The environment will remain friendly to hedge funds--

The environment will remain friendly to hedge funds(2)

2007-07-31 13:48:52 [ Big Normal Small ] Xing Zong 　Comment

Xing Zong: Now let’s talk about the general strategies that hedge funds use, could you please introduce to our readers the general strategies for them?

Brown: As I indicated before, the term “hedge fund” refers to any unregistered investment partnership. Hedge funds do not “hedge” and there is a remarkable diversity of hedge fund styles. In my own work, I have found that there are at least eight distinct hedge fund styles, and probably many more. My research shows that differences in hedge fund strategies account for more than 20% of the cross-sectional dispersion of hedge fund returns. The most common hedge fund strategy is the AW Jones long-short style. The next most common strategy, at least in the U.S. is the ‘event driven’ style which like private equity funds attempts to profit from merger and acquisition activity. Fixed income arbitrage and convertible arbitrage styles looks for differences in yield across fixed income securities and attempts to make money where the differences in yields cannot be explained by economic fundamentals. Managed futures funds try to profit from mispricing in the commodity markets, while global macro funds, like George Soros, try to predict changes in currencies. Equity market neutral funds, popular among institutions, attempt to produce returns uncorrelated with the market by short term liquidity trading. Dedicated short bias funds, as the name implies, restrict themselves to taking short positions. During favorable market conditions, these funds find it very difficult to make money in this way.

Xing Zong: More and more hedge funds pay attention to China, India, etc. In your opinion, how they can profit from investing in those emerging market?

Brown: Hedge funds can profit from providing liquidity to these markets as they profit from providing liquidity to other markets. These markets are different however because they are considerably less liquid than other markets, which raises the possibility of extraordinary returns available to hedge funds operating there. On the other hand, many of the strategies commonly used by hedge funds, including short sales and certain derivative strategies are either not available or are sharply restricted by Government authorities. Finally, there is a general lack of information and differences in accounting rules that increase the cost and difficulty of operating in these markets. For this reason, funds tend to specialize in emerging markets. As it happens, I am currently advising a hedge fund run by MIR Investment Management, in Sydney Australia, which is extensively investing in China, India and other Asian emerging markets.

Xing Zong: Some managers use multi-strategy. For example, fund of hedge funds, i.e. fund of funds. Could you please elaborate a little bit on this point?

Brown: Because of the diversity of hedge fund strategies, it makes sense to diversify hedge fund investments. The financial risk diversifying to just ten funds can reduce financial risk to half that of the S&P 500 index of the U.S. equity market. However, the cost to doing this is the fact that many hedge funds are opaque investments, and it is very costly to study each fund when you are investing in so many of them. Also, there is a multiplication of management fees incurred when you invest in many hedge funds. For this reason, funds of funds have been developed to provide institutional investors with a diversified hedge fund exposure. These funds of funds are themselves hedge funds which invest in other hedge funds, and they charge a fee over and above what the individual funds charge, typically one percent of the assets under management and 15% of any profits they make doing so. These fees are intended to compensate the fund for the very expensive business of doing the necessary investigation work on each and every fund they invest in.

A way of avoiding these fees is to invest in a so-called “multi-strategy fund” where the manager will invest in a variety of strategies within the one fund. The problem with this arrangement is the possibility that it puts the manager in a conflict of interest. He will not fire himself if one of his strategies does not work out. In fact, this was the problem at Amaranth Advisors LLC last year, a celebrated case of a hedge fund failure. On their web site, they explained that they were a multi-strategy hedge fund and that their investment professionals deploy capital in a broad spectrum of alternative investment and trading strategies in a highly disciplined, risk-controlled manner. In fact, more than 80% of the over $4 Billion invested with the fund was invested in just one energy commodity strategy which failed.

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Xing Zong: What important trends do you see in this industry? Are you optimistic about hedge fund?

Brown: The most important new development in the industry is the extent of institutional involvement in hedge fund investment. Up to about eight years ago, the predominant investors were high net worth individuals. Now institutions make up about 50% of the business. Along with institutional interest comes increasing pressure to regulate the industry, to protect the interests of those for whom the institutions are investing. Up to last year, the industry in the United States fought any effort by the Government to regulate them in any way. However, at a Committee Hearing of the U.S. Congress House Financial Services Committee Hedge Funds and Systemic Risk in the Financial Markets March 13, 2007 at which I testified, the industry representatives understood that regulation of some kind was inevitable. They explained that many funds were voluntarily registering with the Securities and Exchange Commission, even though there was no legal requirement to do so. They recognize that without some form of limited disclosure, Congress will demand that the industry be more heavily regulated. I am optimistic that the environment will remain friendly to hedge funds which I believe play an important role in financial markets.

Xing Zong: Blackstone went public last month and attracted a lot of attention. Prof. Brown, what is the difference between hedge fund and private equity?

Brown: Private equity firms are like investment banks that provide consulting services or take an ownership interest in financially distressed companies to effect necessary changes. There are many companies run by good people who work hard and make good products. However, they are not necessarily experts in financial affairs. These private equity firms therefore perform a very important function. The reason these firms are attracting a lot of attention is that they enjoy a very favorable tax treatment relative to their investment banking competition. Many people do not understand why this should be the case.

Hedge funds can do many of the same things as private equity firms. However, while private equity firms consist of a small but active partnership group, hedge funds are a large but passive partnership group with all important decisions being made by the fund manager. They also tend to have a somewhat shorter investment horizon. However there is nothing to prevent a private equity firm setting up as a hedge fund, and there may be operational and tax reasons for doing so. These funds are referred to as “event driven” strategies and are the fastest growing segment of the hedge fund industry, with 25% of the $US assets under management by all hedge funds as of the end of 2006.

Xing Zong: Another striking characteristic for hedge fund is that, it is a private enterprise therefore enjoys the privilege of not disclosing its details to SEC. But there is increasing call to regulate the hedge fund industry because there are many illegal investment activities. What is your opinion on this issue?

Brown: One point of some confusion is that while hedge funds are unregistered investment partnerships and for this reason are not required to disclose information to the SEC, they are subject to anti-fraud provisions, and are not allowed to engage in illegal investment activities. As I mentioned before, there is a vast diversity of hedge fund strategies. The problem with the lack of disclosure is that many people believe that all hedge funds are alike. Therefore, when one hedge fund is found to act illegally, it is often assumed incorrectly that all hedge funds act illegally. It is actually for this reason that the industry is voluntarily starting to disclose information to the SEC, even though there is no legal requirement for it to do so. According to the Managed Fund Association, the leading hedge fund industry association in the U.S. most hedge funds are in fact reporting to the SEC.

Xing Zong: Have you ever been to China? What experience can China learn from the development of hedge fund industry in U.S.?

Brown: I visited China several times last year, both as a tourist and to visit with many friends I have there. As the Chinese capital markets develop I see an increasing role for the Government to protect small investors from over-extending themselves. It was this kind of concern that led to the development of the SEC in the United States back in 1934. However, these restrictions necessarily limit the liquidity and the functioning of the capital markets, so necessary for Chinese development. The main role of hedge funds is to provide the necessary lubricant for the capital markets and to provide an opportunity for poorer and less advantaged sectors of society to shift risk to those sectors best able to manage this risk. Therefore, I see hedge funds as playing a very important role in Chinese development. With appropriate safeguards, including limited disclosure and strict enforcement of anti-fraud provisions, I believe China has much to gain from encouraging this new financial sector.

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