While history does not accurately anticipate the future, it does indicate where we have been, ties implications together and implores us to consider whether we are reliving it.
It is remarkable that in little more than a decade’s-period hedge funds, as a group, have leaped from the back pages of business publications to become cover stories of mainstream media, subjects of “bestselling” books, feature-length films and part of vernacular tossed around at middle- and upper-middle class dinner tables at many corners of the world. Unbeknownst to most, including some in the hedge fund business, we have been here before—at least a couple times.
Broad popularity of certain speculative vehicles, widely called “hedge funds” today, operating in financial markets has a very long history. While the vehicle has come in many forms, it’s a phenomenon that likely stretches back for centuries. This entry will focus on that experience in the United States since early-20th century.
While history does not accurately anticipate the future, it does, at minimum, indicate where we have been, helps tie implications of those experiences together and, most importantly, implores us to consider whether we are reliving it and, if so, ponder whether and how it will differ from the future.
Catallactic posits below that hedge funds, and other types of speculative vehicles with incentive fee structures known by other monikers, have during the 20th century largely followed a four-decade pattern of (1) obscurity, (2) development, (3) broad popularity and awareness and, finally, (4) descent before repeating the cycle. This pattern of course closely mirrored that of the broader US equities and credit markets. It remains unexplained however why the patterned decades comport largely with that of the calendar.
Catallactic herein reviews the last two complete hedge fund cycles of four decades each and expounds on the current cycle’s 30-year run. Catallactic concludes with a speculative look at what the future may hold for the funds, their advisors and the environment they may encounter in the US. It is worth noting that the below is not intended to serve as either a complete history of or an authoritative source of information on an asset class. It rather demonstrates a historical trend.
SPECULATIVE POOLS. SYNDICATES AND JOINT-ACCOUNTS
It is likely that as long as man has ventured guesses about his world’s future and coupled that with an element of motivating persuasion, he has found a means to earn a very good living. Speculation is, as best as anyone can tell, as old as man. An engagement whereby expenses and speculative losses are incurred by one party while speculative gains are shared may seem inherently unfair to some. It has been however a common arrangement for many sorts of speculative ventures outside of financial quarters. The original English East India Company in the early 17th century, before it became a merged and perpetually chartered enterprise, funded each trade expedition in similar fashion. Other similarly chartered enterprises of the period executed comparable arrangements that form the early basis of corporate structures extant today. Viewed by some as brilliant commerce that exchanges know-how for speculative capital, it has come under criticism from some detractors today. This arrangement nonetheless summarizes most of today’s hedge fund structures.
Such arrangements have been in existence long before the term “hedged fund” entered financial lexicon in the late 1940s via business-journalist-turned-trader Alfred Winslow Jones (1900-1989) and his firm A. W. Jones & Co., which was founded 1949. Jones and his company became widely known when a popular monthly financial publication read by many leading businesspersons profiled in 1966 the man, his firm and their outstanding performance in an article, The Jones Nobody Keeps Up With.
Notwithstanding Jones’s acknowledgement of his predecessors during a ‘70s Institutional Investor interview, to the contrary, many widely respected business and financial publications and academic research journals continue to claim such arrangements were first invented by Jones. History has shown otherwise.
In his memoir Benjamin Graham, the Memoirs of the Dean of Wall Street, written during the 1960s and ‘70s and released for publishing by his estate in 1996, the subject person recollects the following:
“[In 1916, my] good friend Algernon Tassin, professor of English at Columbia College—a confirmed bachelor and, let us say, a supereconomical person—had saved up a fair sized sum, most of which he had invested in a very high-priced gilt-edged public utility stock named American Light & Traction common. My initial success with the Guggenheim Exploration dissolution had given me a strong interest in specialized operations of this kind—arbitrages and hedges—and also in the wider field of undervalued securities, which I staked out as my own particular domain in Wall Street. Among other things, I concluded that money could be made both conservatively and plentifully by buying common stock which analysis showed to be selling too low and selling against the other common stocks which a similar analysis indicated to be overpriced.
When I described my ideas to Tassin, and recounted some successes obtained in minor operations along these lines, he was greatly interested. We worked out an arrangement under which he would supply $10,000 of capital in the form of twenty-five shares of American Light & Traction, then selling at $400; I would operate the account; and the profits and losses were to be evenly divided between us.”
