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Hedge Funds Face Big Losses $50B and more

Labels: fraud, hedge funds, madoff, ponsi scheme

posted by Victor Lloyd Smith @ 11:50 AM 0 comments

Hedge fund issues could cause economy to slow

Hedge fund issues could cause economy to slow

While hedge fund failures are typically seen as a Wall Street problem, economists are forecasting that recent hedge fund meltdowns could impact Main Street and may even slow the U.S. economy. Turmoil in credit markets could push up borrowing costs for businesses and consumers and cause a ripple effect.

Hedge fund woes could hit Main Street
Upheaval in credit markets could hit consumer, business borrowing - and slow the economy; risk premiums already rising.

By Chris Isidore, CNNMoney.com senior writer
June 21 2007: 3:21 PM EDT
NEW YORK (CNNMoney.com) --

When Bear Stearns's hedge funds melted down this week because of too big a bet on subprime mortgages, it may have seemed like a Wall Street problem.

But numerous economists said the latest turmoil in the nation's credit markets could spill over to Main Street as well, raising borrowing costs for consumers and businesses alike - and possibly putting the brakes on the surprisingly resilient U.S. economy.

Subprime mortgages, made to home buyers with less than top credit ratings, have been skidding since early this year as delinquencies and foreclosure rates soared. Now problems with those mortgage loans have sparked a big headache for Bear Stearns (Charts, Fortune 500) and the Wall Street firms that lent it money to invest in subprime mortgages, such as Merrill Lynch (Charts, Fortune 500), JPMorgan Chase (Charts, Fortune 500) and Citigroup (Charts, Fortune 500).

But the problems threatening the credit markets could mean far more than just billions in possible losses for those firms. It could push rates higher for corporate debt, which has been relatively cheap even for companies with poor credit ratings.

Even if those companies don't fall behind in their debt payments the way many subprime borrowers have on their mortgages, the investors making money available for those riskier loans are now demanding a much higher premium than they had until just recently.

Deadly ripples threaten subprime funds That could choke off the supply of relatively cheap money that has kept the U.S. economy humming in recent years, putting a dent in everything from business investment to consumer spending.

"That's clearly high on my list of things to worry about," said David Wyss, chief economist at credit-rating agency Standard & Poor's. "I think it's healthy that pricing for risk changes. I think it's too loose now. But the transition could be painful. It depends on how fast it happens."
Wyss doesn't believe that the rise in borrowing costs for most companies will plunge the U.S. economy into recession - and many economists agree with him. They said there's enough underlying strength in the economy to keep it growing. But it will mean slow growth in the second half of this year rather than more normal "trend" growth of 3 percent a year or greater, said John Silvia, chief economist at Wachovia.

"I would think that that as you reprice risk, it will have a negative impact on economic growth going forward," said Silvia. "It will extend the workout in the housing market. And at the margin, they [higher rates] will crimp consumers and their spending."

Others see an even more drastic correction. Peter Schiff, president of Euro Pacific Capital, a brokerage firm specializing in overseas investments, said he had already been expecting a recession in late 2007. Now he believes the recession will come sooner, and hit harder, because of the problems with the Bear Stearns hedge funds.

"This is just another graveyard they can whistle by," he said, referring to Wall Street firms. "Eventually they're going to be overwhelmed. Interest rates are going to rise across the spectrum, and spreads are going to widen considerably."

That widening of the spreads - the difference between what it costs top borrowers and those deemed more risky - has already started. The spread between corporate debt that is not investment grade, popularly known as junk bonds, and a basket of U.S. government bonds was 2.89 percentage points on Thursday, according to Wyss, up from a record low of 2.65 percentage points on May 25.

Wyss said the spread had gotten too narrow and that a correction was likely even without the Bear Stearns problems. A more typical spread is close to four percentage points, and it was as high as 3.85 percentage points as recently as last September.

But he said an event in the credit market such as this week's meltdown typically sends spreads soaring. He noted the rise of roughly one percentage point in just two months in 2005 from a then record low in March following General Motors (Charts, Fortune 500) and Ford Motor (Charts, Fortune 500) debt being cut to junk bond status for the first time.

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hedge funds, economics, capital markets, interest rates, bond yields, valuations, CDO, credit derivatives, derivatives, pooled securities

Labels: bond yields, capital markets, CDO, credit derivatives, derivatives, economics, hedge funds, interest rates, pooled securities, valuations

posted by Victor Lloyd Smith @ 5:55 PM 0 comments

Hedge fund future bleak with Merrill sell-off

Hedge fund future bleak with Merrill sell-off

Merrill Lynch's planned auction of about $800 million of bonds held by a money-losing Bear Stearns hedge fund could signal the end of a Bear Stearns effort to save the fund. The 10-month-old fun run by Bear Stearns senior managing director Ralph Cioffi has lost 20% this year and is under increasing pressure from creditors, including Merrill. Bear Stearns has attributed the falloff of the fund and a sister fund to the slump in the U.S. housing market.

Some Lenders Dislike Plan to Save Bear Stearns Fund
By JULIE CRESWELL and VIKAS BAJAJ

An effort to save a troubled hedge fund at Bear Stearns hit a major hurdle yesterday when Merrill Lynch signaled that it would move forward with plans to auction $850 million in subprime securities that had been held as collateral.

While negotiations are continuing and the auction could be averted, the move signaled that some lenders in the High Grade Structured Credit Strategies Enhanced Leverage fund are not happy with some terms of the Bear Stearns bailout plan.

Executives at the bank have been scrambling to shore up the fund since three lenders — Merrill, Citigroup and JPMorgan Chase — asked the bank to put up more capital. The executives had offered to inject $1.5 billion in new loans into the fund, and a consortium of other banks, including Citigroup and Barclays, would infuse $500 million in new capital.

