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Why the Emperors Have No Clothes

Hedge funds were designed to prosper in volatile markets. So why are so many of the biggest names suffering now?

LOT OF VERY ORDINARY PEOPLE made merry in the markets in the first half of 1998. The Standard & Poor's 500 index soared almost 17 percent by the end of June; U.S. government bonds rallied as yields probed record lows; European equities surged to record levels.

It didn't take a genius to make money. It may have taken a special kind of genius to lose money.

By summer many of the most illustrious names in investing -- superstar hedge fund managers who rake in tens or hundreds of millions of dollars annually for their speculative skills -- were turning in terrible years. Some merely trailed their benchmarks, others posted a fraction of their typical returns, a few hemorrhaged losses. The list of market laggards constitutes a virtual hedge fund Who's Who: John Meriwether of Long-Term Capital Management, Warren Mosler of III Associates, David Tepper of Appaloosa Management, Leon Cooperman of Omega Advisors, Bruce Kovner of Caxton Associates, Peter Gruber of Latinvest, Marco Dimitrijevic of Everest Capital International. And that was before last month's carnage in Russian markets spread its devastation across European and U.S. stock exchanges.

Hedge funds promise many things -- too much, perhaps, to too many people. But in the end their managers get paid those extraordinary sums (a standard 1 percent of assets and 20 percent of profits) not to underperform when markets crumble. They won't necessarily deliver outperformance in strong markets, but their returns should shine when times are hard. Indeed, volatile markets present mouthwatering opportunities for some traders imagine the benefits of shorting the sagging yen or cratering ruble -- at the risk of racking up roller-coaster returns. The problem this year seems to be that while many hedge funds underperformed in strong sectors, just as many fell to pieces in some of the hardest-hit markets: emerging markets, currencies and mortgage-backed securities.

Why the Emperors Have No ClothesTo be sure, a few superstars have posted eye-catching returns. Tiger Management Corp.'s Julian Robertson, written off two years ago by Business Week, is up 25 percent through July. Lee Ainslie's $2.5 billion Maverick Capital posted 22 percent for the same period. And George Soros' top managers were sailing along as well: Nicholas Roditi's Quota Fund continues to post sky-high numbers, up 36 percent, while Stanley Druckenmiller has come back -- after two years' lagging the pack (Institutional Investor, March 1998) -- to record a year-to-date return of 19 percent at Quantum Fund, even after absorbing a cumulative $2 billion in Russia-related losses.

But these performances only stand out because so many others have fizzled. Through July U.S. equity hedge funds tracked by the London-based Tass Management database posted total returns, net of fees, of 5.98 percent; investors would have been better off parking their cash in a U.S. stock mutual fund, where average returns, according to Morningstar, hit 7.04 percent for the same period while the S&P 500 rose 15.48 percent. Global equity hedge funds returned 4.49 percent, versus 6.9 percent for global equity mutual funds and 16.13 percent for Morgan Stanley Capital International's Europe, Australasia, Far East index. Hedge funds that invest in other hedge funds so called funds-of-funds -- could only boast a 2.53 percent return, compared with an average mutual fund return of 5.31 percent. And emerging markets? Better, but not by much: Emerging-markets hedge funds fell 14.45 percent, a virtual dead heat with the 14.47 percent lost by mutual funds in the Lipper Analytical Services emerging- markets equity index. Mortgage hedge funds posted returns of only 0.77 percent, compared to 3.91 percent for the Lehman mortgage index.

This poor performance is likely to get much worse before it gets better. The collapse of the Russian market portends one of the biggest debacles ever for hedge funds. Mosler, already lagging because of mortgage trading in his bond arbitrage funds (Institutional Investor, March 1998), was hit hard by Russia; his $400 million High Risk Opportunities Hub Fund may now be forced to liquidate, according to a source close to the fund. Dimitrijevic's Everest was reported to have dropped 20 percent in August because of Russian-related losses, while Meriwether's LTCM confirmed it was down 50 percent for the year, after sharp losses in August.

That's Russia. How much the subsequent damage to European and U.S. markets -- the S&P plunged 19 percent from its midJuly peak to the end of August -- hammered hedge funds will only be known fully as they begin this month to report their monthly numbers to nerve-racked investors. (U.S. equity mutual funds, up 7 percent through July, ended August down more than 9 percent for the year, according to preliminary Morningstar numbers.)

"It's like 1994 all over again," groans the felicitously named James Hedges IV, managing director of LJH Global Investments, which advises on $2.5 billion in hedge fund investments for wealthy families. That year, when bond markets collapsed, major funds racked up billions in losses.

