Funds & Games

“I worked at a hedge fund for two years before I knew what one was,” jokes one fund employee, who, like many others in the secretive world of hedge-fund management, would talk to New York only if his name wasn’t mentioned. Hedge funds are the sporty investment vehicles of the late nineties, but most people don’t have a clue what they are. Maybe that’s because they’re better defined by what they are not. A hedge fund comprises a group of individuals whose pooled money is invested by a manager. But unlike mutual funds, hedge funds aren’t SEC-regulated, and their managers don’t have to be registered investment advisers. And if you aren’t an “accredited investor” – that is, someone who makes at least $200,000 a year and has more than $1 million in assets (primary residence included) – you can forget about parking your stash in one. Wealthy families, school endowments, and pension plans are among the largest investors in hedge funds. Think of them as mutual funds for the plutocrats; if you have to ask the price of admission – well, you know the rest.

Hedge funds are very private, very lucrative, and very hot. It took just seven months to raise $1 billion for Ocelot, Julian Robertson’s latest hedge fund at Tiger Management (on average, all of Tiger’s funds were up 63 percent through mid-December, before fees were subtracted). Robertson and George Soros are the industry’s glamorous Garbos – rarely talking to the press about their wheeling and dealing but still the subjects of endless fascination. Whenever the Wall Street Journal gets wind of their shopping sprees, the pair’s purchases are dutifully recorded (see page 26 of this issue for their biggest recent buys). Generating considerably more ink is James Cramer, hedge-fund manager of the Cramer Capital Corporation, contract writer at Time and GQ, part owner of industry website, and former New York Magazine financial columnist. Recently, Cramer joined the likes of Michael Jordan and Shaquille O’Neal, appearing in footwear ads – for Rockports, not Reeboks, but you get the idea.

Their often astonishing returns are splattered across the newspapers, so the names of these cowboys are on a lot of people’s lips – even if the funds they run are banned from advertising. Not that the better ones have to. Just as at the Union Club, if you want to join in the fun, you have to know the right people. “Some of these guys have waiting lists for investors,” says John Broadhurst, a San Francisco lawyer who works with hedge funds. Casually mentioning your hedge-fund manager at a dinner party now has the cachet that owning an outsize house on Southampton’s Gin Lane had in the eighties.

There is a growing feeling that the real money has tunneled into hedge funds – where the managers (who usually invest their own money alongside their clients’) get a 1 to 3 percent management fee in addition to 10 to 25 percent of the profits. The management fees ensure they make money anyway, even when their strategies don’t pan out. The million-dollar bonuses paid to Wall Street investment-banking honchos look like a pile of peanuts next to the hundreds of millions hedge-fund managers and their relatively junior employees take home. Some of them have so much cash, they’ve taken to giving it away: The legendary George Soros has disbursed more than $1.5 billion over the past twenty years (the bulk of it in the nineties) to all manner of causes. Soros’s right-hand man, Stanley Druckenmiller, and Tiger Management’s Julian Robertson are two of five fund managers who preside over the philanthropic Robin Hood Foundation.

The perception is that many managers feel compelled to try to hit the ball out of the park to justify their immense paychecks. Hedge funds can carry a great deal more risk than a plain-Jane mutual fund. But stupendous risk sometimes yields stupendous rewards, as anyone who has invested with George Soros will tell you. Soros’s flagship Quantum fund has returned, on average, around 33 percent annually – after fees – since 1969.

A hedge-fund manager tries to make money any way he or she can: by going short or long on securities and by using currencies, options, futures, leverage, or any variety of white-knuckle (entirely legal) techniques to swell the coffers. That’s another reason managers tend not to welcome the scrutiny of the press. The hedge fund rubric is generally used to describe a fund that can invest in more than one asset class (stocks, futures, or currencies, for example); use borrowed money, or leverage, to increase investment assets; and hedge, which is simultaneously buying one security and shorting another, ultimately balancing trades to limit downside risk. While a mutual-fund manager is obliged to lay out a specific investment style in a prospectus – and stick to it (or risk hearing about it from the SEC) – a hedge-fund manager is free to employ whatever strategy he or she believes makes the most sense for different markets and investment conditions. Even with such a liberal charter, many hedge-fund managers have taken it upon themselves to outline their strategy for investors in a “placement memorandum”: some purposely give themselves tremendous flexibility; others set limits on their own investing activities.

Although mutual funds could have some of the same flexibility (as long as it’s clearly defined in their prospectuses), relatively few managers choose that route. “There is greater risk in engaging in high-risk activities with widespread mutual-fund ownership than with a sophisticated group of investors,” says Weil Gotshal & Manges senior partner Robert Todd Lang, chairman of the American Bar Association subcommittee on private investment entities.

“The brightest minds on Wall Street are not on Wall Street,” insists one hedge-fund manager. “They’re with the hedge funds.” That might be slightly self-serving, but hedge funds are vacuuming up a lot of talent. Why? There’s that hefty percentage of profits, known as “incentive compensation.” Not having somebody looking over your shoulder all the time is another perk.

