A Critical Review on Hedge Funds Omniscient or Just Plain Wrong by Brown - Essay Example

A critical review on Brown’s Hedge Funds: Omniscient or just plain wrong Stephen Brown’s paper discusses the origin and many aspects about “hedge funds” and its role in the Asian financial crisis of 1997. Brown tries to give in a “reasoned discussion” on hedge funds and to prove the other misconceptions about it. These misconceptions, or myth, are properly analysed and compared to what has really happened. The first part tells about how this came to be and applied by the man who first investigated technical methods of market analysis for an article titled Fashions in Forecasting, and in a few months became a master himself in the financial market. In the later part, we give an analysis, consult other authors and available literature in the field, and critically assess Brown’s article on hedge funds. The phrase “hedge funds” alone has not been well defined. Dr. Grenville, Deputy Governor of the Reserve Bank of Australia could not mention the proper definition. The Bank of Australia, in a paper submitted to the Australian House of Representatives, indicated that it was very concerned about the activities of highly leveraged financial intermediaries known as “hedge funds”. The paper stated that they were concerned that the funds made money “by attacking an exchange rate that has already overshot, so that it overshoots even further.” Through published actions and short selling, a bandwagon forms, then the funds would pull out. The Bank paper further stated that this was what happened to the ERM crisis that hit the British Pound in 1992, the Asian currency crisis in 1997 and speculative attacks on the Hong Kong dollar peg in 1998. With their action, the funds were holding the small countries hostage. (p 301) Brown (2001) pointed out that the International Monetary Fund reported that in the 1990s, there were financial intermediaries that had been investing steadily into South East Asia. There was a net inflow of about US$20 billion into the region over and above portfolio and direct investment; this was up to 1995 and 1996 when it increased to US$45 billion per annum. Then, there was a collapse of the Baht and the Ringgit in 1997 (the start of the Asian financial crisis), and a sudden outflow of US$58 billion. It was then perceived by the central bankers in the region that the collapse in the currency had everything to do with an attack on the currencies of the region by well-financed international speculators. Hedge funds could be the cause of the Asian financial crisis. One of those who believed on this was Dr. Mahathir bin Mohamad when he said, “We are now witnessing how damaging the trading of money can be to the economies of some countries and their currencies. It can be abused as no other trade can. Whole regions can be bankrupted by just a few people whose only objective is to enrich themselves and their rich clients.... We welcome foreign investments. We even welcome speculators. But we don’t have to welcome share- and financial-market manipulators. We need these manipulators as much as travelers in the good old days needed highwaymen”1. But Brown countered this observation of Dr. Mahathir. He said that taking at face value the assertion that hedge funds acted in concert with the sole objective of bringing down the Ringgit, their behavior would have to have been extreme indeed to explain the observed facts (303). More on the details of the Baht and the Ringgit are discussed on the later portion of the paper by Brown, in which he analysed, along with Will Goetzmann and Roger Ibbotson (1999) the TASS database net inflows and outflows over the period covered in financial crisis. Brown further quoted Nick Leeson when the latter was interviewed by David Frost in a German jail. Leeson stated that he lost £800 Million in hedging operations but gave no further explanations except that “sometimes you make money hedging, sometimes you lose money”. This means that hedging could not be all getting and winning profits. The origin of hedge funds Alfred Winslow Jones was a sociologist, turned journalist turned fund manager. He was preparing a paper to analyze financial market trends, but before anything else could be divulged to the public, or before Fashions in Forecasting went to press, Jones already made his move and established an investment fund as a general partnership. Jones is described as an amiable man who cared for other people. While he 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 hedge fund as a tool for others to help themselves. His son-in-law, Robert Burch, who currently runs A.W. Jones & Company, said that Jones was more interested in the intellectual challenge of the business than the rewards it provided.2 “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.”3 Gabelli (2008) describes Jones as a truly remarkable individual who, after graduating from Harvard in 1923, toured the world working as a purser on tramp steamers, served as a U.S. diplomat in Germany during the rise of Nazism in the 1930’s and as a journalist covering the Spanish Civil War. In 1941, he received his Doctorate in Sociology from Columbia University and became a reporter for Fortune Magazine. In researching and writing a 1948 Fortune article on the current fashions in investing and market forecasting, Jones came to the conclusion that he had a better system for managing money. In 1949, he raised $100,000 ($40,000 of which was his own money) and began putting his theories to practice in a general investment partnership.4 These few sentences describe the man who invented hedge funds. The article Fashions in Forecasting which was the start of Alfred Winslow Jones’ “discovery” of hedge funds is described by Strachman (2007): The article was