This strategy was not unusual for the time (cf. Meyer H Weinstein’s Arbitrage in Securities (1931), perhaps the first book to elucidate hedging operations with detailed examples of convertible bond arbitrage; though different, the strategy like Graham’s exploits relative value differences between securities). Benjamin Graham would go on to operate jointly from 1927 to 1958 the Graham-Newman Partnership, a fund and its successor that undertook long and short positions in publicly traded; illiquid and semi-private securities that was managed with a performance fee (twenty percent at time of its liquidation) as incentive.
These funds likely existed before Graham’s activities. While the hedging component of such funds is not as well documented, the performance fee structure seems to have a long history. Since the 19th century, pools and syndicates had operated usually in individual publicly traded securities under similar profit-sharing arrangements between sellers, which were often the issuing company or its officers, and the operators hired to raise the share price. Penned as a roman à clef, reenactments of trader Jesse Livermore’s (1877-1940) exploits are recounted in Edwin Lefèvre’s Reminiscences of a Stock Operator (1923), including how pools and syndicates, which were lawful at the time, operated.
Apart from private investment funds, it was not unusual for publicly offered investment funds to contain incentive fees for their sponsors and / or other profit-sharing structures prior to their becoming outlawed under the Investment Company Act of 1940. Following the US Senate’s Pecora Commission hearings and investigations (named after the third Senate appointed special investigator, Ferdinand Pecora (1882-1971), after the first two resigned) in the aftermath of the 1929 crash and the 1930s depressions, the newly established Securities and Exchange Commission (the “SEC”) reviewed scores of funds and interviewed a similar number of finance executives. In a report on Installment Investment Trusts, a precursor to today’s payroll investment plans and certain insurance investment products, an exhibit lays out some structures for such trusts (notice that not all were equity-focused):
There were also publicly listed investment funds with performance fees. Perhaps the most celebrated was The Goldman Sachs Trading Corporation (the “GSTC”), which became famous not just for its size of $500mn after merging with other funds but also for its pyramid scheme structure that led to its collapse. Its sponsor, Goldman Sachs & Co., charged GSTC investors “in any year in which the realized net profits exceed…8%, the firm will be entitled to receive an amount equal to 20% of the net profits but only to the extent that the payment thereof will not reduce the net profits below this 8%.”
The GSTC and The Lehman Corporation’s vintage 1928-9 funds’ fee structures paled in comparison to those offered by less reputable firms. A smaller fund, Oil Shares, Inc., later renamed Oils & Industries, Inc., was structured with a management fee of 1/24 of 1% charged monthly and 20% of annual profits in excess of $1.50 per share on its $50 par value common stock. Less reputable firms commonly charged sales loads of 17-20% while still sharing in the funds’ profits.
All this should conclusively demonstrate that hedged funds, by substance rather than by name, were not uncommon on Wall Street a century ago. Whether marketed during the 1920s as pools, trusts, joint accounts or otherwise, funds with incentive fee structures are not new. Indeed a certain section of the SEC’s Investment Company Act (15 USC § 80a–15 – Contracts of advisers and underwriters) was originally enacted to prohibit fund sponsors from charging profit-sharing fees. During the Apr. 1940 Senate hearings, the SEC’s Chief Counsel David Schenker, testified:
“Section 15 (a) [of the Act] virtually says that you cannot act as a manager unless you are paid in one of three methods. One of those is where you get a definite sum per month or per year; that would be a salary basis. Another is a percentage of the income. The third method is a definite percentage of total assets—or any combination of these three.
What we aim at really is to kill profit-sharing arrangements, where a man makes an arrangement to the effect that he will take a cut of the profits but he does not take any cut of the losses. It is one of these “heads I win and tails you lose” propositions. By and large, I do not think the industry finds any difficulty with this provision.”
And obligingly, the performance-contingent fund structure was relegated out of mainstream offerings by the 1940s.
Thus, contingent-fee funds, including those using hedging strategies, were available but obscure in the first decade of 1900s, developed an audience in the 1910s, becoming wildly popular with the bull market that started 1924. In the climax of the Roaring Twenties, they peaked with record offerings before crashing with the broader markets and ultimately descended, with or without regulations, during the 1930s—just in time for enactment of the Investment Company Act of 1940 making the structure unlawful for publicly offered funds. As the Pecora Commission report exhibits:
Amongst a small group of others, Graham-Newman’s private funds and accounts, with restructured fees during much of the bear market, continued operating through most of the cycle and set the stage for A.W. Jones & Co. in the next cycle.