In return, the Wall Street banks and brokerage firms that had provided nearly $6 billion to the hedge fund would have had their own exposure reduced but would have had to agree not to demand more cash or collateral from the fund for a year, according to people briefed on the plan who were not authorized to speak for attribution.

If Merrill moves forward with an auction, it could make it much more difficult for Bear Stearns and the longtime portfolio manager of the fund, Ralph Cioffi, who has spent the last few days scrambling to try to bring in new money, to save the 10-month-old fund. If other lenders decide to follow Merrill’s lead and seize and sell assets, it could lead to the dissolution of the hedge fund.
Late yesterday, some people briefed on the plan said that one option might be for Bear Stearns to buy out Merrill’s stake. Representatives at Bear Stearns and Merrill declined to comment.
But if the assets — securities and bonds backed by subprime mortgages that can be difficult to value — are sold at prices well below where they are currently valued, the reverberations across Wall Street would be strong. Not only would Merrill be forced to post losses on its holdings, but other banks, hedge funds and investors owning similar securities would have to mark down the value of those holdings to new, lower prices.

“If we end up seeing these assets sold at significantly distressed prices, it will likely cause other funds to have to re-evaluate how effective and fair the values that they have been carrying these securities have been.” said Josh Rosner, a managing director at Graham Fisher, an investment research firm in New York.

The potential for a large ripple effect across the financial markets has been one reason many of the other lenders, even those unhappy with the terms of the bailout plan, stayed at the negotiating table with Bear Stearns, according to people briefed on the talks.

Started just last year, the Bear Stearns hedge fund was hit by a combination of bad bets on bonds backed by subprime mortgages as well as high levels of leverage. Investors originally put $600 million into the fund and another $6 billion was borrowed from the Wall Street banks.

Through the end of April, the fund had lost about 23 percent, prompting investors to try to redeem their investments. In May, the fund froze redemptions and soon faced margin calls from its banks.

While Bear Stearns has little exposure to the fate of the fund — the company and individual executives invested just $40 million in it — its stock nonetheless declined 2.2 percent, to $146.79. in the last two days.

Investors are probably concerned about how the outcome could affect the larger Bear Stearns business of underwriting and trading bonds backed by mortgages.

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hedge funds, mortgage backed securities, CDO, CDS, credit derivatives, mortgage derivatives

Labels: CDO, CDS, credit derivatives, hedge funds, mortgage backed securities, mortgage derivatives

posted by Victor Lloyd Smith @ 6:31 PM 0 comments

Research days are numbered. (Part 1)

Research days are numbered. (Part 1)

Research is a major cost center. It used to be coupled with marketing IB services. Yet the Research/IB relationship has been de-coupled. Mid-tier firms will find it difficult to sustain full coverage research teams. You’ll see the major firms enhance their research capabilities, while other firms sell-off. The true research team may wind up at the ratings houses (Moodys, S&P, D&B, Fitch) and market news/data companies (Bloomberg, Reuters/Thompson).

Prudential closes stock-research department
Prudential Financial ended a 25-year run with involvement in the Wall Street securities business this week when it said it would shutter its well-known stock-research department. The insurance giant attributed the move to bigger rivals and lower stock-trading commissions.

Prudential closes research operations
By Darla Mercado
June 6, 2007

Prudential Financial today announced that it would close its equity research and trading business business, Prudential Equity Group.The group will drop coverage of all the companies it covers and shut down offices across the globe causing some 420 employees to lose their jobs.
Prudential’s latest move marks its exit from the securities industry.

The insurance giant made its Wall Street debut in 1981, upon acquiring retail brokerage Bache Halsey Stuart Shields and forming Prudential-Bache Securities, according to Reuters.
Prudential had been losing ground, unable to keep up in the research and trading businesses, a Prudential spokeswoman told Reuters.

Just this March, Prudential lost analyst Michael Mayo and his research team to Deutsche Bank. Prudential started trimming costs in its trading business in 2003 with the sale of its retail brokerage and investment banking units to Wachovia, forming Wachovia Securities.

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equity research, research, IB, downsizing, hedge funds, independent research, company-funded research

Labels: company-funded research, downsizing, equity research, hedge funds, IB, independent research, research

posted by Victor Lloyd Smith @ 5:33 PM 0 comments

Hedge funds start to resemble major markets

Hedge funds start to resemble major markets

With their low correlations to major stock and bond markets, hedge funds are increasingly looking like independent markets of their own. Major investors see hedge funds as an insulated investment vehicle that protects assets when more traditional markets tank. Douglas C. Wurth, global head of alternative investments at JPMorgan Private Bank, said $1 billion a month was flowing into hedge funds on JPMorgan's platform.

As Money Pours in, Hedge Funds Come to Look More Like the Markets
By JENNY ANDERSON

“We are somewhere between the third and fifth inning in the growth of assets invested in alternative strategies,” said Todd Builione, a managing partner at Highbridge Capital Management, a $15.7 billion hedge fund that is majority owned by JPMorgan Chase.
Indeed. According to Douglas C. Wurth, global head of alternative investments at JPMorgan Private Bank, $1 billion a month is flowing into hedge funds on JPMorgan’s platform, where wealth managers are now recommending that very rich individuals ($25 million or more) and institutions put 35 percent of their portfolios in alternatives, and 20 percent of that into hedge funds.

Mr. Wurth and Mr. Builione were both speaking on a panel with other senior executives from the private bank at a briefing in New York. It was clear that alternatives continue to be the rage for a number of reasons, including the low correlations that hedge funds have historically had with major equity and bond markets. In other words, when those markets tank, hedge funds, in general, do not.

Then there’s Ray Dalio.

