TCS Daily

So Much Money, So Much Talent

By Dominic Basulto - September 1, 2005 12:00 AM

It's been rough sailing for the hedge fund industry lately. As if the threat of increased regulation of the worldwide hedge fund industry wasn't enough, the recent flap over nearly $440 million in missing funds from Connecticut-based hedge fund Bayou Management surely provides additional ammunition for those who continue to view the trillion-dollar hedge fund industry as a bunch of gunslingers playing fast and loose with the financial markets in the hopes of outsized returns. On August 24, The Wall Street Journal jumped into the act, publishing an op-ed piece called "So Much Money, So Little Talent." While the Wall Street Journal op-ed piece didn't call for more regulatory shackles to be placed on the rapidly-growing hedge fund industry, it offered a far more damaging assessment: "Further regulation is unnecessary: the hedge-fund boom is coming to an end and market forces will force the industry to contract."

The real zinger came midway through the op-ed piece, when none other than Charles Munger, the right-hand man of Warren Buffett at Berkshire Hathaway, called into question the extraordinary performance of the hedge fund industry over the past five years: "Never have so many people made so much money with so little talent." During the post-bubble period, making money in the hedge fund industry was like shooting fish in a barrel, mostly because hedge funds were able to make money by shorting stocks. However, performance over the past nine months has suffered as hedge fund managers increasingly discover fewer and fewer obvious inefficiencies to exploit in the financial markets. As a result, hedge fund managers have been forced into riskier and more daring trades in order to outperform their peers: they are taking on more leverage, seeking out more illiquid and esoteric financial instruments and devising fiendishly complex trading strategies that are difficult to execute.

Backtrack for a minute, though, and consider what's happened to the mutual fund industry over the past 30 years. How many mutual fund managers actually beat the market index in any given year? According to a study from Wharton business school professor Jeremy Siegel, in the period between 1982 and 2003, there were only three years in which more than 50% of mutual funds beat the market. In some years, up to 85% of all funds failed to beat the market index, which is usually defined to be the S&P 500 - and that's before fees and expenses. By the time fees and other charges are calculated, it's safe to say that anywhere between 50% and 85% of all mutual funds fail to beat the market every year. Yet, how many people are predicting the demise of the mutual fund industry or accusing these mutual fund managers of lacking talent?

The hedge fund industry was able to make outsized returns for investors over the past five years because of the vast potential for exploiting market inefficiencies. In other words, hedge funds made money because they could make short bets when others couldn't. They could take advantage of trades like the "carry" trade and the "relative value" trade. They could double their money by leveraging their bets.

To argue that hedge funds only made money as the result of a perfect storm of macroeconomic factors is to confuse the issue. It's more accurate to say that hedge funds made money in volatile markets - and what markets are more volatile than those experiencing the spectacular deflation of a worldwide stock bubble? Most hedge funds are essentially market-neutral, hence the term "hedge" fund. If the market goes up, they make money. If the market goes down, they make money. It's only when the market meanders around without too much activity that hedge funds have a difficult time making money.

With the hedge fund industry tripling in size over the past five years to become a trillion-dollar industry, it's not surprising that so many hedge funds are racing into new, more illiquid financial instruments and exploiting more sophisticated trading strategies. If you believe in the Efficient Markets Hypothesis, this makes sense. Given efficient markets, it's almost impossible to beat the market consistently. (Imagine thousands of MBAs running around, trying to find a market edge over their rivals.) Thus, these hedge fund investors are searching for market inefficiencies, in the hopes of exploiting improperly valued assets before others do. If close to 80% of mutual fund managers fail to out-perform the market, it's safe to say that a similar percentage of hedge fund managers will fail to out-perform the market if they stick to vanilla trading strategies that ignore these types of market anomalies.

Whether by intention or not, The Wall Street Journal op-ed piece portrayed the hedge fund industry as being in a "race to the bottom." More risk, more leverage and less chance of ever beating the market. If, however, the hedge fund industry is viewed in the same context as the mutual fund industry, it's clear that the hedge fund industry is actually engaged in a "race to the top." It's a race to reward investors and a desperate race to outperform others. Like the mutual fund industry, the hedge fund industry is here to stay for the long run.

Dominic Basulto is a TCS contributing writer.


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