June 2004 Newsletter
Issue Six, Volume Five

THE HEDGE FUND ISSUE

By Mike Gasior

Occasionally the mood strikes me where I feel compelled to highlight a certain trend I see occurring in the financial markets and this is going to be one of those months. Without a doubt the most significant trend I have been watching with great interest in the past five years has literally been the explosion in the hedge fund business worldwide. Since the U.S. stock market ended its upward run in 1999 no other event even comes close in importance.

My own exposure to the industry dates back over 20 years ago (God...I hate admitting that) when I landed my first hedge fund client during my broker career. Now a litany of fund administrators, prime brokers, banks, attorneys and audit firms send their staff to my seminars trying to get a handle on the activities of these complex and busy clients. I have even created a special session aptly entitled: "Providing Services to the Hedge Fund Industry", which I will offer later this year in:

Grand Cayman - September 27, 28 and 29, 2004
http://www.afs-seminars.com/cayman.html

Bermuda - October 12, 13 and 14, 2004
http://www.afs-seminars.com/bermuda.html

There has been a "gold rush" in the past 5 years of people seeking to open their own hedge funds and a comparable rush by service providers trying to garner the funds as clients. What is scary to me is that I am usually early in predicting the ultimate end to trends that I view as unsustainable, yet I cannot imagine this expansion slowing down anytime soon. Recently I was reading an article in the Financial Times regarding hedge funds and it was the first time I had seen mention of there now being over $1 trillion U.S. being managed in hedge funds. I was also in attendance at the Managed Funds Association conference in New York a couple of weeks ago and heard that same number being tossed around quite freely by attendees. To more clearly understand why I keep using the word "explosion" to describe the growth, please consider that as recently as 1990, the hedge fund industry was estimated to be a total of $15 billion U.S. in size.

So if you were curious why I have chosen to dedicate this month's edition to this topic, it is simply because I can no longer ignore any industry that is over 50 years old, yet has grown in size by over 6,600% during just the past 14 years. I will begin with the origin of the concept and by the end I hope you will more vividly understand this marketplace including some of the most recent news that is affecting it.

First, though, let me share with you a new terminology I was exposed to just a week ago.

SEAGULL MANAGEMENT

I was having a conversation with someone at one of my client companies about some of the developments that have been occurring in their division, when they made a reference to someone being a "seagull manager". Since I can generally be quite a moron, I immediately requested a definition to this new term. Here is what I got:

"Seagull Manager" - A manager who swoops in out of nowhere. Makes a lot of noise. Craps all over everything. Then takes off.

Over the years I have been exposed (no pun intended) to many of these "seagull managers" and found the term very profound. Plus, I thought you all might enjoy it yourselves because perhaps you may know one of these types personally.

VIDEO COMMENTARY

Due to the U.S. holiday I have decided to put the new video commentary onto the website on July 7th when many people will be back at work after the long weekend. This month it is pretty interesting, and pretty funny too. I'll send a brief email next week after it has been posted, but you can view it via the homepage at:

http://www.afs-seminars.com

Now on to the featured subject.

THE VERY BEGINNING

Back in 1949 a gentleman by the name of Alfred Jones had a brainstorm that would serve as the building block that would grow into today's $1 trillion business. The stock market had been a fairly miserable place since the crash of 1929, with no sustained long-term upward movements. His idea was elegant and simple. What if you were to buy some stocks (go long) while at the same time selling others short?

To put the idea in current terms, let's say that we are looking at General Motors stock and think their prospects look pretty decent, while at the same time Ford's outlook didn't appear as bright. We could go long the GM stock and sell the Ford stock short. At this point it could be said that we are neutral to the stock market (so when you hear someone say they are "market neutral" this may be what they are doing), but what we have done is isolate our difference of opinion between GM and Ford. To some degree, our exposure to the stock market is "hedged". Both stocks could go straight into the toilet, but as long as Ford went down further we could make profits. Superficially this seems like a fairly low risk idea. Please remember though that we could be all wrong in our opinion and GM could go straight down and Ford straight up and we could lose plenty of money.

Alfred Jones also thought the fund manager should share in the profits if the fund was profitable, as well as using leverage beyond the investor's core capitol. Lastly, Mr. Jones kept a considerable amount of his own money invested in the fund. The only problem with Alfred Jones idea was that many of these characteristics are not allowed in mutual fund management, so he came up with another option. Only offer the fund to "accredited investors" in a private placement that would be exempt from SEC registration.

These characteristics are very much the blueprint for a modern day hedge fund:

--Using both long and/or short positions in any market around the globe.

--The manager receives a share of the profits, typically 20%.

--Add leverage to the portfolio to increase exposures.

--Fund managers keeping significant portions of their net worth in the fund.

--The fund is offered only to wealthy individual and institutional investors and is exempt from SEC registration.