not some how-to or get-rich quick piece about making a fast buck, but rather a though-provoking look at how money is managed and the idea that going long 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.5 Strachman (2007) explains it: Some stocks go up while others go down and very rarely do all stocks move in the same direction at the same time. While the stocks go up and down, there is a way to make money both when they go up, i.e. by being long a basket of stocks, and when they go down, by being short a basket of stocks. So the key is to forecast which stocks go up and which go down and to position a portfolio.6 Jones then developed the idea as a “market neutral strategy, by which long positions in undervalued securities would be offset and partially funded by short positions in others.” This position allowed leveraged investment capital and large bets with limited resources. (p.303) The advantage of Jones concept is that the partnership is not subject to the regulatory controls stipulated by the (U.S.) Investment Company Act of 1940. The number of investors was limited, at first, to 99 but was later increased to 500 in 1996 when the National Securities Markets Improvement Act modified the Investment Company Act7. In fact, Brown states in the first stage of his paper that “hedge fund” is best defined as a limited investment partnership, and of a heterogeneous lot, and only a minority follows the market neutral style that Jones represented. (304) This innovative concept of Jones produced imitators in the financial market, but it was only in 1966 that the term “hedge fund” was used to describe the market neutral style that he had developed. Some imitators borrowed the fee structure but not, in Brown’s words, the “hedged” philosophy that Jones represented. The Quantum Fund managed by George Soros boasts of compounded annual returns exceeding 30% for more than 2 decades. (304) Hedged funds are similar to mutual funds and other investments but the latter are bound by restrictions such as leverage, short selling and ownership. Institutional investors most involved in hedged funds are public pension plans, endowments and family offices and foundations. (305) The superior returns have attracted both institutional and private investors. Hedge funds are similar to mutual funds in that they are actively managed portfolios holding positions in publicly traded securities. But hedge funds have broad flexibility in the types of securities they hold and the types of positions they take, which is not the case with mutual funds. Hedge funds can also invest in international and domestic equities and debt, and the entire array of traded derivative securities. They may take undiversified positions, sell short, and lever up the portfolio.8 Jones’s other innovation was an incentive fee. According to Caldwell’s (1995) account of Jones’s original investment fund, the compensation was 20% of realized profit—no high water marks and no fixed fee.9 A “high water mark” means that the manager does not receive performance fees unless the value of the fund exceeds the highest net asset value it has previously achieved. For example, if a fund was launched at a net asset value (NAV) per share of $100, which then rose to $130 in its first year, a performance fee would be payable on the $30 return for each share.10 This high water mark was explained by Brown when he said that the manager must make up past losses before they are entitled to the performance fee under their contract. The manager is granted a call option, an option which goes into the money as the fund returns enough to cover past losses. In 1949, Jones raised $100,000 ($40,000 of which was his own money) and began putting his theories to practice in a general investment partnership11. (Gabelli, 2008) Gabelli (2008) describes Jones’ novel idea as “hedging” his long stock positions by selling short other stocks to protect against market risk. He used leverage, or borrowed money, to enhance the potential return on the partnerships assets. In 1952, he transformed his general partnership into a limited partnership and introduced another wrinkle, a 20% of the profits incentive fee for himself as managing partner. His partnership had outperformed the best performing mutual fund that year by 44% and the best five-year performing mutual fund at the time by 85%.12 Most hedge funds have greater investment flexibility than regulated investment advisors. They can profit from leverage in up markets and varying forms of short selling in declining markets, whereas most mutual fund companies cant use leverage and their only defensive option is to raise cash.13 For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.14    Hedge fund risks Hedge funds may not be at all profit, in fact investing in a hedge fund is considered to be riskier proposition than investing in a regulated fund.15 Reasons for the risks can be enumerated here: Leverage – a hedge fund borrows money, most of the time greater than the initial investment. Short selling – losses that can be incurred on short selling are limitless. Appetite for risk – hedge funds take more risks on high yield bonds, distressed securities and collateralized debt obligations based on sub-prime mortgages. Lack of transparency – hedge funds are secretive entities and therefore difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision. Lack of regulation – hedge funds are not subject to regulation.16 Claims that hedge funds are gunslingers It appears at first that hedge funds deliver extraordinary returns, but this is one of the confusions that Brown would like to raise. The compensation arrangements would appear to encourage risk-taking behavior that generates extraordinary returns, but Brown said that this is not so. Hedge funds are not, in Brown’s