Mr. Dalio, the founder of Bridgewater Associates, a hedge fund with about $30 billion under assets, has some different thoughts on his industry, including some tough questions on why hedge fund returns look so much like stock market returns when they are not supposed to be correlated.

In a private research letter sent out this month, he and a colleague examined the correlation of hedge fund returns to the returns of certain market indexes.

In general, hedge funds returns should not replicate stock market returns. If they did, investors would be smarter to buy index funds and not pay the steep fees of hedge funds. Because hedge funds can hedge their bets, borrow to increase their bets, tread where others fear to tread and seek out nontraditional assets, they should generate excess returns (alpha), not just reflect market returns (beta).

According to Mr. Dalio’s analysis, over the last 24 months, hedge funds were 60 percent correlated to the Standard & Poor’s 500-stock index, 67 percent correlated to the Morgan Stanley Capital International EAFE (for Europe, Australia and the Far East) index of foreign shares, and 87 percent correlated to emerging market equities (unhedged). They were 41 percent correlated to the Goldman Sachs Commodity Index, 52 percent correlated to high-yield, or junk, bonds, and 42 percent correlated to mortgage-backed securities.

The letter also parsed the correlations by strategy, which is a more precise way to think about hedge funds, since different types of funds take different kinds of risks. Short-biased hedge funds have a negative 70 percent correlation to the S.& P. index, while equity long-short, the description applied to what most people think of as a hedge fund strategy (betting that some stocks might go up and others might fall, usually with leverage) had a huge correlation of 84 percent.

Then Mr. Dalio looked at data back to 1994, which showed that historical correlations were in the range of 49 to 54 percent; high, but not as high. So as equity markets have done well, hedge funds have done well — not necessarily because of their genius but because they have the wind of the stock markets at their back and because a lot of them use leverage to magnify their bets.
(Mr. Dalio did not return calls for comment.)

In a period when volatility is low and credit spreads are tight, it should be difficult for hedge funds to make a lot of money. But many funds appear to be taking the easy way out.

Still, no one cares about correlations, or anything else really, until the markets head down. But a lot of investors like Bridgewater as a part of a diversified group of hedge funds because Mr. Dalio has a contrarian view, and if and when the markets tank, he should — and he had better — trounce his more correlated peers.

And Mr. Dalio clearly has more than his powers of prognostication on the line: Bridgewater returned a meager 3.4 percent last year.

Many people in asset management think the whole correlation thing is overblown: of course hedge funds will take advantage of strong markets to make money. The key is that when the markets turn, these managers can do something about it. The question is whether they are smart enough to know to do it.

Maybe they are. But investors would be smart to try to understand how exposed they might be to the markets when they think they are well protected against them. (Private equity firms, another popular place to dump money these days, are buying highly leveraged large-cap companies.)

Of course, understanding returns may be hard. Mr. Wurth of JPMorgan expressed concern about aspects of hedge fund investing, notably the lack of transparency, which makes it harder to try to monitor trading by fund managers and the lack of influence a single client might have on a big fund. Which is why JPMorgan suggests clients limit themselves to only 35 percent in alternative investments, even though many want their portfolios to look more like those of foundations and endowments, which can have as much as 60 percent of their assets in alternatives.

“You do things that foundations don’t do,” Mr. Wurth joked. “You die and you pay taxes. So don’t get ahead of yourself.”

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hedge funds, asset valuation, asset correlation, portfolio management

Labels: asset correlation, asset valuation, hedge funds, portfolio management

posted by Victor Lloyd Smith @ 5:23 PM 0 comments

Research days are numbered. (Part 2)

Research days are numbered. (Part 2)

Research is a major cost center. It used to be coupled with marketing IB services. Yet the Research/IB relationship has been de-coupled. Mid-tier firms will find it difficult to sustain full coverage research teams. You’ll see the major firms enhance their research capabilities, while other firms sell-off. The true research team may wind up at the ratings houses (Moodys, S&P, D&B, Fitch) and market news/data companies (Bloomberg, Reuters/Thompson).

End of Prudential's research arm illustrates trends
Prudential Financial's decision to close its equity-research arm this week illustrates the latest trends in research, including less funding for research settlement and a poaching of top researchers by hedge funds. Additionally, the Securities and Exchange Commission has put an emphasis on buy-side research in a series of rulings, which has also put pressure on sell-side research firms like Prudential.

Equity Research: What's Next?
Prudential's purge is the latest change in the industry as research-settlement funding dries up and hedge funds poach top analysts.

When Ben Rose started his own stock research firm, Battle Road Research, back in 2001, he wanted to examine companies in a different way. Instead of starting with sit-downs with corporate execs, he would start by talking to customers, suppliers, and industry experts, people whose unbiased reviews cut through the typical press releases and industry show pitches. Rose calls his method "doing [what] analysts were paid to do in the good old days."

Battle Road is one of hundreds of independent research shops that have sprung up in recent years, with a variety of methods and areas of focus. "No one has figured out the secret sauce to conducting equity research," Rose said. "There are different approaches, all of which have validity in the marketplace."

Analysts Move to Buy-Side Firms
But finding ways to make money from providing all this research is getting more difficult. This was underscored on June 6 when Prudential Financial (PRU) closed down its equity research operations, Prudential Equity Group, and laid off more than 400 employees, including 33 senior analysts.

Few in the industry think Prudential's analysts will have trouble getting new work. Demand for analysts is strong, but the landscape has shifted. More research dollars are flowing away from firms such as Battle Road or Prudential, so-called "sell side" firms that sell their research to others. Instead, "buy side" firms such as hedge funds and other money managers are hiring in-house research staffs, paying top dollar to keep those investing insights all to themselves.

