Chapter One
The Hedge Fund Industry
The growth of the hedge fund industry over the past five years is truly amazing. Many industry observers believe that since the dawn of the new millennium, assets in these often-called secretive investment vehicles has grown fourfold. If you factor in the number of funds of funds, the growth factor is probably closer to fivefold. The industry continues to grow at a record pace, even with the weak performance numbers in 2005 and the decrease in asset inflows in the first quarter of 2006.
According to one published report, 2,073 hedge funds were launched in 2005, up from 1,435 in 2004. As of spring 2006, there are an estimated 12,000 hedge funds in operation globally. The numbers are shocking and quite compelling, especially if you are working at a service provider. Some in the industry equate the substantial growth in hedge funds over the past five years to what happened in the mutual fund industry in the late 1980s and early 1990s. The result was an industry that contracted in light of the bursting technology bubble and bear market. Many believe that as the hedge fund industry continues to grow, it is readying itself for a bursting, of sorts. Therefore, as the new manager on the block, you need to be ready for what lies ahead, because, quite frankly, it does not look so pretty. That being said, the strong will survive, and they will prosper. Your job as a new manager about to launch a fund is to make sure that you are ready, willing, and able to deal with everything that the market and investors throw at you and that you are prepared for the worst.
To understand where the industry is going, you need to first understand where it has been. The evolution of the hedge fund industry is best seen by coming out of the Wall Street subway stop. When you exit the station, head northwest toward Broadway and make a quick left on Broad Street: In front of you will be the New York Stock Exchange, behind you will be the former headquarters of J.P. Morgan, and to your left will be a statue of President George Washington.
If you make this trip around 9:00 A.M., you will see exactly what Alfred Winslow Jones saw-traders and brokers hustling to get inside the building before the market opens. It was the action and excitement of this place that led Jones to create the first known hedged fund, an investment vehicle that went long and short the market and was able to protect and grow its investors' assets regardless of market conditions.
Jones, a sociologist turned journalist, came up with the concept of this long/short fund based on a thesis he had written for an article in Fortune magazine.
In the late 1940s, Jones had held a number of positions in journalism, writing about finance and industry as well as social issues. During this time, he realized that the income he earned as a freelancer was not going to be enough to sustain him or his family in the life that he expected and wanted. He looked to Wall Street for the answer. What he found was an idea that he believed would work. In turn, he would earn enough money to support his family and to fulfill his major passion-helping people. While Jones clearly developed his concept and his business for the money it earned him, his idea was to take the wealth and put it to work in the community. His idea was to use his hedged fund as a tool for others to help themselves. His son-in-law, Robert Burch, who currently runs A.W. Jones & Company with his son, said that Jones was more interested in the intellectual challenge of the business than the rewards that it provided.
"Jones was not a man that was very interested in Wall Street," said Burch. "Although he made a lot of money over the years, he gave quite a lot of it away in order to create programs and organizations to help people here in the United States."
Jones was not interested in talking about the fund, how it worked, or what it did; he wanted to talk about how to make the country and the world a better place.
"When you had dinner with Jones, you always had four or five guys from various parts of the world," recalls Burch. "You didn't know if that night you were going to discuss some pending revolt in Albania or what language they speak in Iran. But what you did know was that you would definitely not be talking about money, Wall Street, or the firm. His mind was beyond that."
The foundation of the hedge fund industry lay not in the pursuit of money for conspicuous consumption but in the pursuit of money to help people.
It all began in a magazine. The article was not some how-to or get-rich-quick piece about making a fast buck, but rather a thought-provoking look at how money is managed and the idea that going long some stocks and short others can earn great and stable rewards. In short, the Jones piece looked at how you could go long a basket of stocks and short a basket of stocks and still protect and grow your assets.
The article that put his plan in motion was titled "Fashion in Forecasting," which ran in the March 1949 issue of Fortune magazine. It gave him the foundation for what today some people view as one of the most important tools used by money managers to actually make money. Following is an excerpt from the article:
The standard, old-fashioned method of predicting the course of the stock market is first to look at facts and figures external to the market itself, and then examine stock prices to see whether they are too high or too low. Freight-car loadings, commodity prices, bank clearings, the outlook for tax legislation, political prospects, the danger of war, and countless other factors determine corporations' earnings and dividends, and these, combined with money rates, are supposed to (and in the long run do) determine the prices to common stocks. But in the meantime awkward things get in the way (and in the long run, as Keynes said, we shall be dead).
In the late summer of 1946, for instance, the Dow Jones industrial stock average dropped in five weeks from 205 to 163, part of the move to a minor panic. In spite of the stock market, business was good before the break, remained good though it, and has been good ever since.
Nevertheless there are market analysts, whose concern is the internal character of the market, who could see the decline coming. To get these predictive powers they study the statistics that the stock market itself grinds out day after day. Refined, manipulated in various ways, and interpreted, these data are sold by probably as many as twenty stock market services and are used independently by hundreds, perhaps thousands, of individuals. They are increasingly used by brokerage firms, by some because the users believe in them and by others because their use brings in business.
The idea was simple: Some stocks go up while others go down, and very rarely do all stocks move in the same direction at the same time. If this makes sense to you, then the next thing you need to understand is that as some stocks move up and others move down, there is a way to make money both when they go up, by being long a basket of stocks, and when they go down, by being short a basket of stocks. The key is to forecast which stocks go up and which go down and to position a portfolio accordingly.
The issue then was no different than the issue today: How do you determine which stocks are going to go up and which are going to go down? Jones had a unique problem. He was not a stock picker. Fortunately, he learned this early on and was able to compensate for his inability to pick stocks by hiring those who could.