words, the gunslinging risk-takers of public perception, but are somewhat “gun-shy”. (302) George Soros, the global macro manager He was held as the exemplar of the “global macro” manager who would profit from bets taken against countries and currencies. The absence of regulatory oversight and restrictions on dissemination of information means that reliable information on hedge funds is hard to come by (304). There are no clear stories behind hedge funds. Sometimes, there are stories about the remarkable investment prowess of George Soros, so that his widely publicised and attack on the pound Sterling in 1992 allowed the hedge fund industry to grow. So it was perceived that hedge funds were like George Soros, gunslingers on a global scale (304). Brown asserts that the accusation that all hedge funds are global gunslingers is to go beyond what the data can support. He supports this by analyzing data, along with Will Goetzmann and Roger Ibbotson, in their paper entitled Offshore Hedge Funds: Survival and Performance, 1989–9517. In the data presented, for the period 1989 – 1995, hedge funds did not earn on average anything like the returns attributed to Soros, it earned a good 300 basis points less than the S&P500 over the same period. But the Soros funds were larger and their returns superior to those of the average fund, that the value weighted average return of all funds is more than 800 basis points greater than the S&P500. Brown says that Soros is the exception rather than the rule. Brown supports his contention that hedge funds are not the gunslingers that their fee schedules would suggest by saying that there is a reputation factor that offsets the obvious incentive to take risk. Reputation is a very significant factor. Hedge funds almost have a half life of about two and a half years. The fee option, which is aggressively performance based, is valuable only so long as the fund stays in existence. The younger the fund, the most like it is to fail. Hedge funds responsible for the Asian financial crisis? Dr. Mahathir bin Mohamad and his friends maintain that hedge funds were responsible for the Asian financial crisis. Again analysing the TASS database which has maintained currency positions over the Asian financial crisis, Brown (1999) with Will Goetzmann and Roger Ibbotson came up short on the amount needed to finance net inflows of US$45 billion in 1995 and 1996, and a net outflow of US$59 billion in 1997. The analysis is that taking all the funds together, they had a total asset size of only about US$29 billion, not including leverage. This is contrary to Dr. Mahathir’s contention (and the IMF’s) that there was a net inflow of about US$20 billion into the region over and above portfolio and direct investment, then the amount increased to US$45 billion per annum. The sudden outflow reached US$58 billion. What Brown et al is trying to do is to disprove Dr. Mahathir’s contention that hedge funds were involved in the Asian crisis to benefit themselves and their rich clients. They found no evidence of enrichment over the period of the crisis, adding that the funds were even losing a considerable amount of money. In August of 1997, the Ringgit fell 4.21% relative to the US$, while at the same time all of Soros’ funds lost money when his flagship Quantum Fund lost 7.4% of its value. (308-309) Brown et al also examined with weekly data the exposure of two prominent currency traders to the range of currencies and they concluded that there was evidence to show dramatic changes in net exposure to the Asia basket prior to the collapse of the Ringgit. The fact that at the time of the collapse these funds were virtually out of the market altogether still does not support Dr. Mahathir’s allegation. The funds just chose safe harbor from the storm. (309) Brown could not however give explanation on the collapse of the Ringgit. But he stated that in 1997, there was a net outflow of funds from the countries in the region equal to more than twice the capitalization of all of the currency hedge funds in the TASS database, while Malaysian investors were seeking safe haven in property markets abroad, particularly in Australia where news stated that there was aggressive acquisitions of blue chip real estate in Sydney, Melbourne and Adelaide by wealthy Malaysian investors coincident with the collapse of the Ringgit. There was a flight of capital from Malaysia but there was no evidence to show that hedge funds led the flight. Discussion There are claims, or should we say misconceptions, about hedge funds that when taken in its face value and without proper investigation, could result to hasty conclusions. Brown concluded his paper by saying that he was sorry that to say that Dr. Grenville of the Reserve Bank of Australia, whom he respected so much, believed in Dr. Mahathir’s claims which did not have factual claims. According to Brown, there are a variety of claims, each one of which is false. These claims were mentioned above: a. Hedge funds act in concert as global market manipulators. b. Hedge funds are gunslingers. (My figurative explanation for gunslingers is that when one displays his gun in the presence of others, who are helpless in a situation, he can do everything, or he has the leverage. And in a financial situation, what can you do with your money, if someone has the gun.) c. Hedge funds were responsible for the Asian financial crisis. Brown, Goetzmann and Ibbotson also broke down the results of the data available which were representative of the hedge fund industry taken as a whole. Hedge funds did not earn on average anything like the returns attributed to Soros. Soros funds were larger and their returns were superior to those of the average fund. And it was also found that global macro funds did better than any other