Much of the work done by Battle Road's tiny staff goes out to its clients through something called "soft dollars." Money managers pay higher trading fees, and in exchange, trading firms provide their clients with research by firms such as Battle Road. Last year, the Securities & Exchange Commission moved to restrict the use of soft dollars, and last week SEC Chairman Christopher Cox said he may lobby Congress to ban the practice altogether. "This witch's brew of hidden fees, conflicts of interest, and complexity of application is at odds with the investor's best interest," Cox said.

Fallout from 2003 SettlementSoft dollars' supporters say no one is being deceived. The practice rewards the best research, and spreads it to a wider audience, proponents say. "The SEC has systematically undermined the business model and payment system for research," says Scott Cleland of the research firm Precursor.

Cleland used to be an independent analyst, and he proudly describes pointing out problems at WorldCom before others realized anything was wrong. However, he quit at the end of 2005 to do research for industry instead, saying the economic model for independent research just wasn't working. He's particularly critical of the 2003 global research analyst settlement, which was a result of analyst scandals in which banking deals tainted top firms' research. The deal, with the biggest Wall Street firms, separated investment banking from research operations, ending a key way those firms justified research costs.

The agreement also meant that big brokers would pay $450 million toward giving their clients independent research. The settlement, while well-intentioned, ended up giving lots of research away for free, Cleland said, setting "the market price for independent research at zero."
Money from the research settlement dries up in mid-2009, and no one knows whether big brokers will continue offering the extra research alongside their own.

New Business ModelsWhile funding dries up for traditional sell-side research firms, resources and talent migrate to the buy side, the many money managers, hedge funds, and private equity firms beefing up their internal research operations, said Jeff Diermeier, president and chief executive of the CFA Institute. Analysts, along with business-school professors and administrators, say there's a perception that sell-side research, once a place where top analysts made top dollar, is not where the rewards are.

All the uncertainty is driving the research industry to come up with new business models. Some firms farm themselves out to money managers for specific research projects. Others sell research directly to investors through subscriptions. Some big firms are restricting wider access to their top researchers, using their insights for in-house trading.

"There's still demand for innovative research," said John Eade, president of Argus Research. "There's less and less demand for traditional sell-side research." Firms must come up with innovative methods or new ways to exploit research insights. For example, "few people need another e-mail report coming to them," but many investors will pay for time on the phone with a top analyst, Eade said.

Yet it's an open question how much sell-side research could survive without soft dollars. It could hurt smaller firms, Diermeier said, but using hard dollars should result in a better, more efficient allocation of research money.

Company-Funded ResearchHow much would investors pay directly for research, and would it be enough to make up for the loss of soft-dollar funds? "There is a fear in the industry that firms [won't] pay for research," Rose said. That may sound unlikely, but many point to the fixed-income market, where corporations, not potential investors, pay Standard & Poor's and Moody's to evaluate debt. Could that happen to equities?

Actually, that business model is already being tested as a way to spur coverage of smaller publicly traded companies.

Instead of covering every firm, research firms all seem to chase stocks with higher trading volume. The result? "Investors are not getting exposed to companies that are early in their growth cycle," said Karin McKinnell, president of the Independent Research Network. The lack of exposure means investors miss opportunities and small companies end up with higher capital costs.

Many smaller publicly traded firms have lost coverage as research budgets shrink. About a quarter of all public companies are not covered by a sell-side analyst. A total of 43% have two or fewer analysts covering their stock, according to data collected by IRN.

Middle Man Could Aid ObjectivityThe Independent Research Network, a joint venture of Reuters and NASDAQ (NDAQ), places itself as a middle man, enabling companies to hire research firms to cover them. The National Research Exchange has a similar business plan. Some are suspicious of any research funded by the companies being researched. McKinnell said IRN provides "multiple levels of protection," including a code of ethics, an oversight board, and two- to three-year contracts for all research coverage.

Nobody is sure where all this is leading equity research. But independent, sell-side firms say they provide a valuable service to markets. They spread information, helping markets work efficiently, and they're a key ally to investors. "Our views are aligned with investors," Eade said. "Our business interests are the same."


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research, market trends, down-sizing, hedge funds, equity research

Labels: company-funded research, down-sizing, equity research, hedge funds, market trends, research

posted by Victor Lloyd Smith @ 5:16 PM 0 comments

Outsourcing Investment Management

Outsourcing of funds could be good for investors

As hedge fund and mutual fund managers rely on third parties for risk management and other controls, investors may profit with better products, reduced costs and more transparency. About 31% of investment-management firms expect to increase this type of outsourcing over the next few years, found a survey by PricewaterhouseCoopers.

Market or manager?
- 29-May-2007

The imminent departure of Anthony Bolton, Fidelity's star fund manager, has rekindled the debate about the relative merits of active management versus passive. Should investors put faith in a manager or an index, asks Adam Lewis"A blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by the experts."

That is the accusation made by Burton Malkiel, an economics professor at Princeton, in his classic work A Random Walk Down Wall Street.

Some fund managers, such as Fidelity's Anthony Bolton, could justifiably object to being compared to primates. But the debate between active and passive fund managers remains central to the investment industry.

Given the performance record of Bolton on the Fidelity Special Situations fund, it was hardly a surprise that the announcement of his successor two weeks ago was covered widely in the media. According to Morningstar, the fund, which was split into two last year, grew 160-fold from its launch in December 1979 to May 14, 2007.

As is well known to most readers, Sanjeev Shah, the former manager of Fidelity's UK Aggressive fund and current manager of the European Aggressive fund, will take on the £3.2bn UK Special Situations portfolio in January next year. His appointment was mostly welcomed by the fund industry. But his relative lack of experience means that advisers and fund of fund managers are looking at alternative funds.

On the week of Bolton's departure, Bestinvest, an IFA firm, recommended no fewer than five potential funds that have similar objectives to Fidelity Special Situations, if investors wanted to switch to "a more proven manager".