‘60s PERFORMANCE FUNDS & ‘70s WASHOUT
In his 1973 business bestseller, The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60s (1973), John Brooks (1920-1993) brilliantly recounts the 1960s performance funds mania and makes reference to Gilbert Kaplan’s (b. 1941) The Money Managers (1969). Preceding both of those was George J.W. Goodman’s (b. 1930) The Money Game (1968), written under the pseudonym “Adam Smith”. That kicked off the genre as it became a top ranked bestseller; an unusual accomplishment then for a business book. Amongst others, even one for the coffee table was published, New Breed on Wall Street: The Young Men Who Make the Money Go (1969) by business writer Martin Mayer (b. 1928) and photographer Cornell Capa (1918-2008). These popular books chronicled the resurgence of the investment advisory business and profiled moneymen of the period. There is of course a precursor to their stories.
Early action in WWII European and Asian combat theaters demonstrating the strengths of the Axis Powers cast a pall over US markets as the Dow Jones Industrial Average index sank 38.2% from the start of the decade and 20.3% from the Day of Infamy to its Apr. 28, 1942 low of 92.92. That low quarter marked also a turning point in the war and served as an economic spring as the wartime boom began. The US economy expanded annually at 6.8%, 17.1%, 18.7%, 18.2% and 7.1% between the decade’s start and its 4Q44 peak. Despite the post-war lull resulting in an eight-month long recession beginning Feb. 1945, investors discounted as temporary the economic setbacks and raise the index to a decade peak of 212.50 on May 29, 1946; a figure 128.7% higher than it was less than four years earlier.
As par for the course in this sort of environment, speculative fever hit investors. For the first time in decades, Jones, who then coined the phrase “hedged fund”, and presumably others launched investment advisory services for investors. In a post-atomic world, innovations, such as computing and nuclear power, were afoot that would change the societies and the commercial landscape. The grim and dull experiences of Wall Street in the 1930s that led to consolidation in the investment counsel business gave way to a period of optimism and expansion.
Despite the uplift in animal spirits, Wall Street was still seen as a sleepy corner overlooked by many. The 1929 peak of the index would not be breached until Nov. 23, 1954—over a quarter century. Markets however do not stand still and neither did investors and their advisors. The planned closure of the Graham-Newman funds spawned other offerings whereby sponsors earned performance participations or profit-sharing structures. The best known today is the Buffett Partnership Ltd., launched by Warren E. Buffett (b. 1930) in 1957. Following their obscurity in the 1940s, performance fee funds began to be marketed again in the ‘50s.
Returning to the ‘60s zeitgeist of performance managers, a phenomenon that began in the mid-fifties was becoming an influential factor in US financial markets. The commencement of employer-sponsored pensions that were broadly offered at large American companies introduced a new player to Wall Street: the institutional investor. In came research firms (e.g. Donaldson, Lufkin & Jenrette, et al.) and media (e.g. Institutional Investor magazine, et al.) focused on these investors. Combined with mutual funds, they overtook the colorful, larger than life Wall Street personalities from earlier in the century.
These pension funds, further bolstered by the Employee Retirement Income Security Act of 1974 (better known as “ERISA”), would decades later become a millstone on many US companies’ and municipalities’ balance sheets. Overtime time however, they led to many changes on Wall Street, including the abolition of fixed commissions on May 1, 1975, a date known in the industry as “May Day”, and pushed for improved corporate governance. They quickly became the force on Wall Street and their effects can still be felt from trading desks to corporate boardrooms. Three decades later still, they would also go on to play a major role in hedge fund expansion.
After more than a decade of bull markets, the public’s appetite for equities was raw. Shaken off were memories of the 1929 Crash and the Great Depression and, as one book put it, a new breed of brash young men entered the market and popularized the performance fund. These were generally open-end and closed-end mutual funds that sought to outperform broad market indices at any measured time—monthly, quarterly, annually and even hourly.
The two perhaps best known and celebrated fund managers of the period are Gerald Tsai, Jr. (1929-2008) of Fidelity Investments and Frederic S. Mates (b. unknown-1982) of Mates Investment Fund. After success at momentum investing managing Fidelity’s Trend Fund in the 1950s and early‘60s, Jerry Tsai launched his own fund, the Manhattan Fund in 1965. So successful was the fund’s launch that it raised about 10 times more from investors than expected.
