possibly true of certain individual strategies that are over trawled, but there are new ones that are opening up. For example, there were very few hedge funds with Far Eastern emerging market strategies 10 years ago. There are quite a lot today and there will be more in 10 years’ time. There are people trading new derivatives like weather derivatives and pollution derivatives and my view is one of the biggest risks that pension funds can’t hedge today is how long people are going to live. That’s bound to form a new derivative contract over the next 10 or 20 years.

DAY: Now hedge funds have a reputation for secrecy and that’s partly because of their clientele. They’re definitely not designed for the man or woman in the street. But if these hedge funds really exist to spread the risk of stock market investment, shouldn’t their advantages be open to small investors as well? A question for Doug Shaw, a Managing Director at the international group BlackRock Investment Management.

SHAW: We have to be very careful to whom we market our funds here at BlackRock and we have to make sure that the people who are seeking to invest in our funds are qualified and accredited, by which I mean they generally have to prove themselves to be rich and sophisticated, and typically minimum investment sizes for individuals are over a million dollars.

DAY: But it’s a bit mean, that. If the idea of a hedge fund is to mitigate risk rather than add to it to get higher returns, then it seems unfair to cut out small-scale investors from the benefits of this advantage.

SHAW: I think that’s really a point for the regulators, which typically have been quite cautious about the degree of market penetration that fully blown hedge funds can undertake. However, the regulators I think in the UK, in particular, have played a very wise hand and they have not over-regulated the hedge fund management industry; but over the past couple of years a new form of unit trust under a different set of regulations has come through and it’s now possible to introduce certain hedge fund strategies into the retail marketplace. And my company BlackRock has responded to that by creating the UK Absolute Alpha Fund, which in its own way is effectively an equity long/short fund seeking to create returns for investors in a low risk way by picking stocks it likes and going short on stocks it doesn’t like.

DAY: And if that Greek jargon was slightly indigestible, well “beta” investors follow the benchmarked ups and downs of the stock market as a whole while “alpha” investors, such as hedge funds, seek to benefit from changes in the price of individual assets – hence the “alpha”. But back to those alpha hedgers: fund managers get annual fees plus a hefty chunk of the profits they make on behalf of their clients. Why, Doug Shaw at BlackRock?

SHAW: Well it certainly focuses the mind. Typically fees are anywhere from between 1% per annum to 2% per annum and there’s also typically, but not always, an incentive fee structure as well whereby the management company typically stands to enjoy a fifth of the gains made by the client.

DAY: These big returns have made working for a hedge fund what a lot of bright, young people want to do, particularly in America. Rich Blake tracks the business as an editor of the magazine Trader Monthly.

BLAKE: A young hedge fund manager, if he’s got enough assets under management, can start to break out of that 600,000, one million, two million, and now we’re talking about money upwards of five million, 10 million. Steve Cohen, who is by our estimation the number one or (if not) number two ranked hedge fund manager in terms of earnings, pulls in an estimated one billion a year.

DAY: A year?

BLAKE: A year. But there are only so many guys that are making one hundred million plus, but there’s enough of them that it’s exciting to cover this field.

DAY: Big, mysterious, well rewarded – hedge funds are making other people worried. Billions of dollars were vaporised this summer when the Amaranth hedge fund got into trouble trading natural gas contracts out of Calgary, and saw its assets shrink by two thirds in only a week or two. And when that sort of thing happens, fears quicken that collapsing hedge funds could undermine the stability of the world’s financial markets as a whole. Back to the Professor, Colin Blaydon, at Tuck Business School.

BLAYDON: People have been concerned that no one knows quite what they’re doing and is there an amount of risk in the capital markets that could come together under some emergency or crisis, circumstances that would create a perfect storm that could cause a major financial crisis? People have worried about it. People are trying to collect the data to take a look at it. My personal view is that it may be well on its way to correcting itself without governments having to figure out quite what to do about it. The saving grace of it may be the fact that as markets and economies have steadily improved over the last two years, that the opportunities for hedge funds with their diverse strategies to make a lot of money has greatly diminished. The returns of the hedge funds have plummeted. Huge amounts of capital have been pulled out of them. A number of the most prominent and aggressive hedge funds have actually closed up.

DAY: Hedge funds are supposed to lessen the risk, at least lessen the total market exposure risk. Do they do that or do they actually surreptitiously increase it because high returns equal high risk, don’t they?

BLAYDON: They do and for many hedge funds where the risk comes from is that they borrow in addition to the funds they take in to enhance the returns. And that’s great as long as they’re doing well, but if things turn against them they can be disastrous. And there have been some recent disasters.