Is this year's sorry performance an aberration? Unfortunately, it may not be. From their inception in 1949, when sociologist and former Fortune magazine reporter Alfred W. Jones set up the first such partnership, hedge funds have had a history of booms and busts. Jones's trailblazing A. W. Jones & Co. managed a cluster of long stock positions matched against a basket of short sales, hence the name, hedge fund. (No fool, Jones began the trend of charging fat fees; he got a guaranteed 20 percent of profits.) Dozens of copycats followed in the go-go '60s, but most collapsed a few years later, when the bull market died. Jones's fund lost 86 percent of its value between 1968 and 1970.

By the time the next fund boom surfaced in the late '80s in conjunction with another great bull market in stocks and bonds -- hedging was passe. Macro funds, like those pioneered by Soros, came into vogue, making giant leveraged bets around the world on stocks, bonds and currencies. Those bets boomeranged in the 1994 bond debacle, dragging down veteran macro managers such as Michael Steinhardt and Cooperman. Several funds posted double-digit losses. A few, like David Askin's mortgage-backed fund blew up spectacularly, costing investors billions. Askin's fund was supposed to be "market neutral," promising 15 percent-plus returns, according to his marketing literature, "regardless of whether the market goes up, down or remains the same." Not even close. Since then hedge funds have proliferated like never before to their own detriment. Today there are 5,500 or so funds wielding some $300 billion in capital, compared with just 1,400 funds with $42 billion in capital ten years ago, according to Van Hedge Fund Advisors. That's too many funds with too much money to invest in too few truly lucrative opportunities. Competition has driven many managers into specializations that may be too narrow to avoid volatile swings. Shifts in market structure, abetted by technology and the instant availability of information, are leveling the trading field, erasing the most lucrative niches -- the reason Travelers Group offered in July for shuttering the storied Salomon Smith Barney U.S. bond arbitrage unit. Not surprisingly, fund managers are responding by drifting away from the core strategies that made them successful traders.

Still, there's no shortage of supporters for hedge fund investment. The anecdotal -- not to mention the visceral -- lure is obvious: Plunk your money down with the hottest managers and watch your wealth multiply in good times and bad. Lately, some theoretical studies supporting hedge fund investment have appeared to buttress the anecdotal, including ones by Morgan Stanley Dean Witter and Goldman, Sachs & Co.

Both these analyses conclude, with caveats, that investing in hedge funds makes sense. But the caveats are critical. Goldman's lengthy study, written in conjunction with London-based hedge fund consultants Financial Risk Management, argues that a mixture of hedge funds, blended with other holdings in a large institutional portfolio, can boost risk-adjusted performance, in large part because returns are not correlated with overall stock and bond market returns. MSDW strategist Leah Modigliani, a granddaughter of economics Nobel laureate Franco Modigliani, recommends in her study that investors mix a combination of hedge funds with an investment in a stock index fund.

Why endorse portfolios rather than individual funds? Turn to Goldman's appendix. Over the past five years, most of the several hundred individual hedge fund managers examined by the study couldn't produce risk-adjusted returns that beat the S&P 500 or the FT/S&P actuaries world indexes. Modigliani discovered that only one of ten major funds she examined beat the S&P 500 on a risk-adjusted basis over five years.

So what is the Goldman study asserting? To get the "hedge" in hedge fund investing, investors need to hedge the funds against each other. Odd.

In fact, there are a number of, well, correlated reasons why the hedge fund phenomenon, circa 1998, is in grave danger of becoming the victim of its own success. Consider:

Too big not to flail. Hedge fund success depends on picking stars. Problem: The stars quickly wind up with so much money it's harder for them to get top returns -- a phenomenon well established in mutual funds, where the most prominent victim, Jeff Vinik, the former guru of the gargantuan Magellan Fund, left in 1996 after subpar returns, to -- of course -- open a hedge fund. More than 30 funds now boast at least $1 billion in capital each. The stars understand the problem. Druckenmiller, with $10.6 billion under management at Quantum, concedes that such size can depress his returns. "To some extent, the chickens have come home to roost," he told II in March.

Adds David Shaw of the eponymous quant fund (Institutional Investor, August 1998): "We're often approached by investors who are interested in participating in our proprietary strategies. The problem is that if we were to accept too much capital, our returns could be significantly degraded."

Not everyone agrees, of course. "I don't think there's any correlation between size and bad performance," says the manager of one of the world's largest hedge funds, who prefers that his name not be used -- possibly because he is underperforming his benchmark this year.