Fred Mates’s go-anywhere fund invested heavily in restricted shares or what were then called “letter stock” and today “PIPEs” (private investment in public equities). The nature of these transactions allowed the fund to purchase stock at significant discounts to prevailing market prices and, per fund accounting standards then, mark the securities at or near market prices, showing an instant profit.
Smack in the middle of these fundamental shifts and phenomena was the 1966 Fortune magazine profile by Carol J. Loomis of Jones that introduced many to the term “hedge fund”. With a new mutual fund boom underway, the article set a direction for groups of young men to launch their own funds. A minor footnote to the period was the Hubshman Fund, the first publicly offered mutual fund that expressly used strategies common to hedge funds for the period including leverage, derivatives and short-sales. Another similar mutual fund was Hedge Fund of America, which launched 1968.
The bull market volume on the exchanges was so great that many brokerage firms were delayed in handling and processing customers’ transactions, leading regulators to curtail trading hours and mandate weekends to recover lost securities certificates and paperwork. So from obscurity in the ‘Forties to quiet development in the ‘Fifties to feature articles and books in the booming ‘Sixties, the sun was soon to set on the long bull market and the hedge fund business.
Signs of an economic slowdown began appearing late in the decade as the DJIA approached 1000; Dec. 3, 1968 would be the second and last time for the decade. Closing out the decade was difficult for many managers of all stripes. The ‘Seventies would prove even tougher for hedge funds. In a revisit published Jan. 1970, Fortune’s Loomis writes Hard Times Come to the Hedge Funds and lists 20 operators, of which most would later be presumed restructured, merged or closed at decade’s-end.
Following the 1968 merger of the Pennsylvania Railroad Co. with the New York Central Railroad, the combined Penn Central Transportation Company would form the largest transportation company in the US and the sixth largest overall. It would soon be insolvent and petition the courts in mid-1970 for debt relief in the largest bankruptcy then in US history.
From the 1960s peak close of 985.2, the index declined almost without relent to a Jan 2, 1970 low of 631.2, losing 35.9%. Since hedge fund fee standards then still did not accord management fee charges, some hedge funds were shuttered. Other fund managers soldiered on; but most not for long due to financial and exogenous events making the decade into a hyperbolic rollercoaster ride.
The new decade’s optimism would overcome the unexpected 1971 abolishment of the Bretton Woods Agreement and take the index to 1051.7 on Jan 11, 1973 or 66.6% above its penultimate decade low. Heated rhetoric in the Middle East would lead to the Yom Kippur War and the Arab Oil Embargo sending crude prices skyrocketing in global markets. Interest rates furthermore rose significantly. Rates for one year US T-Bills in Treasury markets went from 5.7% at the close of 1972 to just over 10.0% on Aug. 23, 1974.
The ensuing economic slump of 16 months was the longest since the Great Depression. The DJIA bottomed at 577.6 on Dec. 6, 1974 or 45.1% lower than its all-time high less than two years earlier. The subsequent 1975-76 market rally was followed by another equities bear market, whereby one-year US T-Bills rates increased from their Dec. 20, 1976 low of 4.8%. By the time rates peaked at 13.6% on Oct. 23, 1979 the 1977-78 bear market all but concluded this run of the hedge fund cycle. The cover of the Aug. 13, 1979 issue of BusinessWeek said it all.
The 1980s hedge funds scene kicked off largely with a clean slate yet still in doldrums. Though a good number of funds failed as the late-‘70s market’s tides ebbed, a relatively small number survived. One eponymous advisor and its manager would go on to become nearly a household name by the 1990s. The new decade however offered further toll for the funds.
As the BusinessWeek cover story illustrates, inflation was pummeling equities and credit investors alike. Largely overlooked in the early 1980s’ mania of deal making between and amongst Wall Street securities firms cashing out and Main Street financial services and even technology firms and energy firms buying in was investment banking and securities firms’ headfirst entry into the commodities action. Larger financial institutions with heft sought securities firms that survived the ‘70s crucibles and these targets themselves sought smaller commodities brokers and traders. While commodities-related companies and brokerage was the fashion on Wall Street, few hedge fund operators were acquainted, let alone geared to these markets as the asset class rose through the ‘70s and early ‘80s. Financial futures contracts and other similar financial derivatives innovations, which hedge funds, commodities trading advisors and other speculative funds were amongst their early adopters, would not become common until later in the decade. In contrast, the funk in equities continued as the DJIA promptly loss 9.5% by Apr. 1980 before prices meandered the remainder of the first two and one-half years of the decade. Further pain however was inflicted on hedge funds’ borrowing costs.
