"Don't Cry for Me, Argentina"

Sydney M. Williams

Thought of the Day

“Don’t Cry for Me, Argentina”

July 8, 2011

Contrasting articles in the Wall Street Journal on successive days this week indicate the shoals over which hedge fund investors’ must sail: The first reflected the hazards of overzealous regulation; the second, the risks associated with an apparent absence of regulators.

At the peak of the market, in 2008, FrontPoint Partners managed $10 billion, not bad for a firm that had started operations eight years earlier. In November, when U.S officials arrested a French doctor for allegedly passing on confidential information about a disappointing drug trial to a FrontPoint employee, the firm was managing $7.5 billion. Insider-trading allegations involving “expert networks”, whether true or not, have had a magnified impact on the financial operations of many in the hedge fund industry. Today, FrontPoint’s assets have declined to $1.5 billion. The article also reported that Michigan’s state pension fund had decided to “yank its remaining $375 million investment.” No FrontPoint executives were charged in the complaint, though one manager, Joseph “Chip” Skowron, was placed on leave. Nevertheless, the flight of lemmings persists, to the detriment of what had been a successful investment operation. (I have no basis for believing in the innocence or guilt of anybody at FrontPoint. This is only to point out that when regulators act precipitously, the innocent can get hurt.)

The second article, in Thursday’s paper, is about a firm, Fletcher Asset Management that offered 12% annual returns to three public pension boards in Louisiana in 2008. They were assured of such returns for one simple reason, as the Journal reported: “Any shortfall would be made up by other investors.” That sounds like the definition of a Ponzi scheme. However, when asked by the Journal about the “guarantee”, a former executive said the use of the word was “colloquial” and not meant within “the legal definition.” Not being a lawyer, that explanation left me nonplussed. Nevertheless, the three pension boards invested a total of $100 million. Redemptions are a bit trickier. When the Louisiana funds requested the return of a third of their investment, with cash not available, Fletcher offered them promissory notes that pledged payment in two years “in satisfaction of this redemption request.”

The Journal’s article also questions the total of assets under management at Fletcher Asset Management. The complexity apparently arises because of the existence of “feeder” funds that then invest in other Fletcher funds. The two Journal writers, Steve Eder and Josh Barbanel, who collaborated on the article, described it this way: “Mr. Fletcher gave an example. If investors put $2 in one Fletcher fund and this fund borrowed $1, and then put the money in a second fund, that would make $5 the firm managed, he said.” Mr. Fletcher concentrated in applied mathematics at Harvard. But I don’t get it; of course I was never a math major. (To the best of my knowledge, Fletcher Asset Management, an SEC registered investment advisor, is not under scrutiny.)

Even when the Press does their job for them, one cannot help wonder how the SEC spends its day. The agency employs about 4700 people, thirty-three of whom, incidentally, were recently counseled or disciplined for viewing porn. The SEC will receive a “modest” boost of $74 million to their 2011 budget of $1.12. “Modest” in government-speak is a 6.6% increase, about twice the rate of inflation! Yet they seem to spend too much time “tilting at windmills”, while ignoring what appear to be obvious violations. Like airport screeners, SEC investigators seem to ignore the advantages of profiling.

Hedge funds are often grouped as a single asset class. Yet nothing could be further from the truth. Collectively they manage about $2 trillion, approaching the peak reached in early 2008. There are big ones and small ones. There are those that focus on growth and others that consider value. In total, there are about 6800 funds, down from about 8000 in 2008. Approximately 225 hedge funds control two thirds of the assets. The amount of leverage deployed varies widely. There are quant funds specializing in government securities that might leverage twenty or thirty times. There are long-only equity funds that may use very little leverage. There are traditional hedge funds that go long stocks they like and short those they don’t. Collectively they trailed the indices in both 2009 and 2010, yet $55.5 billion flowed into hedge funds, the most since 2007, suggesting that hedge fund investors discriminate intelligently.

What they all have in common is a compensation system that is based on performance and on total assets under management. Two percent of the assets and twenty percent of the fund’s performance is typical. As hedge funds become larger, performance becomes more difficult, as investment opportunities become more limited. Thus, there is a tendency among some funds to invest in unusual or non-public vehicles. (A unique characteristic of equity investing is that the more money one manages the more limited the opportunities. There are perhaps ten thousand public companies in the U.S., but for one managing $10 billion the universe of available investments is reduced to about 200.) As a result, the 2% fee on assets under management becomes relatively more important to overall compensation.

Despite the requirement that only “sophisticated” investors can invest in hedge funds, the term applies to the amount of money available for investment, not to the individual whose money may be at risk. Fifteen years ago most hedge fund investors were wealthy individuals who likely understood the risks they were assuming. Today about two thirds of all hedge fund assets come from institutions, pension and profit sharing plans, eleemosynary foundations and private and public unions. The managers of those funds may have some degree of sophistication, but the ultimate owners of the money likely do not. It is the interests’ of those small investors that the SEC should be looking to protect. The two Journal articles suggest that diligence on the part of investigators is being parried by the tilting at windmills, or by the charms of porn.

The compensation managers receive has been criticized, most notably by Warren Buffett. But investors in hedge funds become limited partners knowing full well the costs they incur. Two and twenty is pretty simple to understand. Either one is willing to pay the fees or not. No gun is put to an investors head, forcing him or her to invest. Frankly, hedge fund charges are far easier to understand than the myriad fees and expenses charged by mutual funds. For example, using one fund as an example – the Nuveen Large Cap Value Fund, Class C – fees and expenses amounted to 40% of gross returns to that fund over the past ten years.

Regardless, those who live by the sword, as hedge fund managers do, can also die by the sword. The process of creative destruction is alive and well in hedge fund land. In a capitalist society, we praise and reward those who do well, and successful hedge fund managers do very well. At the same time, while we may feel badly for those who fail in hedge fund land, there is never any reason to mourn those managers who fall from grace or from wealth.