These include: the £1bn Artemis UK Special Situations fund run by Derek Stuart; Nigel Thomas's £1.5bn Axa Framlingon UK Select Opportunities fund; and the £729m Merrill Lynch UK Special Situations fund, managed by Richard Plackett. It also suggested that clients look at Mark Hall's £632m Rensburg UK Select Growth fund and the £165m Investec Special Situations fund, run by Alistair Mundy.

Not on the recommended list of Bestinvest, advisers or fund of fund managers, was that investors switch their holdings into an index tracker fund. Hardly a surprise given the difference in styles, but according to several prominent investment professionals, buying a fund that tracks the stockmarket is the only way to properly invest for the long term.

John Bogle, the founder of the Vanguard Group in 1974 and author of The Little Book of Common Sense Investing (reviewed in Fund Strategy, May 7, 2007, page 28) is in the Malkiel camp. At Vanguard, Bogle was responsible for the creation of the world's first index mutual fund (now called the Vanguard 500 Index fund) in 1975.

According to Bogle, out of 355 equity funds launched in America over the past 36 years, only 24 have outpaced the S&P 500 by more than one percentage point a year. Of these, he adds, just three have mounted a record of sustained outperformance: Davis New York Venture; Fidelity Contrafund; and Fidelity Mutual Shares. Meanwhile, the only manager to have outperformed the S&P 500 in the past four decades for 15 consecutive years is Legg Mason's Bill Miller. While Bogle acknowledges Miller's ability, he says the odds of owning a consistently successful equity fund are less than one in a hundred. Indeed, Millar's run of S&P 500 outperformance ended in 2006, when in dollar terms his American-domiciled Value Trust returned 5.85% compared with the index, which grew 15.79% over the calendar year, according to Morningstar.

Bogle also makes the point that in America, over the course of the past 36 years, out of 355 equity funds that existed, 223 have gone out of business. "If your fund doesn't last for the long term, how can you invest for the long term?" he asks.

Another problem with active funds is manager turnover. While Bolton has managed his fund for almost 28 years, according to research statistics in the 2005 UK Fund Industry Review, three-quarters of fund managers in Britain have managed their funds for four or fewer years (see pie chart, above).

The message of Malkiel's book, into its ninth edition since first being published in 1973, is similar to Bogle's. That is, investors are better off buying and holding an index fund than attempting to buy and sell individual stocks and actively managed funds. One of his main arguments is that the developed financial markets, such as America and Britain, price stocks so efficiently that strategies designed to beat it are futile.

Malkiel, who sits on the Vanguard board with Bogle, adds that those mutual fund managers in America who have beaten the market over certain periods have typically underperformed it substantially at times.

This is true of Bolton. Mark Dampier, the head of research at Hargreaves Lansdown, says that between 1988 and 1992, and again in the late 1990s, Bolton's style of investing fell out of favour with the market. The fund underperformed substantially as a result.

James Norton, the director of Evolve Financial Planning (which only offers clients passive funds), notes that if an investor had put money into Bolton's fund in 1989, it would have taken them 11 years for their investment to get back to beating the market, such was the degree of the fund's underperformance.

"There is no doubt that Bolton is a star fund manager," Norton adds, "but investing in him was not without risk. Investors would have had to stick with his fund through thick and thin to have made the returns often quoted."

For Bogle, the main reason for the underperformance of most actively managed funds is that they are hampered by expense costs, poor stock selection and market timing, taxes and inflation. He estimates that management fees, operating expenses, sales charges, the cost of portfolio turnover and broker commissions, can come to as much as 3-3.5% percentage points a year for actively managed funds.

However, Dampier says that while the fees on index tracking funds are much lower, investors who use them are "guaranteeing themselves underperformance". Any fee they charge will mean the return for the investor is less than the index.

This is an argument supported by John Chatfeild-Roberts, the head of the Jupiter independent funds team. He says: "Trackers may be cheaper than active funds, but price does not always represent value for money. Passive index tracking funds are almost guaranteed to underperform the index they track by roughly the amount of their annual charges. That can have a significant effect on the value of an investment over time."

Norton agrees: "If the manager of an index tracking fund does their job properly, an investor will be left with the market return, minus the costs. These costs should be more than 0.5% a year and decent funds charge 0.3%. It remains criminal that Virgin still charges 1% for its passively managed tracker fund.

"If you compare this with research conducted by Lipper Fitzrovia last year, the average total expense ratio of an active UK equity fund was 1.63%. This is a 500% disparity in costs and means the average active managed fund will underperform the index by a larger amount than index funds, as their costs are higher."

Chatfeild-Roberts says the contention for arguing for trackers on the basis that active managers cannot consistently beat the market index is "nonsense". He argues: "Good performance is repeatable if you invest with a talented fund manager. There may only be about 100 of them in the UK market place, and if you do not feel you can identify them, that is your prerogative. However, investors should not be fooled into thinking it cannot be done."

So how does an investor go about finding the next Bolton or the next Warren Buffett? Malkiel has in the past conceded that there are individuals who can consistently beat the index, noting that Buffett is "an investment genius". The problem, he notes, is that "trying to find the next Buffett is like trying to find a needle in a haystack. Why not just buy the haystack?"
Norton adds: "The question boils down to how can you pick the active funds that will outperform in advance? You would need a crystal ball. Allacademic research shows that there is little persistency in the outperformance of active managers."

Bolton agrees: "The real question here is, given that so few managers beat the index consistently over time, can a retail investor identify those managers who will outperform in advance? That's why you need to research the manager and the investment house. For most investors, this means consulting an IFA. So, if you do your research you will have a good chance of identifying which managers beat the index."