"My father was a good salesman; he knew people to raise money from, and was a good organizer and administrator. But when it came to picking stocks, he had no particular talent," said Tony Jones. "This meant that his job was to find people who did have the talent."
Alfred Winslow Jones was an executive, not a stock picker. He understood how to get things done and how to find people to execute his ideas. In the end, he created the first hedge fund-and with it an entire industry.
Some 50-odd years later, in the fall of 2003, a report by the Securities and Exchange Commission estimated that there were 6,000 to 7,000 hedge funds managing between $600 billion to $650 billion in assets. The report noted that hedge fund assets were expected to grow to more than $1 trillion between 2008 and 2010.
Jones never saw this coming. He believed that his business did not have legs, even though it was successful and even though his concept worked. In one of the few profiles of the founder of the hedge fund industry, Jones is quoted as saying, "I don't believe that it [the hedge fund] is ever going to become as big a part of the investment scene as it was in the 1960s. The hedge fund does not have a terrific future."
Jones seemed to have misunderstood the value of his invention because, as many people realize, having a portfolio that is both long and short is the only way over a long period of time to ensure that their assets are protected and grow regardless of whether the market rises or falls.
While a portfolio of longs and a portfolio of shorts make sense, the key to long-term success is not just to hit the ball out of the park with your stock picks but to put up singles and doubles each and every day. Move the runners around the bases and back to home plate while protecting your assets at all costs to make sure you live to fight another day. That, my friends, is the secret of successful hedge fund businesses, and it allows these organizations to maintain and create wealth in a safe and secure environment.
UNDERSTANDING HEDGE FUNDS
The idea of this book is simple. It provides you with the tools you need to understand the functions that go into creating, launching, and running an investment vehicle that is a hedge fund. It provides you with information to make better decisions when choosing a lawyer, prime broker, accountant, administrator, and other service providers-the people who will help you grow and maintain your business. It provides you with insight into the perceptions versus the realities of the hedge fund business. And most of all, it gives you a clear understanding of where the hedge fund industry came from, where it is now, and where it is going. In this way, you and your partners can create and run a successful business that allows you and your investors to build and preserve wealth.
This book is not about managing money or implementing trading strategies. That is covered in other, more thought-provoking books about money and markets. This book is a tool-a reference guide, if you will-that will be used by your front-, middle-, and back-office personnel. It will be used when you decide what sort of funds to launch, how they should be structured, who you should choose as a lawyer and prime broker, among others, and most important, who your funds can be marketed to. If you want to learn about trading, stop reading right now.
With that said, we now need to look at hedge fund basics in order to figure how to get started on developing and running a successful business. The basics are, quite honestly, very basic. One thing that needs to be said up front is that hedge funds, like most things on Wall Street, are thought to be very intricate, confusing, and sophisticated. This is just not the case. Hedge funds, like most everything else on the Street, are quite simple when you break them down and quite easy to understand once you look at them closely and dissect them in an orderly and efficient manner.
Some aspects of the industry are sophisticated, including structuring for tax efficiency and legal issues, but for the most part, once you have done it the first time (i.e., set up a hedge fund), it is like riding a bike: You never forget how it works and what needs to be done.
Although investors may initially assume that hedge funds and mutual funds operate in a similar fashion, in reality the only similarity between the funds is that both operate as pooled investment vehicles. This means that a number of investors entrust their money to a manager for a specific fund that goes out and buys and sells securities in order to make a profit.
Hedge funds differ from mutual funds in that investors provide hedge fund managers with the ability to pursue absolute return strategies. Mutual funds generally offer only relative return strategies.
An absolute return strategy is the new name for the strategy that Jones invented in the late 1940s. It means that regardless of market conditions, a hedge fund manager will make money. This differs from what is called a relative return strategy, which is how one fund does against a benchmark. In recent years there have been a number of indices created to track and benchmark hedge funds. While these products are good, they are not flawless. Therefore, it is best to think of hedge funds as vehicles that are measured on their specific performance, not on how their performance is relative to the S&P 500 Index or the Lipper Small Cap Index or any other benchmark used to measure performance of traditional investments.
Mutual funds, due to their structure and the laws that govern how they operate, invest in a predefined style and strategies such as large-cap growth and mid-cap value or a particular sector such as the utilities or biotechnology. The mutual fund defines its strategy and style in its prospectus, which is given to existing and prospective investors. Manager performance is measured on how a fund's return compares to that of a specific index or benchmark. For example, if you buy into a large-cap value fund, the managers of that fund try to outperform the S&P 500 Index.
Most mutual fund managers construct portfolios by using their stock-picking skills to create a portfolio that they believe will perform well over time and in turn provide them with an edge over the index. All they need to do is to outperform the index by a few basis points and they are deemed to be good at what they do. That being said, mutual fund managers have one goal in mind when they manage their money: beating their relative index. If the index is down 10 percent while the mutual fund is down only 7 percent, the fund's performance would be called a success. The press would anoint these managers as heroes of the money management industry and they would be deemed to be "expert" stock pickers because they beat their relative benchmark. The problem is, as an investor, you can't eat relative returns. In the preceding scenario, you would have lost 7 percent of your investment, plus fees, to these heroes' "expert ability" to pick stocks!
Hedge funds are completely opposite. Hedge funds are managed to seek positive absolute returns, regardless of the performance of an index or sector benchmark. Unlike mutual funds, which are long only (meaning they are able to make only a buy or sell decision), a hedge fund is able to implement more aggressive strategies and put on positions that include short selling. Managers may also employ derivatives instruments, such as options, and use leverage to enhance the portfolio and add to the positive performance of the bottom line.
(Continues...)
Excerpted from The Fundamentals of Hedge Fund Managementby Daniel A. Strachman Copyright © 2007 by Daniel A. Strachman. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.
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