Hedge funds have turned fat, lazy

By Lawrence Goldfarb

When the Securities and Exchange Commission made clear its intention to impose registration and financial reporting demands on most hedge funds, critics accused the government of trying to fix something that wasn't broken. We may never know whether that was true, for the simple reason that hedge funds had already begun losing their edge, and for reasons that have little if anything to do with what the SEC was worried about.

If the SEC had truly been concerned about protecting hedge fund investors, it would have mandated that all hedge funds reinstate two things that have been conspicuously absent for some time now: volatility and real returns. According to CSFB/Tremont hedge fund index, hedge funds have underperformed the Standard & Poor's 500 stock index and Morgan Stanley Capital International equity world indexes over the past two years. That hedge fund index performance was worse than that of the global bond market. In the course of becoming virtually a mainstream product line, hedge funds have gone from being "alpha hunters" to "asset gatherers," the financial equivalent of Muzak. It's time to put the "edge" back in hedge.

Start with another question: What is a hedge fund? As conceived by the now legendary Alfred Winslow Jones in 1949, the first hedge fund was intended to minimize market risk by taking offsetting positions. That's it. Mr. Jones' first effort (Hedge Fund 1.0) was nothing more than a leveraged long-short fund, but it was radical at the time. In part, that's because of his use of leverage and a hefty 20% incentive fee. But mainly it was radical because it beat the shoes, socks and pants off the general equities market, which had grown fat, happy and lazy.

His earliest successors — George Soros and Julian Robertson, among others — applied the principle of negative correlation to the broad debt and equity markets in powerfully novel ways, leading to the era of Hedge Fund 2.0. Equally important, the era of Hedge Fund 2.0 saw funds created explicitly in the likeness of their founders, a crucial distinction borne out in the often heavily speculative, research-fueled and personality-tinted strategies these funds so aggressively employed.

Mr. Jones' innovation hasn't aged that well. Eight thousand or so hedge funds and $1 trillion later, most hedge funds are fat, happy and lazy. Rather than building on the innovation and boldness of predecessors, today's version, Hedge Fund 3.0, is a model of complacency. These days, it's management fees and performance targets that are negatively correlated, with fees pointing upward. Investors, for their part, have been content just to be in the game, regardless of what the score is. Founding-manager stakes have ballooned, encouraging timidity, while legions of wannabe funds have combined to squeeze inefficiencies out of traditional markets faster than ever.

The looming presence of institutional money in the hedge fund universe has significantly affected strategy. Institutions have habitually preferred safety — when did hedge funds find their way into the "safe" asset class — and predictable returns, guaranteeing mediocrity. These preferences hamper the ability of hedge fund "asset gatherers" to take bets that could result in volatile but significantly higher returns. Simultaneously, the monthly liquidity needs of the large funds of funds and the incessant inflow and outflow of cash as they chase a monthly basis-point increase here or there reinforce a short-term, low-return outlook.

As a result, many fund managers have replaced volatility and short-term risk with a fixation on equilibrium. Keeping their Sharpe ratios high is one way to sustain consistently positive returns. The trouble is, consistently positive returns can only be served at one temperature: tepid. All this in the service of a risk-reward profile that belongs to a capital-preservation mutual fund.

How can hedge funds avoid becoming glorified bond funds? Here's what it will take to get to Hedge Fund 4.0:

• Keep your eye on the ball. Hedge funds will require two to three years to digest the costs of complying with SEC registration. Funds cannot afford to let that distract them from the imperative of restoring healthy volatility.

• Inertia is the enemy. The era of institutional money is here, which is why now more than ever you need to decide: floor wax or dessert topping. You can't be both.

• Unlock the leverage. We all know that performance can be falsely magnified through leverage. Still, in the late 1990s the dollar ratio of leverage to assets was 10:1. Today it's 4:1. Leverage is endemic to hedge funds, and managers are moving away from it. Why?

• Truth in advertising. Long-only is not a hedge fund strategy. Period.

• Quit coasting on management fees. Investors are wising up and losing patience. Once the emperor's new clothes are revealed, money will flow out as fast as it flowed in. We're already seeing this happen with high-net-worth investors.

• Keep innovating. Inefficiency is scarcer and more fleeting than it used to be, but isn't that why we collect management fees?

Better-than-average returns means living with volatility. In the words of Warren Buffet, "At Berkshire, we would rather earn a lumpy 15% over time than a smooth 12%." It's time to take our lumps again.

Lawrence Goldfarb is a general partner of BayStar Capital, a hedge fund based in Larkspur, Calif.