Today hedge funds pursue a huge panorama of investment strategies in every financial market worldwide. Even spectacular disasters like the collapse of Long Term Capital Management in the summer of 1998 did little to slow the rapid growth of money flowing into hedge funds. LTCM's implosion brought some glare onto the industry from a variety of regulatory bodies around the world, but the market still operates with little oversight and nearly no regulation at all.

THE REASON FOR THE GROWTH

I find the reasons for the 6,660% growth in just 14 years fairly easy to understand and explain.

First of all, almost anyone can make money in markets like the ones we enjoyed during the 1990's. But in markets like those since 1999 profits are much more difficult to come by. Since a hedge fund manager can move from long to short positions as well as changing from one market to another quickly, makes it easier for the manager to pursue opportunities wherever they appear. This striking difference between hedge and mutual funds has caused a massive flow of money from investors as they seek profit during difficult and tumultuous market conditions.

Second, the lure of potentially huge personal compensation has drawn droves of portfolio managers from the mutual fund, pension fund and insurance industry to chase the big money dream by running their own hedge fund. Today, portfolio manager compensation hovers at about $400,000 on average including bonuses.

Sadly, while that sort of income level may sound envious to many, it qualifies for pauper status among hedge fund managers. Just 5 years ago, George Soros who runs the Quantum Fund broke his own Guinness Book of World Records record for the most compensation earned by an individual in one year; $1,600,000,000. That mean he personally made $4,383,561 a DAY!! Every single day. Seven days a week and 365 days a year.

Before you think that sounds completely outrageous, I must also share with you that his chief investment strategist Stanley Drunkenmiller made $450,000,000 and 8 other Soros Fund Management employees made over $10,000,000 apiece that same year. And that is just the group of them splitting up their 20% share of the profits. One cannot imagine that investors in the Soros funds felt that anyone was overcompensated since they got to keep the 80% share.

This is why I have watched so many of my enormous U.S. clients who are insurance companies or mutual fund companies launching their own, internal hedge fund operations. Certainly some of the reason is wanting to invest some of their own assets into hedge funds. But an equally compelling reason is to cement a talented portfolio manager in place who might be tempted by the lure of leaving to start their own hedge fund and score a huge paycheck of their own. Now, perhaps, the portfolio manager will sit tight and keep running the fund their employer wants them to run, while being able to manage a little hedge fund money on the side. Not to mention the employer offering some seed money to start off with along with office space and back office support. Not a bad deal for everyone involved.

THE DARK SIDE

I'm honestly not seeking to be melodramatic with the "dark side" reference, but no subject and no industry is without risks and regular readers of this newsletter would be disappointed if something didn't worry me.

One potentially troubling aspect of the hedge fund business is the liberal use of leverage by managers. Estimates are that about 75% of hedge funds use at least some leverage in their funds. Other estimates are that about 25% of funds use "extreme" leverage, which means 100% or more. While there may never be another example of the sort of leverage employed by Long Term Capital Management (30 to 40 times investor capital), there already seems to be a loosening of lending quality standards by banks and brokers eager to lure hedge fund business.

When Long Term Capital Management was formed back in 1994, Wall Street was so anxious to get into business with them, that credit was extended to the fund with terms that treated LTCM as if they were of the same credit quality as GE Financial. While that seems crazy in retrospect, there has been a recent reduction in lending standards by many banks, in conjunction with an increased demand for borrowed money by the funds. Greenwich Associates just did a survey of the industry and found that 25% of hedge funds surveyed said that their banks had increased their credit line in the past year. On a more troubling note, 20% of funds also said that their banks had reduced the margin requirements at the same time. Finally, about one third of the funds stated that they were likely to increase their use of leverage in the coming year.

Needless to say, the question people might want to ask me is: "Isn't this situation kind of risky?" My simple answer to that simple question is: "Only if something goes wrong." It is safe to assume that many funds are exploiting opportunities in smaller and more obscure corners of the financial markets. Should we have an event similar to 1994, when hoards of investors all went running for the exits of segments of the bond market all at the same time, we could face another liquidity crisis. At times like those, lenders can become pretty squeamish about collateral that they seemed to love just moments ago.