Still, enough managers do blame size for underperformance, which is one reason some have returned funds to investors, including Tudor Investment Corp.'s Paul Tudor Jones, Caxton's Kovner and Quantum's Druckenmiller, who has given investors a couple of large special dividends this year.

Not that giving back money always helps. LTCM's partners handed back $2.7 billion in January, citing the difficulty of finding profitable trades. They were right. The fund was down 16 percent by the end of July, then plunged in August, to be off 50 percent for the year. Before then, its partners had been holding discussions about farming out some of their capital to private equity managers.

To be fair, many of the year's best records belong to the largest funds, such as macro funds like Robertson's, which 'prospered by shorting Asian equities and putting on a dollar-yen hedged trade. With entire regional economies collapsing, it should be an ideal environment for big directional players. On the other hand, the average macro was up just 7.48 percent through July, badly lagging the S&P and EAFE indexes.

Shifting market structures. Markets are becoming more efficient and less profitable. Bond arbitrage appears to be temporarily tapped out. When LTCM started out in February 1994, it was one of a few funds competing for arbitrage plays -- such as the spread between French and German government bonds, say, or the gap between the Italian bond and swaps market (Institutional Investor, November 1996). Today these oncelucrative strategies have dozens of new funds chasing them. The advent of the euro should eliminate many lucrative currency plays. Bond arbs, like LTCM, could turn to the volatile mortgage-backed market, but that's crowded, too, with specialist funds like Ellington Management Group, Lane Capital Management and Convergence Asset Management.

Sweeping market changes should only make life more difficult. Internet technology is revolutionizing the transmission and accessibility of data, dramatically reducing the cost of instant updates from remote corners of the financial markets. Exchanges are merging or linking, which should reduce some arbitrage gaps between markets. Numerous computerized bond trading systems providing published prices are being launched. Derivatives have been commoditized, reducing easy opportunities. Continued globalization makes it difficult to find a patch of earth not tilled by analysts.

Performance anxiety. Unlike mutual funds, hedge funds operate in relative secrecy; most don't post daily valuations, and they're not subject to daily redemptions. That ought to promote long-term investment. Unfortunately, increasing competition may force them to become more aggressive in their promises. Druckenmiller's goal is to generate consistent returns in the high teens -- modest by his previous track record, but a high hurdle for rivals. "Expectations for a lot of hedge funds have been formed in markets with artificially high returns," says one manager of a $1 billion hedge fund.

Consider so-called market-neutral funds, which often turn out to be anything but. Chris English and Peter Bernard at Finsbury Partners promised returns of 15 percent in their relativevalue fund, launched in 1994, only to get caught out by the Asian crisis last year to lose 14.8 percent in October alone. "Market-neutral funds are supposed to be doing nondirectional trades, but people expect 15 percent," says Jonathan Bren, president of HW Advisors, a hedge fund investor. "There's not a lot out there that pays you 15 percent performance without a lot of risk."

The dangers of style drift. Managers with too much money can scrounge in their own sectors ? or seek larger returns elsewhere. Increasingly, major hedge fund managers are learning on the fly about new sectors. "There's drift driven by the fact that there's a lot of performance pressure," says one Wall Street derivatives executive who markets to many hedge funds. "Now they're saying, 'My mandate is to look at the smartest idea.' "

Take Tepper, who earned his reputation as a high-yield trader at Goldman and whose Appaloosa promises returns far higher than those of corporate bonds. To get those returns, Tepper migrated from junk to investing in South Korea to aggressively playing the Russian government bond market. Appaloosa told investors up front that emerging markets were part of its mandate, but in more cautious times investors might have viewed a former junk bond trader's playing these markets as a trifle risky After chalking up 50 percent returns from 1994 to 1997, problems in Russia and South Korea shrank Tepper's returns through July to 7.75 percent, compared with 4.15 percent for the Lehman Brothers aggregate bond index by the end of July. Tepper was reported to have substantial Russian losses for August.

Another style-shifter tripped up by emerging markets is Dimitrijevic. An '80s high-yield star for investors Nelson Peltz and Peter May, Dimitrijevic's Everest Capital soared from $260 million in capital in 1996 to $1.25 billion in January on the strength of 54 percent annual returns. Through July he was down 9.16 percent for the year and was reported to be falling further in August.

Omega's Leon Cooperman, who spent his Goldman Sachs career as a portfolio strategist before the development of Eastern European markets, now plays the Russian stock markets. Funds such as Omega have hired specialized talent to expand into new markets, and investors are now betting on not only Cooperman's ability to pick stocks but also on his ability to recruit traders and manage them. That point was driven home last month when Cooperman dismissed his emerging-markets team after his fund suffered losses in Russian securities that wiped out his yearly gains.