style of management. In terms of absolute return, risk adjusted return or return per unit risk global macro funds experienced the highest level of returns. What’s now on Dr. Mahathir’s allegation that hedge funds were responsible for the collapse of the Ringgit, and the Asian financial crisis as a whole? This critique finds that there are no reasons to believe that hedge funds did it to strike on the Ringgit and the Baht. In fact, hedge funds also lost in the process of investing, considering the TASS database mentioned in the article. But what were Dr. Grenville and Dr. Mahathir’s reasons and evidence to show that hedge funds caused the collapse of the Ringgit and the Baht? It could possibly be the common claims and myths on hedge funds: that hedge funds are gunslingers and that they attack currencies. It could possibly be, but we can not also take for granted the reputation of these two distinguished gentlemen. They have all the evidence and data at their disposal. They could not just possibly jump to conclusion that hedge funds did cause the Asian financial crisis without first investigating and looking into the actual situations in the field. Dr. Mahathir is an authority in the financial market of his own country, Malaysia. He must know the events of his own country when it comes to financial matters. He knew what happened, and when he said all the negative comments against hedge funds, it is because he investigated the matter and he had the data supplied by his people in the field. This is the same with Dr. Grenville, a distinguished personality in the banking world. With his position and authority, he was supplied with the necessary data and information by his people and the Reserve Bank of Australia. In an article in the New York Times (online), entitled Long-Short Story Short, the same praises by other authors are delivered on Alfred Winslow Jones, the “inventor” of what he first termed as “hedged fund” (with a d on hedge). It said, “The name’s been bastardized, and so has just about everything else about it.” For, we can say that the original idea of hedge funds by Jones is ideal in the financial market. From the traditional ways, we always look at financial trends that way. We have to observe stocks that go up while others go down because they rarely move in the same direction at the same time. And when they go up, be long on the basket of stocks, and when they go down, be short on it. So the key is to forecast which stocks go up and which go down and to position a portfolio. This is his innovation. And it’s been destroyed and, in the words of the New York Times, bastardized. Jones turned his dissertation into a book, turning it into a story for Fortune. Jones idea was something like profit without risk. Jones used a metric which he called “velocity”, the measure of how closely a stock’s movement tracks the broader market. He split his holdings into two groups: good stocks that rose faster than the market in good times and fell slower than the market in bad times, then bad stocks that did the opposite. This means he took positions in the good stocks and short positions in the bad ones. He was assured, along with his partners, of making money whether the market went up or down. But Jones made lapses; had to be patient and humble, admitting that he couldn’t outsmart the market. As we can see, he was working with borrowed money.18 Jones died in 1988, but his firm lives on as a so-called fund of funds, directing $200 million of its clients’ money to firms that employ Jones-like principles. “I’d say a lot of the industry is still based on the long-short model,” says Robert L. Burch IV, Jones’s 32-year-old grandson who runs the firm with his father, Jones’s son-in-law, and operates his own tiny hedge fund on the side. “You just hear a lot less about them.” That may be because such assiduous risk avoidance has gone out of style.19 CONCLUSION Brown’s paper Hedge Funds: Omniscient or just plain wrong is a well researched paper defending the innovative ideas and lapses of hedge funds. However, well researched as it appears to be, there were conclusions still lacking evidence. This could be attributed to the lack of empirical study on the subject of hedge funds. The claims of Dr. Grenville of the Reserve Bank of Australia and Dr. Mahathir of Malaysia can not also be disregarded considering their reputation and the data and evidence at their disposal. These data and information can be the subject of a more detailed study and article in the future. References Book Strachman, D. (2007). The Fundamentals of Hedge Fund Management: How to Successfully Launch and Operate a Hedge Fund (Wiley Finance). John Wiley & Sons Inc., Hoboken, New Jersey: 2007. Journal Brown, S. (2001). Hedge funds: Omniscient or just plain wrong. Pacific-Basin Finance Journal, Volume 9, Number 4, August 2001 , pp. 301-311(11), Available from: http://pages.stern.nyu.edu/~sbrown/omniscient.pdf. Web sources Brown, Stephen J., Goetzmann, William N., Ibbotson, Roger, G. (1999). Offshore Hedge Funds: Survival and Performance, 1989–95. (Journal of Business, 1999, vol. 72, no. 1) 1999 by The University of Chicago [online]. Available from: [Accessed 24 Jan 2008] Gabelli, M. (2008). The History of Hedge Funds - The Millionaires Club [online]. Available from: http://www.gabelli.com/news/mario-hedge_102500.html. [Accessed 25 January 2008] Investopedia website (2008). Hedge funds. Available from: http://www.investopedia.com/terms/h/hedgefund.asp. [Accessed 25 January 2008] New York News & Features (2008). Long-short Story Short. Available from: http://nymag.com/news/features/2007/hedgefunds/30345/. [Accessed 25 January 2008] Wikimedia Foundation, Inc. (2008). Hedge fund. Available from: http://en.wikipedia.org/wiki/Hedge_fund. [Accessed 25 January 2008] Read More