Beginning the decade with one-year US T-Bills interest rates at 11.7%, Federal Reserve Chairman Paul A. Volker, Jr. (b. 1927) sequentially raised Federal Fund targeted rate near 20%. One-year US T-Bills rates peaked at 17.3% on Sep. 3, 1981. A little less than a year later on Aug. 12, 1982, US equities would began a nearly uninterrupted rise, save the 1987 Crash, that would continue into the new millennium.
During the start of this cycle, a small number of hedge funds would launch and remain obscure. Most would never become known outside Wall Street.
By the early 1990s, the hedge fund business was still a cottage industry operating largely in quiet quarters and in Wall Street’s back rooms. Perhaps a single incident changed all that. On Sep. 16, 1992, Black Wednesday, the UK Chancellor of the Exchequer announced at 7pm local time that the UK would suspend its membership in the European Rate Mechanism (ERM), an multilateral agreement on regulated exchange rates for European currencies before the introduction of the euro. The ERM effectively pegged the British pound sterling at overvalued levels vis-à-vis many other OECD countries’ currencies.
The overvaluation, liquidity of foreign exchange markets and their low borrowing costs led groups of funds to short the pound. Though the Exchequer and the Bank of England had been trying in vain to support their currency, including raising interest rates multiple times that September day, by evening the Bank of England’s options were exhausted and the Chancellor capitulated. As the dust settled, one name in financial circles was to receive more press than any other. Hedge fund Soros Fund Management, led by George Soros, would gain approx. US$1bn that day as a result of the devaluation.
Though the industry’s promontory point made front-page news on multiple continents, very few knew what a hedge fund was, let alone what it does or its history. What was clear was the lucre associated with it. Just as opportunity begets capital, so does marketing. Thus, the still nascent industry began to grow again.
Broad news media became increasingly interested in understanding hedge funds and many struggled to explain to their audiences what these funds actually do, which was just as well for the advisory firms. For the funds and their service providers, specialist publications began to appear, often profiling managers at leading funds while serving as soft marketing since the funds were prohibited from advertising.
Media attention was not always welcome, however. As the Asian Financial Crisis of 1997 unfolded, the term hedge fund would truly transcend financial media of developed nations and enter commercial lexicons of developing economies. Many funds were to face scrutiny by local media as they profited from short-sales when these emerging nations’ currencies were devalued.
Before the end of the decade, Wall Street was again setting up services exclusively for hedge funds. What was once called “clearing” and “custodial” services for managing modest-sized investment advisors became “prime brokerage” services for hedge funds. For funds lucrative to their prime broker, services were offered that were more akin to private banking than institutional money. Floors of Midtown Manhattan’s more prestigious and expensive addresses were being leased by brokerages to be sublet or given gratis to fledging hedge funds. Similar to the Dot-Com Bubble’s incubator phenomenon, the “hedge fund hotel” business would mushroom until the Bubble’s bursting, though it remains today.
Another phenomenon was not going unnoticed amongst fund managers in general. Often derisively called the “Greenspan Put”, it referred to US Federal Reserve Chairman Alan Greenspan, who as chair was expected to accommodate financial markets at periods of dislocations or uncertainty. This became most evident following Russia’s Aug. 17, 1998 sovereign debt default that would lead to the collapse of hedge fund Long-Term Capital Management. In the wake of the fund’s insolvency Sep. 1998, one-year US T-Bills rates fell from 5.2% the day of the sovereign default to a low of 3.9% on Oct. 16, 1998. The Federal Funds effective rate (or Fed Funds rate), an annualized interest rate composed of the weighted average rate at which banks lend to each other with counterparty risk through the central bank’s rate targeting mechanism, was decreased from 5.8% on the default date to a low of 4.1% on Nov. 18, 1998.
Some criticized Greenspan’s actions for creating a moral hazard that heartened risk takers anticipating an accommodating central bank during adverse periods. While the Fed chair received the most criticism, other central banks telegraphed similar charades to investors. Regardless of arguments pro or con, lowered rates reduced the cost of leverage for hedge funds, and hence the expense of holding margined securities, and propped equities prices resulting in boosted returns.
The stage was set for a new mania with new vistas in the new millennium.
2000s TO 2010s: FROM COTTAGE INDUSTRY TO INSTITUTIONALLY GLOBAL
What “stock options” was in the ‘90s had become “2 & 20” in the 2000s: a cognitive association for wealth creation or transfer.