LTCM, whose partners made their reputations in bond arbitrage, told investors from the start that it would try any trade that looked good. But who expected Meriwether's shop to hold more than $500 million in risk arb positions by earlier this year. Worse, the firm is said to have taken losses on those positions. Let's face it, most investors don't really sign on with Meriwether to bet on takeovers.

Style drift may be a greater temptation for specialized funds as they get more and more capital to invest. Too much money says Thomas Healey, head of the pension services group at Goldman Sachs and co-author of its hedge fund study, "drives you into doing macro things."

Whether it's LTCM nosing out of its expertise into stock arbitrage or Omega moving into Russian bonds, there's no such thing as a free hunch. And calibrating financial risk isn't the same as assessing political risk -- as many hedge funds are now discovering. "People putting on leveraged Russian debt bets were greedy and stupid," says LJH Global's Hedges.

Delusions of grandeur or dilution of talent? The world's supply of genius is limited, but it has never been easier to raise $1 billion. David Shaw launched his fund in 1988 with $28 million. Clifford Asness, the well-regarded director of quantitative research who left Goldman earlier this year, has just finished raising money for AQR Capital Management; he'll have about $1 billion after turning down a whole lot more.

Asness may do fine. But star traders at investment banks are not always the independent spirits they see themselves as. They're supported by risk monitoring desks, $1 billion technology budgets, multiple levels of management and governance. Many simply won't do as well on their own.

Besides, how many funds can start up without diluting the talent pool? Ex-Tiger equities chief Stephen Mandel recently set up Lone Pine Capital; former Tiger trader Lee Ainslie runs Maverick, and ex-colleague David Gerstenhaber runs Argonaut Capital Management. Glenn Doshay left Ardsley Partners to launch his own hedge fund, Palantir Capital. All these moves can't do much for privacy, either, long the hallmark of hedge funds. How many trading secrets remain out there? Goldman Sachs Asset Management is starting to resemble a hedge fund farm team: Cooperman at Omega, Asness at AQR and Michael Smirlock at the deeply troubled Shetland Fund. Thousands of hedge funds notwithstanding, says Martin Gross, a Livingston, New Jersey, investor who runs several funds-of-funds, "if 3 percent represent outstanding talent, I'd be happy. Of course, that leaves me with over 100 hedge funds to choose from."

Beware the bear. A key goal for most hedge fund investors is outperformance in bear markets. But many funds simply haven't done well when certain sectors soured this year. Consider the mortgage- backed-securities market, which has been devastated by the rapid drop in bond yields. That shouldn't have been too big of a surprise. When rates fall s harply, mortgage prepayments accelerate, and the most interest-sensitive of the securities get hammered. It happened in 1993. And it occurred again this year, whacking many big-name traders. A Fibonacci Associates mortgage fund lost 14 percent of its assets in one quarter. Lane Capital was down 3 percent by the end of July. Smirlock's Shetland Fund lost more than 9 percent in April, prompting massive redemptions. From $400 million in capital in January, it was down to some $75 million by the end of last month.

As always, a few mortgage pros made out. The $1.1 Ellington group of funds, run by ex-Kidder, Peabody & Co. trader Michael Vranos, was up 6 percent by the end of July, down sharply from its average 33.5 percent composite returns over the last few years but still impressive given the carnage. Vranos sees great opportunities now. "When you go from a seller's market to a buyer's market, there's a lot of pain," he says. "But going forward, there's a lot of opportunity."

Hope springs eternal. Should it? Goldman believes its study presents evidence that hedge funds do perform well in periods of falling markets. "In the six periods during the past five calendar years when the S&P 500 index declined more than 3 percent," the report says, "the average return for all hedge fund categories was at least 270 basis points better than for the S&P 500."

Impressive, but a 3 percent decline notwithstanding, the last five years have not exactly represented bad - sustained '70sstyle bad - times, particularly in equities. Last month's huge corrections in the U.S. and other markets, should prove to be a more daunting test of the hedge funds' resilience.

One problem: There's simply no way to know how hot managers will do when markets tank. Of the 1,500 funds in the Financial Risk Management database that underlies the Goldman study, only 279 funds have been around long enough to post five years' worth of returns.

That statistic may say more about the riskiness of hedge fund investing today than any performance study.

Additional reporting was provided by Staff Writer Robert Clow.

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