After slugging it out in a big Wall Street firm, many bankers find the idea of spinning off a small shop appealing. Back in 1991, research chief Leon Cooperman left Goldman, Sachs to start the Omega fund, and three years later, Salomon Brothers vice-chairman John Meriwether was forced to resign from the firm but went on to launch Long-Term Capital Management with eight partners, including Nobel prize winners Robert Merton and Myron Scholes. Merton and Scholes famously helped create the Black-Scholes model for pricing stock options. (Don’t slap your checkbook on the counter just yet – Long-Term Capital is closed to new investors.)

Who else preferred to switch rather than fight? Jeffrey Vinik started his own hedge fund in November 1996, shortly after his very public departure from managing Fidelity’s hypertrophied Magellan fund, where he’d been criticized for making an ill-timed bet on bonds as well as publicly talking up a stock in his portfolio even as he was selling it. Vinik already has an estimated $1.5 billion to play with (after fees, his hedge fund was up 91.6 percent through mid-December). John Hancock Special Equities fund managers Michael DiCarlo and Andrew St. Pierre set up their hedge fund, DFS Advisors, in March 1996 and were featured in a New York Times Magazine cover story nine months later.

It’s a manager’s market. “If you’re well established, people tend to follow you – throw money at you,” says Weil Gotshal’s Lang. The industry is ballooning; witness the dozens of young managers ensconced in “Hedge Fund Row” – the Helmsley Building, at the foot of Park Avenue – and those renting fallow office space inside brokerage houses like Bear, Stearns. Although still dwarfed by the $3 trillion mutual-fund industry, hedge funds command a big cut of the action: in 1996, there were more than 4,700 of them globally (3,500 in the U.S.), managing around $225 billion; that number was up from 2,000 managing $84 billion in 1990, according to Nashville’s Van Hedge Fund Advisors International. Everybody, it seems, wants to run a hedge fund, even former Kidder, Peabody bond trader Joseph Jett, who is still fighting SEC charges related to claims that he defrauded that firm in the early nineties. In April, he announced plans to launch a hedge fund with three partners.

“I’m making money on a day like this,” says hedge-fund manager John Moon of Moon Capital, sitting in his office at 53rd and Madison. It is the morning of December 18, and the Dow has already sunk 225 points. A minute or so later, the Dow is down 253 points, and Moon’s small-cap emerging-markets funds is up about 1 percent. “If you work for, say, a Latin American mutual fund, they usually need to be 90 percent invested, and can only stray from a benchmark by so much,” says Moon, “so even if you think Mexico is going to crash because of a devaluation, you have to be invested.” Before fees, Moon’s fund was up 18 percent in mid-December since its creation in April; his benchmark, the MSCI emerging-markets free index, was down 21.69 percent for the same period.

“In a hedge fund, you’re betting on the manager, not the market,” says Martin Gross, who runs a fund in Livingston, New Jersey, that buys stakes in hedge funds; it’s what’s called a fund of funds. “If you’re in a general technology fund and technology is up, you know you’re up. If you’re in a hedge fund and technology is through the roof, you’re not sure. You have to call the manager and find out what his call on the market was.”

It’s important to note that many hedge funds have actually underperformed U.S. indexes over the past four years. But they did remarkably well in October’s market drop: On average, according to Van Hedge Fund Advisors, domestic hedge funds fell just 0.7 percent, compared with losses of 6.3 percent, 5.6 percent, and 3.3 percent, respectively, for the Dow Jones Industrial Average, the average U.S. equity mutual fund, and the S&P 500.

Was October an anomaly? While hedge-fund managers and consultants will tell you that hedge funds are traditionally supposed to underperform a bull market and outperform a bear market, nobody can say for sure how this bumper crop will do in a protracted market downturn. A study done by Stephen Brown of New York University and William Goetzmann and Roger Ibbotson of Yale University that examined several hundred offshore investment funds found no correlation between performance in one year and performance in the next (George Soros’s operation is the exception, not the rule, says Ibbotson).

The name hedge fund was coined in the fifties by money managers looking, ironically, for a strategy to protect wealthy investors in a down market. Accruing outsize gains wasn’t part of the original mandate; safeguarding principal was. Those early managers probably didn’t envision the kind of wild swings investors now associate with hedge-fund performance or the bets George Soros makes on the direction of the world’s economies. (The prime minister of Malaysia recently accused Soros of garroting the ringgit by betting on its decline – a charge that was widely ridiculed. In fact, it seemed like everybody was shorting the currency, because the Malaysian economy looked like it might tank. And nobody knows exactly what Soros’s exposure was, anyway.)