The first issue of Forbes in 1990 published a cover story: What I Learned in the Eighties, with the leading lesson gleaned from interviews with captains of American industry “go global or die”. As first-tier American companies, from aerospace to x-ray device makers, sped their expansions abroad in the 2000s so too did hedge funds. More relevant to the funds was the overseas expansions of various US financial services firms, brokerages in particular. In light of the common language and cultures, London was more often than not the first beachhead for the brokers before the funds’ arrivals en masse there and other locales.
In light of Europe’s establishing the first formal mutual investment trust, perhaps as an extension of mutual insurance products centuries earlier, hedge funds were not new to the continent. Indeed, one of the oldest hedge fund of funds is Switzerland-based and has been publicly traded since the 1970s. What is perhaps the longest listed hedge fund, though it was restructured from operating as a commodities trading house and acquired its first hedge fund of meaningful size, was London-based ED&F Man Ltd. What was different in the 2000s from hedge funds of the ‘90s and prior was their geographic scale and institutional support.
In New Haven, Connecticut, Yale University’s endowment was being quietly managed with outstanding results in absolute terms or when compared to other similar institutional funds. When the endowment’s Chief Investment Officer penned Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, what was a modest stream of fund flows into hedge funds became a flood of institutional monies. In Pioneering Portfolio Management, David Swensen advocates that managers of funds with very long-term time horizons invest in long duration assets not strongly correlated with public markets, such as private equity, timberlands and others that were being called “alternative investments”. One of those assets was hedge funds.
The result of the aforementioned 1970s pension fund boom was trouble by the ‘90s. Many US companies and some local government branches sought in the ‘80s to push responsibilities for their employees’ post-retirement benefits to the beneficiaries in the form of defined contribution plans, such as 401(k) plans and IRA matching. The legacy of defined benefit plans, where an employer creates a liability guaranteeing retiring employees’ benefits, was becoming more than just an accounting burden. From airlines to auto manufactures, companies and industries began to acknowledge in the form of extraordinary charges and wholesale balance sheet restructurings that their decades-old promises were a problem due to past actuarial optimism over expected investment returns.
The congruence between Swensen’s “endowment model”, with its promise of high absolute returns for assets with very long durations, and these pension funds’ low return dilemmas pointed to one solution: alternative investments, in particular hedge and private equity funds.
The DJIA peaked early in the decade at 11723 at Jan. 14, 2000. Owing to an eight-month long recession, the Dot-Com Bubble bursting and the sudden failure of large US companies including Enron Corp., the nation’s fifth largest company in reported revenues and the largest US bankruptcy at the time, the index dropped 29.7% to 8236 on Sep. 21, 2001 after four suspended trading days following 9-11. Reinforcing the endowment model, hedge funds did not suffer as much due to the two-tiered nature of the market, whereby highly overvalued and often dubious technology companies became dominant factors of even broad indices, such as the NASDAQ Composite. Avoiding holding common shares of technology companies was sufficient to outperform. As heavy issuers of employee stock options and reliant on follow-up securities offerings to fund themselves until reaching profitability, once highly-valued, development stage technology companies’ common stocks began cascading, short-sales arguably helped make their demise a self-fulfilling prophecy.
Further aid was exercise of the “Greenspan Put”. The Fed Funds effective rate had already fallen from its July 3, 2000 rate of 7.0% to 3.4% on Sep. 7, 2001 before emergency steps were taken following 9-11 that had rates bottoming at 1.2% on Sep. 19, 2001. Market interest rates on US one-year T-Bills were 6.1% the day the DJIA peaked in 2000 and would trade at 2.5% at the index’s 2001 bottom. One-year T-Bill rates would trough at 0.88% on Jun. 16, 2003 and not touch two percentage points again until Jun. 9, 2004.
Unlike the late-1960s growth equities bubble bursting and the ensuing early-‘70s Nifty 50 two-tiered market, the script for this scene had been already written, sparing many hedge funds from being scathed. For the fund managers, especially those equity-focused, the necessary execution was Hedge Fund 101. The pension money now came calling.
For the first time, hedge funds were becoming institutionalized. Marketing departments were established. Internal and external investor relations persons were appointed. Trade associations were formed. Public relations firms and lobbyists were hired. The “billion dollar hedge fund” label no longer grabbed anyone’s attention. The London Stock Exchange’s junior market touted the first stand-alone hedge fund advisory firm’s listing, which was a rousing success leading others to follow on both sides of the Atlantic.