Not so, according to Bogle. His book not only casts doubt on how much worth advisers add to investors. It also questions whether just because a manager has done well in the past he will necessarily do so in the future. "Every firm in the investment industry acknowledges my conclusion that past performance is of no help in projecting future returns of mutual funds. This is stated in all prospectus'," he writes.

In terms of investors seeking advice to select funds, Bogle writes that a survey by a research team led by two Harvard Business School professors found that between 1996 and 2002 alone, the weighted average return of equity funds held by investors who relied on advisers (American brokers and excluding all upfront or redemption charges) averaged just 2.9% a year, compared with 6.6% earned by investors who took charge of their own affairs.

While Bogle says advisers may provide a valuable service in reassuring clients in helping establish a portfolio that matches their risk/reward appetite, "advisers as a group cannot be credibly relied upon to add value by selecting winning funds for you."

Justin Modray, head of communications at Bestinvest, says that Bogle makes a fair point. "In terms of the entire IFA market, it's fair to say that a number of firms don't put enough effort and thought into the picking of funds. This is why more and more firms are outsourcing their funds selection to fund of funds - it's an admission they are no good at it themselves."

However, he says the larger IFA firms, such as Bestinvest and Hargreaves Lansdown, have their own in-house research teams. This means, he argues, they can add value.

This need to add value is seen as important. Modray says it has conducted research that shows over three-year rolling periods, going back 20 years, more than two-thirds of active managers have failed to beat their index.

So how much of picking the right active manager is luck and how much judgement? Indeed, how much of an active manager's performance is luck and how much is skill?

In the late 1990s Albert Morillo, at the time the manager of the Investec European fund, and Rory Powe, the manager of the Invesco European fund, were two of the big names in the industry. However, at the start of this decade, as the bear market set in, Powe's growth style of investing, with large amounts invested in technology stocks, fell out of favour and his fund underperformed substantially.

Meanwhile, Morillo built his strong track record in the 1990s while at Scottish Widows. He took over the Investec European fund in April 2000 on an outsourced basis, after he joined Blackrock. However, his fundamental value approach to investing in firms led him to miss out on bounces in sectors during equity rallies, and the fund consistently underperformed the sector from the third quarter of 2002 onwards. On January 1, 2007 Investec ended the outsourcing agreement, bringing the fund back in-house to be managed using its four-factor equity investment process.

Malkiel says the same is true in America. He has written that the fund managers who did well in 1998 and 1999 managed to outpace the S&P 500 by more than two times. However, in early 2000 they underperformed the index by about three times. Similarly the top-performing funds in America in the 1970s underperformed in the 1980s and the top funds in the 1980s underperformed in the 1990s.

Dampier also says there are not many decent active managers for British investors to choose from at present. "Putting it in football terms, how many Cristiano Ronaldos are there? There is no right or wrong answer when it comes to this debate. I object to the religious right of those such as Vanguard who think passive funds are the only place to be, but I'm also aware that 90% of active managers are crap too. As a result you have to spend a lot of time to find the best managers," he says.

Dampier argues that investors can pursue a core/satellite approach, in which their core funds are index trackers, then use active funds for satellite holdings. Modray says it uses index funds as he notes they can be sensible core holdings in clients' portfolios.

Alternatively, Dampier says that investors should look for fund managers they believe will outperform. "While you can try and find the Ronaldos, investors have to realise active managers will have times when they don't perform well. It's all about putting the work in and those who can't are better off going down the indexation route," he says.

However, Chatfeild-Roberts argues that truly passive investment does not exist. This, he says, is because investors are always making choices, with there being more than 13,000 indices in existence, each of which he says have different characteristics. "By picking one rather than the other you are, in effect, being forced to take a view. This will have consequences for the returns you make," he says.

Malkiel notes that over the past few years the S&P 500 index has itself become more actively managed, in terms of the amount of changes made to it. However, he says that it is far less actively managed than active funds.

In the more recent editions of A Random Walk Down Wall Street, Malkiel recommends investors use an index that offers a broader representation of the American stockmarket. These include the Wilshire 5000 or the Russell 3000. This is primarily because he says the S&P 500 only represents the larger American firms that make up three-quarters of the total market. As a result, investors who only invest in an S&P 500 index fund do not have exposure to smaller or mid-sized companies.

In 1981 David Booth and Rex Sinquefield, former students of Eugene Fama, a leading American financial economist, founded Dimensional Fund Advisors. Its business was based on Fama's hypothesis that markets are efficient: prices accurately reflect intrinsic value. It rejects not only the idea that active managed funds can sustain long-term returns through exploiting mispriced stocks, it also rejects the purely passive management concept.

Instead, it uses a third way called "value added management". It has identified three equity and two fixed-interest "factors", or core elements, to its strategy. The equity factors are that shares will return more than fixed interest and that small company and value shares will return more than large company and growth shares. The fixed interest factors are that longer-term and lower credit quality instruments incur greater risk. Indeed, Dimensional's name reflects these three factors or "dimensions" to its approach.

Its strategy also aims to minimise portfolio turnover (which Bogle argues is a hidden cost in active funds) and therefore beat active and passive approaches on dealing costs. Worldwide, the group manages $136bn (£69bn) of assets under management. Most of these assets are run in its so-called "enhanced index funds". The goal of these enhanced index funds is to add 100-200 basis points a year over conventional benchmarks, while tracking their benchmarks almost as well as index funds.

Samuel Adams, the vice-president of financial adviser services at Dimensional, says its primary goal of its funds is to deliver the return of the asset class every year. "If we can add 100 to 200 basis points over the benchmark that would be fantastic, but people buy our funds because we deliver the return of the asset class," he says.

In Britain the group manages six Oeics, with assets under management totalling £750m. The most recent, the UK Core Equity fund, was launched in June last year and now has assets of £170m. The fund provides a broad exposure to the FTSE 350 index and has been designed so that it is not concentrated on just the large cap names.

