College of Business: University of Illinois at Urbana-Champaign

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Finance Roundtable: The State of Hedge Funds


12/8/2008

By Kim Lange, PricewaterhouseCoopers

October 15th brought an extremely timely topic to the College of Business Roundtable Series. Three experts in the financial world discussed hedge funds and other investments and how the current financial crisis is affecting these. Victor Capadona, Managing Partner of the Capital Markets Industry Practice at PricewaterhouseCoopers, which served as the event's sponsor, posed questions to Jay Wang, Jordan Allen and Paul Meister.

The first topic of discussion was whether or not investors should be investing at all and if so, into what should they put their money. 

"It's always a good time to invest in hedge funds," says Jay Wang, Assistant Professor of Finance at UIUC. "But you must be very careful about picking funds. Look for funds with prudent liquidity and risk management." Wang notes that many of the current approximately 10,000 funds are unstable and that those who switched from mutual funds to others were poor performers already.

Wang also predicts that the current crisis will accelerate hedge funds and likely bring bargains in the collateralized debt obligation (CDO) market, which before the current crisis was the fastest-growing market. Some funds will be severely undervalued. Evaluating funds is a difficult task when there is a lack of transparency, however, this does provide a good environment for skilled managers and evaluators to work their craft.

What view of hedge funds should a manager or investor take these days? Paul Meister, Managing Director and COO of Grosvenor Capital Management, states that both his own view and his company's view see hedge funds as still a great way to invest with risk-adjusted assets. He feels that very capable money manager firms have been created, where one can place money with the smartest, most nimble options.

Jordan Allen's firm HFR Asset Management, LLC runs a series of managed accounts, which he says gives it some unique insight. Allen, HFR's President, points out, "On both an absolute basis and a risk-adjusted basis, hedge funds have outperformed other investments." He concedes that there has been a lot of bad PR for the hedge fund industry. However, he believes there is plenty of blame to go around and hedge funds have been unfairly demonized for it. Allen reminds us that there are multiple strategies within hedge funds, such as global macro trading and long-short trading, which have been good. "Hedge funds are generally bullish and represent a good opportunity to step in." 

The panel was questioned on whether the shorting of Lehman Brothers' stock and the aggregate of hedge fund liquidation contributed to its recent low stock price. Allen points out that shorting was developed to create liquidity and that, by and large, it has worked. He has seen no evidence that shorting has had any significant impact on the stock value.

Wang agrees with Allen on this position, saying "We need both optimistic and negative opinions of stocks." Stocks were shorted because they were believed to be overvalued. Wang knows there must be regulations but feels shorting should not be blamed for the collapse of Goldman Sachs and Lehman Brothers, and notes that these two actually shorted each other's stocks.

How would further regulation affect hedge funds' standing? Wang believes there should be less regulation and states he is firmly against making hedge funds a retail product. There is only limited opportunity for hedge fund managers, so we shouldn't have more money coming in. He feels the industry will lose its edge as well as its best managers and become more like mutual funds. "Hedge funds are designed for wealthy and institutional investors, not as an individual retail product," says Wang.

Allen notes that the U.S. government has stayed outside retail hedge funds because it feels they aren't worth dealing with the SEC and all the regulations. However, he's not sure if he agrees with Wang about lower investments. If there is some demand for hedge funds as a retail product, perhaps a $50,000 investment would make sense. Allen does agree that the average person is not aware of all the risks of hedge funds, but still thinks it's unfair that someone who has $100,000 to invest cannot do so with "the best and the brightest."

Meister points out that there are two different types of regulations to consider. One set consists of regulations from the SEC that chief compliance officers must consider. This type is what the hedge fund industry has thus far resisted and by doing so has caused some bad PR, as most hedge funds could actually afford these regulations. A different set of regulations – those that deal with implications and efficacy of how hedge funds are run – is the kind Meister hopes is not implemented.

A Roundtable attendee brought up how one concern of hedge funds is that they've introduced a level of risk not present in the market previously, and he wondered if the fact that we typically pay hedge funds a set amount and percentage has created any problems.

Allen feels this has not caused problems. Hedge fund information is best garnered by educated consumers, who consider the fee structure when investing; it's just one factor to look at in due diligence.

Meister suggests potential investors look at what the hedge fund manager is doing with his/her own money as well as a combination of the incentive fee structure and his/her own net worth. He also reminds everyone that there is nothing new about hedge funds; they've been around a long time. Firms have been employing the same strategies as those used in hedge funds for years, but now it's just more out in the open as people have left big firms and gone out on their own.

This led to a more detailed discussion of hedge fund fees. Allen says most funds involve a 1% to 1.5% management fee plus a 20% incentive.  However, fund-to-fund incentive fees typically range from 5% to 7%. He admits it's difficult to predict future fees due to the current dramatic economy. Some might reduce fees while others will certainly go higher, but this may not be important overall. What is more definite is that after two years of investigations with the current debacle, the SEC will go through some reform in order to survive. In Meister's opinion, the industry has been dominated too much by leverages instead of financial experts, possibly related to the fact that the position of head of the SEC has been filled with everyone but real practitioners like Treasury Secretary Henry Paulson.

Whatever is in store for the hedge fund industry, whether in line with or beyond experts' predictions, should be far from boring.

UIUC College of Business