Wednesday, December 2, 2009

The two faces of hedge funds

An interesting dichotomy arose at the Walkers Fundamentals of Hedge Funds Seminar in New York today. Seeing the beauty in the hedge funds industry, not surprisingly, was Joel Press, managing director in the prime brokerage division at Morgan Stanley. Seeing the beast, also not surprisingly, was Gregory Zuckerman, hedge funds reporter at the Wall Street Journal and author of the recently-released The Greatest Trade Ever, an account of Paulson & Co.'s bet against the mortgage and financial services market in 2007-2008.

Here's a quick summary of both points of view:

Joel Press -- The beauty is back in hedge funds
  • Press predicted that AUM by hedge funds will be "well north of $3 trillion" in four years.
  • "There is no need for [hedge fund] fees to go down," because the the performance of the asset class is better than anything else an investor can find. He also says FOF fees should not go down.
  • He says that in the run-up to the credit crisis hedge fund investors "didn't know what they were signing," referring to the LP documents, but the "documents were clear." "Managers never thought they would need to gate" investors claims Press.
  • When it comes to liquidity, Press said "you can't fight what investors want, but we are not a mutual fund industry...We need to reestablish what we are about." Investors, according to Press, mismanaged their asset liability and were forced to redeem underwater hedge fund investments.
  • Press predicts that hedge funds of funds will continue to control 40-45% of the industry, due in large part, he says because FOFs will "maintain the standards of due diligence"
  • Press sees institutions and endowments returning en masse to hedge funds -- particularly for the equity strategies in their portfolios. Furthermore, Press predicts that funds dedicated solely to pension fund assets (because of regulatory requirements) will be a growth area for the industry.
Greg Zuckerman -- The beast is still loose in the hedge fund industry
  • Gates continue to"bother" investors, says Zuckerman. He says that it is "remarkable" that certain funds have maintained their gates, despite the return of liquidity to most markets and called it an act of "hubris" for a manager to launch a new fund while the gate was down on other funds he manages.
  • Returns touted by the hedge fund industry are inflated by the "survivorship bias" (if a fund closed in 2008, for example, its losses are not tallied in the final calculations for the industry for the year).
  • Hedge fund industry players knew Madoff was a fraud, but "played along," says Zuckerman.
  • "We are in an age of bubbles," said Zuckerman. He says there in an incentive for the industry to "pile on trades" and follow the herd."
  • Zuckerman sees gold as the "hot trade" of the day. He pointed out that the downside is much greater with gold than it was with mortgages, when Paulson placed his prescient trade, or earlier this year with financials, when Citi was at $0.97. He characterizes the run up in gold as a "crowded" trade that "follows conventional wisdom," hinting that it is a bubble. Yet, Zuckerman notes that Paulson & Co. has $30 billion invested in gold and will launch a gold-focused fund in January.
  • Zuckerman appears to doubt the wisdom of the industry itself. He notes that "funds are fully invested" and thinking about "adding leverage," but managers don't have conviction about the rally we are seeing in the market. "Will they all get out in time?" wonders Zuckerman.
Who is right? Maybe they both are, but Zuckerman raises interesting questions about correlation, contagion, and diversification that hedge fund investors need to carefully think about. Press of Morgan Stanley himself admits that reputation is a leading factor for investors allocating to hedge funds. Zuckerman as a journalist is, perhaps, more skeptical than most, but his opinion, in part, shapes the reputation of the industry.

It was a shame that the program went long and Zuckerman, as the last speaker, had to rush his presentation. Outside perspective in healthy doses is what the hedge fund industry needs.