In effect, what “stock options” was in the ‘90s had become “two and twenty” in the 2000s: a cognitive association amongst the business class for wealth creation or transfer. The cottage industry was no more.
Fund flows to hedge funds were so heavy that many running out of public market capacity sought private market opportunities to expand further. Private equity advisory firms witnessing the encroachment reciprocated and began to launch hedge funds themselves.
Reminiscent of the 1720 South Sea Bubble at the London Stock Exchange, by mid-2000s, the most dubious of “hedge fund” products were being launched including those focused on wine, rare coins or art. Another in this vein was fund-of-fund-of-hedge funds, or sometimes referred to as F3 or F4 funds, with three or more layers of fees charged, all apart from administrative costs, such as securities custody, absorbed by investors. Though the term hedge fund was used to market these products, the only feature each had in common was a combination of fixed- and contingent-fees.
The period was in some ways also captured by the names of hedge fund advisory firms and their funds. Unlike the above 1970s list, the new hedge funds took on names of Greek mythological characters and other antiquities, often to lend an air of erudition. Some adopted names suggesting aggressive postures such as historical battlefields, war ships or sporting ploys. Others were even named after pirates or their vessels from centuries ago. Still others used exotic names perhaps to act as mnemonics to the marketing efforts.
In an echo of Asian government criticism during the last decade, a German minister reflected some political ire in Europe referring to these alternative investment funds as “locusts”. Notwithstanding the slight, by the time of the Financial Panic of 2008-09, the term hedge fund had a global awareness and their aggregate size was in the trillions of dollars.
The Greenspan Put of low Fed Funds rates that had been exercised since earlier in the decade however would eventually begin to unwind. The rates increased in 45-degree, step-ladder formation from approximately 1.0% on Jun. 27, 2004 before plateauing about 5.25% between Jul. 3, 2006 and Aug. 9, 2007. The Greenspan Put was once again exercised.
The Put’s exercise this go ‘round was to counter a more pernicious problem than the last. Real estate markets, especially residential assets, and their associated securities were unraveling. But the shakeout should not have been surprising. Having faced criticisms in the aftermath of the 2000-01 equities bear market for partaking in the ‘90s Dot-Com bubble promotions, media outlets were taking a more critical view towards markets.
Early in the 2000s, there had been series of articles in different publications highlighting a worrying trend of rising real estate prices outstripping inflation since the ‘90s. The real estate industry protested. The media companies stood by their stories. One in particular was a Fortune cover story of Oct. 28, 2002. While the article makes clear that the rise in real properties that began in 1995 was most exaggerated in coastal markets and was not yet a national bubble, it went on to note that:
“[W]hat looks like a gift to homeowners today is potentially a recipe for disaster later on: If the boom persists, housing will become so overheated it’ll pull the entire economy into dangerous, fragile territory. In a year or two, prices will fall with a thud, unleashing a double-dip recession that will pummel home prices even more.”
The writer would go on to speculate further that if a bubble occurs, the US economy would face meaningful job losses and delinquent mortgage payments. “As foreclosures multiply, prices would collapse further, then scrape bottom for several years. So one way or another, the fun is ending. The best hope is that it ends soon.”
As the future cover stories suggest, it didn’t. Mortgage-backed securities, along with over-the-counter derivatives, were already sizeable profit centers on Wall Street. Subprime mortgages held special attraction as they were the most lucrative for all involved in the chain, despite their low quality. The Greenspan Put’s low rates made them that much more interesting and hedge funds sought to get in on the action.
Amongst the more creative financing aspects of the housing bubble was what were called “no-doc” loans where borrowers provided no concrete documentation of their mortgage application responses and limited or no due diligence conducted by the underwriting lender. They would later be derisively called “liar” or NINJA loans, in reference to mortgagors with no income, no job and no assets.
By the latter-half of 2006, delinquent mortgages were beginning to surface noticeably. Yet financial firm’s common shares were being sustained by talk of Wall Street firms, amongst others, being acquired by foreign banks eager to enter US markets. Bear Stearns Cos. and Lehman Brothers Holdings, Inc., the parent companies of Wall Street’s smallest and second smallest “Bulge Bracket” firms and most exposed to mortgages on their balance sheets, were often the subjects targeted. By spring 2007, the tune of the rumors changed as speculation spread that some financial firms were bound to become insolvent.
