Hedge Funds, Humbled: The 7 Mistakes That Brought Hedge Funds to Their Knees and How They Will Rise Again

By Trevor Ganshaw

The fall and rise of a trillion-dollar industry

Just three years ago, hedge funds were at the top of the investment world. Years of unparalleled growth had pushed assets to nearly $3 trillion. Leverage was used so aggressively that total long and short investments approached an astonishing $10 trillion. Thousands of new funds had sprouted in every corner of the market, and managers, enjoying an almost unimaginable pool of fees, were dubbed the new “masters of the universe.”

Then came 2008.The industry suffered its worst performance ever, losing $600 billion or roughly 20% in a single year. Multibilliondollar hedge funds collapsed overnight, epic frauds were revealed, and assets plummeted as spooked investors scrambled to get their money back.

The near collapse of the industry is one of the most dramatic stories of the global economic meltdown. It’s also among the most instructive—because hedge funds are still alive and, if managed wisely, will emerge stronger than ever in the coming years.

In Hedge Funds Humbled, industry insider Trevor Ganshaw provides a detailed primer of the industry and explains how the people who earned more than $100 billion in fees during their short but happy heyday planted the seeds of their own destruction. He paints a vivid picture of how the industry leaders’ major mistakes destroyed hundreds of billions of investor capital; Ganshaw calls them the “seven deadly sins” of the hedge fund industry:

• Out-of-control leverage
• Inadequate risk management
• Flawed fee structures
• Overcrowded strategies
• The Peter Principle of too much capital
• Capital instability
• Fraud, enabled by lax controls

Ganshaw examines the future of the industry and shows investors what to look for and what to avoid. There’s still money to be made in hedge funds and, in his estimation, the industry is poised for a comeback. “As all good hedge fund managers know, greed is good,” he writes. “Humility, it seems, may now be an essential part of keeping it that way.”

More dramatic than fiction, Hedge Funds Humbled is a timely work that provides a critical look at an industry gone bad—and an optimistic look at its future.

• Language: English
• Publisher: McGraw-Hill Education
• Release date: Dec 18, 2009
• ISBN: 9780071713719

Book preview

HEDGE FUNDS HUMBLED

HEDGE FUNDS HUMBLED

The Seven Mistakes That Brought Hedge Funds to Their Knees and How They Will Rise Again

Trevor Ganshaw

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To Kaitlin, Sara, and Eric

CONTENTS

Introduction: The Tale of a Shark

one    The True Evil in Hedge Fund Compensation (No, It’s Not Greed)

two    Excessive Leverage: Gorging at the Buffet

three     Narcissistic Risk Management

four    Hedge Fund Correlation

five     The Hedge Fund Peter Principle

six     Capital Instability and Illiquidity: A Toxic Combination

seven    Fraud

Conclusion: The Road to Redemption

Endnotes

Index

Introduction

THE TALE OF A SHARK

Eight million dollars. Even by the rarified standards of the contemporary art scene, it was a staggering number, one of the largest price tags ever affixed to an artist’s work.

The work was a 14-foot tiger shark, pickled in a tank of formaldehyde. Steven A. Cohen, the billionaire founder of the hedge fund SAC Capital, was the buyer. As it turned out, the shark had not been properly preserved, and it was actually decomposing from the inside out. A problem? Not in the world of hedge fund masters. A special team was dispatched to capture and embalm a new shark that would be swapped for the original wrinkled, rotting carcass. The expense of the replacement, according to Cohen, was inconsequential.

Oddly enough, the shark served as an apt metaphor for the hedge fund industry as it was at the time: awe inspiring, reveling in excess, and, in some ways, slowly rotting from the inside out.

With its promise of vast riches, everyone wanted a piece of the action. The number of hedge funds grew from a few hundred in the early 1990s to more than 9,000 in the United States alone by 2007. Assets skyrocketed, reaching $2.9 trillion in Q2 2008—up an astonishing $2.0 trillion since 2003.

Not satisfied with just a few trillion, the industry leveraged this capital by two to three times or more, enough to make long and short investments that approached a total of $10 trillion and generated annual fees of more than $100 billion for the anointed few.

And then, in 2008, it all came crashing down.

Rattled by the Lehman Brothers bankruptcy that September, banks began to yank financing from excessively leveraged hedge funds. Equally nervous investors, panicked by the growing market uncertainty, also rushed to redeem their capital. Stuck in overcrowded, thinly traded investments and armed with few options, many hedge funds were forced to dump assets into an increasingly unforgiving black hole of market illiquidity.