Victor Niederhoffer, who for 25 years successfully ran a group of funds, made Business Week’s best-seller list in the summer with his self-congratulatory (when it wasn’t self-deprecating) biography, The Education of a Speculator. But shortly thereafter, Niederhoffer got taken to the woodshed when he bet wrong on the Thai baht and then on the S&P 500. He was wiped out in October’s market rout, and reportedly has been left liable for much of the $45 million deficit. “My idea has always been that the only way to make above-average returns is to take above-average risk,” Niederhoffer told New York in December, adding, “I think I learned that the lessons of the Western markets don’t apply to Eastern markets. It’s a different ball game out there.” The chastened speculator isn’t planning to reboot anytime in the near future. “I’m just licking my wounds and trying to meet my obligations for the year,” he says.

“When you deal with hedge funds, the principal risk you face is manager risk, not market risk. If you’re in an asset class where the manager has the tools to make money in all sorts of markets, he’s not there to mirror any index; he’s there to perform on an absolute basis,” says Joel Katzman, president and CEO of Chase Alternative Asset Management, which manages around $1.2 billion (half of which is in hedge funds). “For every Soros and Robertson you read about, there are many, many smaller managers that might not be as aggressive as Soros and Robertson are. They have different return objectives, much lower volatility.”

Some of the better-known hedge-fund managers, including Soros and Robertson, have held substantial long positions in U.S. stocks over the past few years. Weil Gotshal’s Lang says the term hedge fund is itself a misnomer; what most people think of as hedge funds, says Lang, are simply “private investment entities.” Under the terms of their partnership agreements, clients can bail out only at the end of a quarter and sometimes have to wait as long as five years. That promotes some measure of stability; in market dips, mutual-fund switchboards are known to gear up for shareholder redemptions.

Recent legislation will actually increase the amount of money under this kind of management – the buccaneering hedge-fund industry lobbied for it. Until 1997, every hedge fund was capped at 100 accredited investors. But under the new rules, funds can take in 499 investors; however, each individual investor must have a minimum of $5 million in investment assets (primary residence not included), and each institutional investor must have at least $25 million under management. “Knowledgeable employees” of hedge funds are also now allowed to buy in, regardless of their financial status. In addition, fund managers were finally allowed to set up parallel funds with similar investment strategies. Permitted to have more investors, managers may start bringing down minimum investment requirements, which now range from $250,000 to $20 million. Julian Robertson’s Ocelot fund, for example, requires a $1 million minimum investment, compared with $10 million for the other Tiger funds. Ocelot is a “3C7 fund,” created under this new legislation.

For accredited investors who still can’t meet the minimums, there are always funds of funds, offered by individual managers and institutions like Chase and DLJ. Funds of funds allow individuals to pool their money to meet hedge-fund minimums and – occasionally – get into closed funds (those in which fund-of-funds managers staked positions before they closed). Of course, in exchange for this kind of access and diversification, you are paying a whole other round of fees – the ones levied by the actual hedge funds themselves, in addition to the management fee charged by the fund-of-funds manager. And the returns of the top-performing funds of funds over the past five years haven’t kept pace with those of the top-performing hedge funds.

How does one go about selecting a hedge fund or a fund of funds? It’s not like they’ve got 800 numbers with operators standing by to dispatch prospectuses. Companies like Van Hedge Fund Advisory and New York City-based MAR/Hedge will send investors performance information and minimum-investment requirements. There’s also a new website, a password-protected directory of funds called Hedgescan. San Francisco lawyer John Broadhurst says the SEC has given Hedgescan the go-ahead with the proviso that only accredited investors be allowed on the system. In addition, a number of local banks, such as Republic Bank of New York and Chase, track many of the bigger hedge funds for their clients.

“Presuming you can find the one you want, it’s imperative to meet with the fund manager, the guy who makes the decisions,” says Noah Lerner, assistant vice-president of investment management with Hartz Mountain Industries. “In a mutual fund, we have to go by what we see in writing. With a hedge fund, you have the opportunity to meet face-to-face. Always get references from current investors, auditors, and attorneys. Don’t be shy.” Look for funds that have done well over time (make sure the performance numbers you review don’t include fees; they’re hefty and can skew an understanding of just how well a fund has done). Like many other hedge-fund investors – and mutual-fund investors, for that matter – Lerner says he shies away from the giant funds because he thinks smaller funds respond better to a volatile market; they can get in and out of positions quicker.

With the bull market in its seventh year, more and more money is looking for a hedge. It can be tough for the neophyte: At least a quarter of all hedge funds are based offshore (including all seven of the Soros funds, even though Soros’s headquarters is in New York), and a good number of those don’t take many – or any – U.S. investors, generally because they seek to avoid stringent U.S. reporting requirements. It didn’t matter that Ocelot’s distributor, Donaldson, Lufkin Jenrette, couldn’t take out ads on CNBC or in the Wall Street Journal; the fund is already sold-out. Julian Robertson’s Tiger funds are all open, but each requires a $10 million minimum investment. And would-be Soros investors are out of luck; his funds have always been closed to U.S. citizens. “It’s a market in which there are lines drawn in the sand and everybody is looking to get around them,” says one manager. “Hedge funds are definitely a growth business. And America is a wealthy, wealthy place.”

Funds & Games