Adams says: "The fund takes weights out of the top 10 stocks and buys more outside, buying more small cap and value companies, as these are the areas that traditionally provide stronger returns. However, the funds we run are 100% passive and remain within 1-3% of the FTSE 350."

As Dimensional funds are designed for long-term investing, all discretionary IFAs who want to sell its funds must attend a two-day training course.

Ian Shipway, the director of investment at Thinc Group, has used Dimensional's range of UK Oeics ever since it first launched at the start of 2004. Thus far he says he has been happy with the results. "Dimensional is not an index tracker, it engineers passive portfolios. Using its funds allows us to gain pure exposure to the asset classes we want at very low cost."

The obvious presumption is that despite the benefits listed of passive funds, most investors in Bolton's fund will continue to want their money managed in an active manner. Whether or not this is the best way to invest in stockmarkets is a debate that will continue for a long time.

Dampier says: "If everyone agreed that indexation was the way to go and money was invested in size in index tracker funds, the result would be more capital becomes misallocated. This happened in the late 1990s to 2000 when there was a gigantic misallocation of capital to large caps, purely because of their size, rather than the fact they were good businesses."

Chatfeild-Roberts concludes: "On the upside, I would argue that passive funds are great news for active investors, as the more money that becomes passively managed, the more potential profits there are to be made by the best active investors."

However, whether or not there are the active managers to pick up on these returns, consistency remains the big question.

Hot fundsOne criticism often directed at the active funds industry by advocates of passive investing is the propensity of group's launching funds based on the short-term performance of certain sectors in stockmarkets. These are the so-called hot funds. In Britain, a classic example of this was during the technology boom of the late 1990s.

As the tech bubble grew and grew, ever more fund management groups cashed in the sector's popularity by launching dedicated technology portfolios. In May 1999, Framlington launched its NetNet fund and Gartmore created its Techtornado fund in February 2000. Jupiter, meanwhile, launched its Global Technology fund right at the top of the cycle in March 2000, with the fund taking in £132m in its offer period.

Indeed, in March 2000 some £877m of Isa money was invested into the technology sector, with the money flowing into a 28-strong fund sector. However, since the dotcom crash in the same month, only 14 funds remain. In May last year, Axa Framlington merged its NetNet and Nasdaq funds into one portfolio, AXA Framlington Global Technology, while Gartmore merged Techtornado into its UK & Irish fund in February 2003.

The most recent fund to announce its impending closure was Aegon Technology. Launched in 1985 it was one of the oldest tech portfolios, but its assets peaked in October 2000, reaching £341m. Since the tech crash, however, its assets have fallen to £8m and the group announced at the start of this month its intention to close the fund on July 31.

Following the bursting of the tech bubble, commentators have consistently looked for the next potential bubble, and one such sector could be property. Buoyant demand for commercial property and the launch of real estate investment trusts has seen several groups launch dedicated property portfolios over the last couple of years.

The IMA specialist sector, which contains all the commercial property and global Real estate investment trust funds, was the best-selling net retail sector for the whole of 2006 and the first quarter of 2007. And in March this year, £471m was invested into property funds according to the IMA.

John Bogle, founder of the Vanguard Group and author of The Little Book of Common Sense Investing, writes: "There have been many new paradigms over the years. None have persisted. The "concept" stocks of the Go-Go years in the 1960s came and went. So did the "Nifty Fifty" era that soon followed. The "January effect" of small-cap superiority came and went. In the late 1990s, high-tech stocks and "new economy" funds came as well. Today, the asset values of the survivors remain far below their peaks. Intelligent investors should approach with extreme caution that any new paradigm is here to stay. That's not the way financial markets work."

Diagram: Length of Fund Manager Service
Diagram: Active Funds vs. Trackers

hedge funds, investment management, business process outsourcing

Labels: business process outsourcing, hedge funds, investment management

posted by Victor Lloyd Smith @ 4:26 PM 0 comments

Hedge Fund Managers Top Wall Street Earners

Hedge fund managers sitting pretty

Annual lists of high-paid hedge fund managers show astronomical gains ($1.7 billion at the top of the list -- for just one man), but is it worth it to use a hedge fund manager? Typical hedge funds come with a 2% management fee no matter how they perform, and they include a big cut on profits that exceed certain amounts. Even low-performance hedge funds can mean big profits for managers.

Worth a Lot, but Are Hedge Funds Worth It?
By DAVID LEONHARDT

When Institutional Investor’s Alpha magazine released its annual list of the highest paid hedge fund managers last month, it allowed the rest of us to play an entertaining little parlor game: what could you buy if you made as much money as those guys?

James Simons, a 69-year-old mathematician who was at the top of the list, earned $1.7 billion, which equaled the amount of money that the federal government spent last year running its vast network of national parks. Down at No. 3 on the list, Edward S. Lampert of Greenwich, Conn., the investor who owns a large chunk of Sears, made $1.3 billion, which, if you forget about taxes, would have allowed him to buy the entire economic output of Sierra Leone. We’re talking about real money here.

Today, Alpha magazine will release another big list, and this one offers a chance to answer another, arguably more important, question: Are these billionaire hedge fund managers really worth it?

The reason hedge funds are a license to print money is their fee structure. A typical fund charges a 2 percent management fee, which means that it keeps 2 cents of every dollar that it manages, regardless of performance. Mutual funds, on average, charge about 1 percent.
On top of the management fee, hedge funds also take a big cut — usually at least 20 percent — of any profits that exceed a predetermined benchmark.

So in a good year, a fund’s managers bring in stunning amounts of money, and in a bad year, they still do very well. Some quick math shows why: 2 percent of a $5 billion portfolio, which was roughly the cutoff for making Alpha’s list of the 100 largest funds, equals $100 million. A fund’s managers get to take that fee every single year.