For some, this perfect storm ended in collapse, a complete wipe-out of investor capital. In most cases, performance simply fell off a cliff; the industry went on to record its worst performance ever, down 20% for the year. More than 1,400 hedge funds, 14% of the industry, closed shop in 2008.¹

Investors requested to redeem an estimated $1 trillion in hedge fund investments but managed to grab back only a fraction of that amount as the hedge funds tried to block the exodus of capital through gates and withdrawal suspensions.

Once the tide was out, some of the most stunning frauds in history were revealed, including the legendary Bernie Madoff, in his invisible $65 billion swimming trunks, and scam artist Samuel Israel, who scrawled a faked farewell to the world—suicide is painless—on the hood of his car.

Hedge funds have been humbled, and if the $8 million dead shark is any indication, the industry needed some humbling.

This book explores the seven key flaws that led to the industry’s violent downfall in 2008: uncontrolled leverage, inadequate risk management, flawed fee structures, overcrowded strategies, the Peter Principle problem of too much capital, capital instability, and the lax controls that enabled fraud.

Fortunately, there is a bright side to this tale: what hasn’t killed the industry will ultimately make it stronger. The thinning of the hedge fund herd will create more attractive investment opportunities that will produce better risk-adjusted returns. Risk management and fund governance will improve. Investors will demand better and more balanced fee structures. All of these factors, over the long term, will create a better and more sustainable product for both managers and investors. As all good hedge fund managers know, greed is good. Humility, it seems, may now be an essential part of keeping it that way.

The Beginning

It may surprise some readers to learn that the seeds of this madness were planted quite recently, around 2000. At about this time, the true institutionalization of the industry began.

As pension plans, university endowments, and other institutional investors began to diversify away from their traditional fixed income and equity investment strategies, they sought investments that would generate attractive, stable returns while exhibiting low correlation to the bond and equity markets. To these ends, investors dramatically increased their allocations to a variety of alternative investments that included hedge funds, private equity, real estate, and others.

Hedge fund managers, being the enterprising group they are, were not about to be left out of this multitrillion-dollar bonanza. But their industry had to adapt to meet the institutional investor’s objectives.

In the 1990s, the hedge fund industry comprised a few hundred funds that focused largely on two strategies—global macro and long-short equity—and managed a total of less than $500 billion.

For the most part, these smaller funds did not meet the high standards that institutional investors were looking for. These investors were not about to entrust hundreds of billions to entities that were more like garage bands than Goldman Sachs. They wanted larger, multibillion-dollar institutionalized funds with fully built-out legal, compliance, operations, accounting, and finance teams to support the fund’s investment operations. They also wanted a more diversified set of strategies that produced uncorrelated, stable, double-digit returns.

As it turned out, the industry was more than happy to super-size. Over the next decade, assets under management (AUM) became increasingly concentrated in the hands of a few hundred multibillion-dollar managers. By 2008, 80% of all assets were controlled by just 390 funds, each managing more than $1 billion.²

Additionally, as Figure I-1 highlights, hedge funds began to diversify away from long-short and global macro strategies as they sought to provide more investment opportunities that fit the low volatility, low correlation objectives of their investors.

Apparently, the growth program worked. As the industry evolved, it continued to provide consistent, attractive returns, drawing institutions back to hedge funds again and again with more aggressive allocations. Between 2006 and 2007 alone, hedge funds took in more than $1 trillion. At the peak in early 2008, hedge fund AUM had grown by approximately $2 trillion in less than five years!

Figure I-1 Hedge fund breakdown by strategy

Source: AIMA’s Roadmap to Hedge Funds, November 2008

Figure I-2 Hedge fund asset growth, 2003 to 2009

Source: HFN Hedge Fund Industry Asset Flow/Performance Report, March 31, 2009

With this capital, however, came a new, unofficial set of rules. If a hedge fund could not reach a critical mass of at least $1 billion in AUM, it was unlikely to get a seat at the table. Few institutional investors wanted to represent more than 10% of a fund’s assets, limiting the size of allocations to smaller funds. Second, in an attempt to place their capital in safe hands, institutions wanted to invest in large, established funds with substantial infrastructure and a track record of successful investing.

Once a fund reached this critical mass (while maintaining reasonable investment returns), it could join the multibillion-dollar club and swim in the flood of capital that was pouring into the industry. Membership in this rarified circle entitled top individual hedge fund managers to more than $2 billion in personal earnings in 2007. Even second tier managers took home more than $100 million in a single year. Below that billion-dollar ceiling, the lack of capital limited access to fees, which restricted a fund’s ability to attract top talent. It also made big investments in risk management systems, compliance teams, and other key elements of infrastructure potentially unfeasible.

While thousands of hedge funds chased trillions of dollars, there were almost no official rules to govern the game. There was effectively no outside regulation; access to leverage was virtually unlimited; few transparency requirements existed; and accounting standards were unprepared for the scope and complexity of risk being assumed in the industry.