To better illustrate what I mean, I need to tell you the story of Michael Vranos. Back in October of 1998, Vranos was running a $1 billion U.S. hedge fund that focused on sophisticated debt and derivative instruments that had made him a star trader during his days at Kidder Peabody. As many hedge do, Vranos was using leverage to augment returns for his investors, but one of his lenders, Salomon Smith Barney had issued a margin call demanding a payment be made on a loan that was outstanding. Unfortunately for Mr. Vranos, it was the weekend and the bond market had been plummeting during the preceding week making it particularly difficult to unload much of his complicated portfolio. His traders worked feverishly throughout the weekend trying to locate buyers in order to sell enough securities to make the payment on Monday morning. By the time the sun rose on Monday, the traders had successfully liquidated about $1 billion worth of the portfolio and were able to meet the demand issued by Salomon. So, you wonder, what kind of money was Salomon asking for that caused this fire sale of assets by Mr. Vranos? Try a total of $20 million. If you wonder why so much had to be sold to raise seemingly so little, welcome to the world of extreme leverage. Mr. Vranos had about $1 billion of investor money, but was carrying positions totaling about $5 billion, so he was employing leverage of approximately 500%. Add to the mix that his holdings were complex and abstract in a bond market that was collapsing and you have all the ingredients for a disaster.

One other interesting thing to consider is that literally anyone can start a hedge fund. Banned for life from the securities industry? Convicted felon? No problem. Welcome to the hedge fund industry.

I am not implying whatsoever that the industry is fraught with these sorts of individuals. I'm simply suggesting that the barriers to entry are fairly low or non-existent. Recently I was at a client in Wisconsin and the conversation turned to the mutual fund company, Strong Financial, and its founder Richard Strong who had recently paid a fine of $60 million and accepted a lifetime ban from the securities industry. My audience thought this was a fairly stringent punishment, and that the lifetime ban was effectively capitol punishment for Wall Street people. Off the cuff I mentioned that the lifetime ban was no problem if Mr. Strong should decide to enter the hedge fund business. When a few of the people suddenly were sporting stunned looks on their faces, I had to ask if it was something I had said. The reply I got was that they had heard reports that indeed Mr. Strong, or Strong Financial had begun to set up a hedge fund operation not long ago. All I could think was, pretty interesting timing.

Generally, I try to avoid giving any sort of personal or professional advice, but I will offer some here. If you are an investor thinking of investing in a hedge fund, or a bank, broker, administrator or accountant considering taking on a fund as a client then do some basic research on the person running the fund. In this day and age of the Internet, running a background check on almost anyone is easy, cheap and quick. I've been shocked at friends of mine who have ponied up hundreds of thousands of dollars to a fund manager, or a bank or audit firm who have taken on a fund as a client without having the foggiest idea who this person is, or if they are wanted in 7 states. The reason it is shocking is that these same people wouldn't rent out the apartment over their garage without spending the 20 bucks to check the tenant out, but WILL risk their savings or professional reputation without doing the same thing. It's both interesting and frustrating to me, so do us both a favor and do your homework.

HEDGE FUND NEWS

The Bank of England, which has been aggressively raising interest rates in the U.K. made statements in the past week that it is concerned about market stability due to the activities of hedge funds.

As I have been telling my audiences and readers since early this year, there has been a steep escalation of "carry trading" in many parts of the world in the past few years. With such a large difference between short-term rates and longer-term rates (a very steep yield curve environment) it has been tempting for many hedge funds to borrow short and invest long. The worry of the Bank of England (and also of the Federal Reserve I believe) is that when short-term rates continue to increase, we might be faced with the same sort of implosions like we witnessed in 1994 when the Fed was aggressively raising rates. It is likely that many hedge funds are carrying substantially similar positions, and as their borrowing costs begin to increase while at the same time the assets they purchased with the borrowed money are plummeting, the markets could be faced with a liquidity crisis as everyone scrambles to sell at the same time. This is the worry of the Central Banks.

Another current development is the rapid growth of U.S. pension plans investing in hedge funds. This situation is causing the SEC to make hedge funds register with the agency so the public can have access to more information. Personally, I think this is a foolish requirement since many of the hedge funds bought by pension plans are already registered because some pension laws or pension administrators require them to do so. To make all hedge funds register even if they don't market to pension funds is just too burdensome and unnecessary. A much easier thing to do would be to simply require pension funds to only invest in registered funds. What the SEC ought to be concentrating on is the latest trend of hedge funds trying to circumvent securities laws by selling funds to retail investors who are not wealthy or accredited. This is a much more troubling trend and one that could allow a few unscrupulous operators to give the entire industry an avoidable black eye in the future. We will have to wait and see how this proposal pans out.

YOUR MONTHLY BRAIN TEASER

Well given that it is the beginning of summer, I thought I would give you an amazingly easy brainteaser that requires no mathematics at all. Frankly, it took me a couple minutes until I realized my stupid oversight, but see how you do on it.

Here is this month's brainteaser:

"Mary's father has got four daughters. The first is called Ann, the second is called Anna and the third is called Annie. What is the name of the other daughter?"

Don't quit too quickly, but you can view the solution at this URL:

http://www.afs-seminars.com/brainteaser_June2004.html

And the answer to LAST month's brainteaser is:

"I've been working on the railroad, all the livelong day."

http://www.afs-seminars.com

Copyright 2004, Michael Gasior. All Rights Reserved.

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