Last year was actually a pretty tough year for the industry. Because hedge funds tend to make a lot of countercyclical bets — thus the name — they can often turn a profit even when the stock market falls. When it’s rising broadly, though, many struggle to keep up. Last year, the Standard & Poor’s 500-stock index jumped 14 percent, while the average hedge fund returned less than 13 percent, after investment fees, according to Hedge Fund Research in Chicago.

But the men — and they are all men — who appear on Alpha’s list of top earners don’t manage average hedge funds. They manage the biggest funds in the world, the ones that are winning the Darwinian competition for capital, and many of them aren’t having any trouble beating the market. One of the funds at Mr. Simons’s firm, Renaissance Technologies, delivered a net return of 21 percent last year. The other returned 44 percent after fees. And Mr. Simons, who relies on a fantastically complex set of algorithms, doesn’t charge “2 and 20” — as the typical industry fees are called. He charges “5 and 44” — a 5 percent management fee and 44 percent of profits — yet he has still been doing very well by his investors for almost two decades.

I realize that a lot of people find 9- and 10-figure incomes to be inherently excessive. Or even immoral. From a strictly economic point of view, however, they are also perfectly rational. You cannot find anyone else who is providing the same returns as the best hedge fund managers at a lower price. If you don’t like it, you don’t have to give them your money.

(Even if you do like it, they probably won’t take your money. In exchange for being lightly regulated, hedge funds are open only to wealthy investors and big institutions.)

Thanks to their incredible performance, the biggest funds have grown far bigger in recent years. The 100 largest firms in the world managed $1 trillion at the end of last year, or 69 percent of all the assets in hedge funds, according to Alpha. At the end of 2003, the top 100 had less than $500 billion, or only 54 percent of total hedge fund investments.

“The best performance is coming from the largest funds,” said Christy Wood, who oversees equities investments for the California Public Employees’ Retirement System, which, like a lot of pension funds, is moving more money into hedge funds.

But there is an irony to this influx of money. It all but guarantees that hedge fund pay over the next few years won’t be as closely tied to performance as it has been. The hundreds of millions of dollars that have flowed into hedge funds have made it all the harder for fund managers to find truly undervalued investments. The world is awash in capital.

All that capital, of course, also translates into ever-greater management fees, regardless of a fund’s performance. The flagship hedge fund at Goldman Sachs lost 6 percent last year, but it still brought in a nice stream of fees. Bridgewater Associates, which is based in Greenwich, has earned a net return of less than 4 percent in each of the last two years. Yet its founder, Raymond T. Dalio, made $350 million in 2006.

“When we have a bad year, we’re essentially flat,” Parag Shah, a Bridgewater executive, told me. “And when we have a good year, we have a great year.”

Goldman and Bridgewater may well bounce back, but the combination of extraordinary pay and ordinary performance is going to occur more and more in the coming years. Outside of the highfliers on the Alpha list, it’s already the norm. Since 2000, the average hedge fund hasn’t done any better, after fees, than the market as a whole, according to research by David A. Hsieh, a finance professor at Duke. Still, even mediocre managers, after a lucky year or two, are able to attract gobs of capital and charge “2 and 20.”

So are today’s hedge fund managers really worth it? Sure, but only if they deliver the sort of performance that Mr. Simons has, and very few will in the years ahead. More to the point, it’s extremely difficult to know who the stars will be.

In all sorts of walks of life, people tend to think that the past is a better predictor of the future than it really is. That’s why journeyman baseball players — a Yankees pitcher named Carl Pavano comes to mind — are able to sign huge contracts based on a single good season. It’s also why so many investors chase returns.

The genius of the world’s hedge fund managers isn’t only in how they invest their money. It also lies in having set up an industry that takes advantage of a timeless human trait.

E-mail: Leonhardt@nytimes.com

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hedge funds, portfolio managers, hedge fund returns, alpha, beta

Labels: alpha, beta, hedge fund returns, hedge funds, portfolio managers

posted by Victor Lloyd Smith @ 10:36 AM 0 comments

Hedge funds eclipse investment banks in bond trading

Hedge funds eclipse investment banks in bond trading

The significance of hedge funds has increased thanks to computer-driven trading models that generate high trading volume for U.S. Treasury bonds. Electronic trading, and the ability to make trades quickly to exploit small differences in prices, is changing the trading field and has given hedge funds a leg up on investment banks.

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hedge funds, bond market, bond trading, electronic trading, US treasuries

Labels: bond market, bond trading, electronic trading, hedge funds, us treasuries

posted by Victor Lloyd Smith @ 12:15 PM 0 comments

Fraud ring prompts concerns on Wall Street

Fraud ring prompts concerns on Wall Street:

The accusation that more than a dozen people were involved in a fraud ring on Wall Street illustrates why regulators and lawmakers are concerned about the Street's relationship with hedge funds. "Incidents like this strengthen the hands of those who are urging greater scrutiny of hedge-fund activities and their sources of information," said a former SEC general counsel now in private practice.

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hedge funds, risk, fraud, compliance, insider trading, regulation, SEC

Labels: compliance, fraud, hedge funds, insider trading, regulation, risk, SEC

posted by Victor Lloyd Smith @ 11:46 AM 0 comments

Fed's crisis manager Geithner has eye on hedge funds

Fed's crisis manager Geithner has eye on hedge funds

New York Fed President Timothy Geithner has had some luck in getting the credit-derivatives industry to take steps to avoid a potential meltdown. Now he's turned his attention to hedge funds -- an industry that seems not to share his concern nor welcome his interest.

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hedge funds, asset management, regulatory risk FED, SEC

Labels: asset management, hedge funds, regulatory risk FED, SEC

posted by Victor Lloyd Smith @ 5:17 PM 0 comments