Hedge funds - time to rethink?

The wall of money going into hedge funds continues unabated despite - in fact, perhaps partly because of - the latest hedge fund blow-ups.

Yes, there were some high profile victims when the Amaranth energy trading hedge fund ran up losses put at $6bn (€4.75bn) - among them Sweden's AP7 and the San Diego state fund (see page 35). Then there were reports that the Vega hedge fund group was experiencing losses.

Yet while this was taking place, investors were pouring some $44.5bn into the asset class, according to Hedge Fund Research's third-quarter report. In all there was an $111bn inflow into the asset class in the first nine months of 2006, HFR says.

No less a body than the International Monetary Fund characterised pension funds as "lemmings".

"Myriad new unseasoned hedge or commodity funds are started precisely to exploit the distorted incentives of the pension or insurance fund managers who queue like lemmings to dutifully place the public's money," said its research chief Raghuram Rajan.

He noted how losses from "isolated failures have been washed away in diversified portfolios and the public has not noticed. Will this always continue?"

He continued: "The problem is that all too often, it takes place as a form of herding and late in the game - after lagging pension managers see the wonderful returns in energy or from writing credit derivatives made by their more competent or lucky competitors, there is pressure on them to enter the field."

Intriguingly, Mercer Investment Consulting ran a survey saying only 23% of pension schemes were satisfied with funds of hedge funds investments - and that, despite this, 54% intended to increase their allocation to hedge funds within two years.

So it seems that despite some wobbles in the last few years, and the caveats from sceptics, the appetite for the asset class is now back on track. But has the pension community fully analysed how and why some people got burnt?

It's a question of due diligence. AP7's exposure to Amaranth was via a fund-of-funds arrangement, with the fund rightly arguing that this approach limits your losses.

But should AP7 have had the exposure in the first place, given the way Amaranth reportedly made its returns? Did anyone in the Swedish fund's hierarchy fully apprehend how Amaranth generated its numbers?

With each successive hedge fund blow-up the stakes get bigger. After all, LTCM in the mid-1990s was an at-the-time huge $3.5bn explosion, while a decade later the market shrugs off the $6bn Amaranth implosion - without, as far as is known, central bank intervention. Amaranth was able to meet its losses in a way that LTCM was not - but what if Amaranth had been highly leveraged?

The next Amaranth - and it's an absolute certainty that there is already another one brewing - could be leveraged to the hilt or have all sorts of derivative positions that it can't meet. You could have assets with it but you won't find out about problems until it's too late. The smart money will be long gone - look at how the Blackstone Group withdrew from Amaranth at the first whiff of trouble.

And while we are on the topic, let us nail this term "sophisticated investors". What's sophisticated about paying a middleman a hefty fee to let you invest in something you do not understand? A truly sophisticated investor, let's say Warren Buffett, buys an asset he knows is undervalued then waits for the market to catches up.

It was interesting to watch how hedge fund marketers' pitch changed from returns to portfolio diversification, just about the time returns went south. The danger is that investors will shrug off the Amaranth debacle and blithely assume that the system works - storing up even greater problems for the future. We must beware of thinking, ‘well we survived Amaranth, what's the problem?'

After IPE revealed AP7's Amaranth losses, the fund said the attraction of hedge funds is that "they are something in between fixed income exposure and fixed-income return and risk and equity expected return and risk".

Amaranth was effectively speculating on the weather, so how that is similar to fixed income is a question best answered over a few beers. Let us be clear, Amaranth attracted investors' cash because of its high returns (generated by the one-off catastrophe of Hurricane Katrina) and explicitly NOT because of its investment process.

There are an estimated 9,000 hedge funds worldwide. That means 9,000 claims of being able to beat the market, 9,000 ways to diversify. A sceptic would have to wonder if there is really that much skill out there.

Dutch health care pension giant PGGM confronted the hedge fund "dilemma" in its third quarter report - pointing out that there is "no such thing as a risk-free return". Put another way - there is no such thing as a free lunch - or caveat emptor.