As you might guess, this kind of Wild West environment produced a number of hedge fund managers who were willing to bet big at the casino, which led to an array of high profile winners and spectacular, multibillion-dollar disasters. Chronicled in the following chapters are many of the biggest blowups, including Amaranth Advisors (—65%), Bear Stearns hedge funds (—100%), Sowood Capital Management (—56%), and others.

All of this might well bring investors to ask some basic questions. How could multibillion-dollar hedge funds, which held capital preservation as a top priority, suddenly evaporate in a few days? What were the key factors that led to catastrophic failure in these funds? How did the funds’ risk management teams overlook the strategic flaws? We will explore all of these questions in the chapters that follow.

Some Background

For readers less familiar with the hedge fund industry, the following few pages will provide a brief history, outline its most actively pursued strategies, and describe the counterparties that support the funds. For those already familiar with these topics, feel free to skip ahead to Chapter 1.

According to industry lore, the first hedge fund was launched around 1950 by Alfred Winslow Jones. He operated a long-short equity fund, utilized modest leverage, and created attractive double-digit returns. Jones’s success inspired many others to follow in his footsteps, and for the next 50 years, the strategies underlying most hedge funds remained largely focused on either long-short equity or global macro. Not until the turn of the century did institutionalization spur the evolution of a more diverse set of relative value and event-driven funds.

Contrary to popular belief, no hedge fund actually hedges all of its risks. If it did so, there would be no returns. Instead, each fund tries to create hedges that (1) provide some protection in certain downside scenarios and (2) increase the probability of winning by creating option like payoff profiles in which it wins big under one set of outcomes and loses significantly less in others.

Hedge Fund Strategies

A few of the more common types of hedge fund strategies include long-short equity, global macro, relative value, and event-driven.

Long-Short Equity

As the name suggests, funds pursuing this strategy invest in long equity positions hedged with short sales of stocks or stock indexes. Some funds use fundamental research to target growth or value stocks; others are focused on specific sectors or emerging markets. For the most part, the assets underlying these funds are actively traded. In general, this liquidity allows them to accommodate shorter investor lockups.

Global Macro

Funds pursuing a global macro strategy generally take positions in a broad array of financial instruments, including sovereign debt securities, currencies, commodities, rate sensitive instruments, and a host of derivative securities. Through these positions, the funds seek to capture value from anticipated trends or moments in the global macroeconomic environment. In most cases, these trends tend to be driven by changes in government policies, economic growth or instability, capital flows, fiscal instability, or other systemic country- or region-specific issues.

Relative Value

Relative value strategies target and exploit differences in the relative economic attractiveness of one security versus another. These differences tend to be measured by comparing the expected return of an investment for a given set of risks, such as subordination, maturity, liquidity, covenant features, asset coverage, etc. Managers then express these value differences through positions that are long investments in the relatively cheap securities and short the relatively rich.

Most funds that pursue this strategy seek these opportunities within corporate capital structures. Capital structure arbitrage, for example, is generally focused on relative value opportunities within a single corporate capital structure. Fixed income arbitrage, on the other hand, tends to seek opportunities in the debt or fixed income derivative securities of different corporate or sovereign issuers. Convertible bond arbitrage and volatility arbitrage are other examples within the relative value category. Because credit instruments play such a large role in many relative value strategies, the underlying assets can be significantly less liquid and more difficult to trade in times of stress.

Event-Driven

Event-driven funds seek to exploit pricing inefficiencies created by actual or anticipated corporate events such as mergers or acquisitions, spin-offs or split-offs of certain businesses, defaults, bankruptcies or other distress events, recapitalizations, and other reorganization events. Funds within this category include merger or risk arbitrage funds (which seek to capture the difference between the offered purchase price and the current market price of a stock that is subject to a takeover or merger offer), distressed debt funds, and activist funds (which make concentrated investments in companies where they believe they can push for changes that will boost the value of its shares).

Counterparties

Counterparties such as prime brokerage firms, banks, administrators, and auditors also play a key role in the success of most hedge funds.

Prime Brokerage Firms

Prime brokerage firms provide a variety of services that are essential to the operation of a hedge fund:

• Financing (leverage) for certain assets

• Securities lending for short sale activity

• Global custody (which includes holding and/or safeguarding physical securities and clearing services)

For most prime brokers (PBs), the financing they provide is generally limited to a select group of liquid, actively traded securities such as common stock, corporate bonds, convertible debt, and listed options. A hedge fund must seek financing elsewhere for other less-liquid securities like bank loans; structured securities such as collateralized debt obligations (CDOs); and other derivative securities.

Because access to capital is the primary component of a prime broker’s service, most PBs are