DAY: Amaranth.

BLAYDON: Yes, the young man, 28 years old, trading gas derivatives from his bedroom in Calgary or something like that and losing $5bn dollars in a matter of days. That kind of thing can happen, but it is infrequent. I do believe it is self-correcting.

DAY: Now Amaranth was one of the hedge funds that the advisors at Man Group picked out for some of its clients. Stanley Fink again.

FINK: To put it in context, our average investor would have lost a few tens of basis points of his funds, so if …

DAY: A tiny percentage.

FINK: Absolutely, that’s the power of diversification. When Amaranth wound up its positions and it took a loss liquidating its positions, it was still solvent; the investors didn’t lose all their money. It was not a nice event to live through, but worse has happened in the average person’s equity portfolio.

DAY: But it hasn’t just been Amaranth in trouble. The most notorious hedge fund disaster of the 1990s was Long Term Capital Management, an American fund with two Nobel Prize winners advising it. When LTCM got into deep trouble after the Russian government’s debt default in 1998, the American authorities leapt in to arrange a bailout because they were terrified that the debacle might hit the financial markets like the Wall Street Crash of 1929. Does Hector Sants at the Financial Services Authority think that hedge funds really pose that sort of potential risk to our financial world?

SANTS: Over the long-term, in general, hedge funds actually are beneficial to the system because they do actually increase stability – they’ve enabled risk to become more widely dispersed and therefore at the end of the day less concentrated.

DAY: And of course everyone goes back, what, eight or nine years, and thinks of Long Term Capital Management – a great big jolt to the system, fears of systemic risk. You’ve talked about something that could cause serious market disruption, but it wouldn’t be the end of the financial world if a hedge fund or hedge funds collapsed?

SANTS: Well a regulator never says never, but nevertheless the failure of LTCM was a significant jolt. It did not lead to the overall failure of the financial system. And we do feel at the current time that the risk of that happening is extremely low. We’re not a no-fail regulator. It absolutely will be the case that individual hedge funds will fail and we actually think that’s a good commercial discipline for the marketplace.

DAY: Is not the FSA though looking at extending the power of the hedge funds or the ability of the hedge funds into attracting much smaller investors who will be much less sophisticated in where they place their money?

SANTS: We currently have restrictions on the marketing of individual hedge funds to less sophisticated investors here in the UK. We have no current plans to change that. What we have said is that we’re looking at the possibility of being able to offer the opportunity to retail investors to buy funds of funds, which are groups of hedge funds packaged up together, which of course is intrinsically less risky. The investment technique which hedge funds use is not per se something that is undesirable and it may well be that over time – and we’re already seeing this to some degree – that that technique should be usefully made available to the wider retail environment.

DAY: And they’re not getting too big and too influential in the market, so that this thing which started off as a hedging operation in a little part of the marketplace grows and grows so that it becomes the tail that wags the dog?

SANTS: They are a growing and ever increasingly important part of the financial marketplace, so by definition they have to expect more regulatory scrutiny going forward because they are a more important part of the marketplace. And whilst at the moment we’re not particularly concerned that they are posing a significant and current threat to the overall financial stability of the system, clearly they have the potential to do that and it’s absolutely incumbent on the regulatory community to be very focused on that point.

DAY: Hector Sants of the FSA. This programme happens to go out almost exactly 20 years after Big Bang, when the shape of the City of London and its institutions was changed forever. It’s also 19 years since the great crash of October 1987. How risky is this new hedge fund world? Back to Stanley Fink at Man Group, taking a long view of the stock market, alias equities.

FINK: If people had chosen which 10 equity markets to invest in in the year 1900, somewhere between 7 and 8 of those 10 equity markets would have gone to zero; you’d have wiped out all your money. If you look forward the next 50 years – and you can guarantee there’ll be no hyperinflation, there’ll be no major change of political system in the country you’re involved in, there’ll be no major union action that would destroy corporate profitability – then put all your money in equities.

DAY: Otherwise?

FINK: Otherwise it’s better to diversify.

DAY: Stanley Fink of Man Group. Investing anywhere, in any anything, is sticking your neck out. There’s no absolutely safe haven at all. It’s absolutely certain that some time soon a great big hedge fund will lose its investors huge sums of money. It won’t be the end of the world, but avoiding risk can be a risky business.


Our thanks to the editor of In Business, Stephen Chilcott, for his kind permission to reproduce this programme.