As the mortgage crisis evolved, the rumors worked their way up the Wall Street chain starting with the smallest of the exposed Bulge Bracket firms. Bear Stearns, which had bailed out two of its leveraged subprime mortgage hedge funds around mid-Jun. 2007 with $3.2bn in loans, was the first targeted. The bailout, which perhaps was an effort to avoid similar reputation damage caused by the Goldman Sachs Trading Company in 1929-36, shook confidences but gave the firm a reprieve. With worsening real estate markets, liquidity rumors surfaced again spring 2008. On Mar. 16, 2008, JPMorgan Chase & Co. finally rescued Bear Stearns Cos. from failure. Lehman Brothers Holdings, Inc. was less fortunate. Its filing for Chapter 11 bankruptcy on the morning of Sep. 15, 2008 made it the largest firm to fail in US history and resulted in financial markets confidence evaporating over the following month as the DJIA had lost 24.9% by Oct. 15.
Across the Pond a year earlier, Northern Rock plc., a small but aggressive UK mortgage lender to buy-to-let mortgagors that largely funded its balance sheet with loans from other banks, would request a rescue Sep. 12, 2007 from the Bank of England as its access to wholesale funding markets dried up. Despite the help and support efforts, two days later a growing number of depositors sought to withdraw their funds creating a run on the bank and making Northern Rock the first UK bank nationalized in over a century. One hedge fund that sought to catch the falling Rock lost a large chunk of its assets. That fund also happened to have been the flagship fund managed by the advisory firm that earlier in the decade preceded peers to list on the London Stock Exchange.
A consequence for hedge funds of the Financial Panic of 2008-09, was the weakness of their “absolute return” promises. Many suffered losses as a result of leverage or bad bets. Some were directly impacted by the failure of Lehman Brothers Holdings, Inc suspending their access to their funds’ assets. Others that were deemed “safe” or conservative in their focus on credit securities reported massive losses when mortgage-related instruments collapsed. So sudden and swift was the reversal that one of the largest sovereign wealth funds facing political pressure for reporting large losses announced it would liquidate all its hedge fund holdings and bring its assets in house.
Dec. 10, 1998 may have marked the peak or near zenith of the hedge fund cycle begun in the early ‘80s. That was when a confession from the head of a well-established firm came to light. The Ponzi scheme fraud and eventual failure of Madoff Securities, its hedge fund and associated feeder funds led investors to scrutinize more heavily their hedge fund holdings. Bernard L. Madoff (b. 1938) had been fêted by others in high regard and was once chair of NASDAQ, the second largest US securities marketplace. Because of the long persistence of Madoff’s fraud going back decades, his fund operation’s secrecy and his high pedigree, investors in hedge funds lost confidence in nearly any hedge fund manager. Some investors sought to redeem wholly due to suffering market shrinkages and liquidity calls while others requested at least part of their capital as a test for fraud. Responding to enquiries about redemption terms by some clients and their legal counsels became a daily task at many hedge funds.
The Madoff saga in many ways was similar to Richard Whitney’s (1888-1974) fall from grace in 1938: a highly esteemed JP Morgan & Co. partner who once was president of the New York Stock Exchange and later discovered and convicted of embezzling the exchange’s monies amongst others. In both cases, investor confidence was seriously impacted. In the Madoff aftermath, many small or medium sized hedge fund advisors, facing relatively outsized redemptions, either shrank, merged or became defunct. The advisory firms and hedge funds that listed earlier in the decade on London’s junior equity market were decimated leading to their consolidations, delistings and insolvencies. More than one fund manager became a fugitive of the law.
As the 2000s closed, so did many hedge funds, fund of hedge funds and fund-of-fund of hedge funds.
WILL THE HEDGE FUND CYCLE’s FUTURE BE DIFFERENT?
The new decade has seen initial hedge fund launches with large sums by pedigreed managers—and also their prompt closure if performance is wanting. Another trend is the continued winnowing out of smaller- and medium-sized funds or those employing niche strategies. Consolidation is en vogue. Repeating their ‘90s experience with venture capital funds, institutional funds increasingly look for larger “branded” hedge fund houses each with menus of diverse strategies. This is happening even at the expense of performance and in spite of research concluding the best years for many hedge funds are when they are establishing themselves as smaller funds.
The leading advocate for investing in alternative assets under the endowment model, further clarified one of his advantages was the ability to negotiate directly fee structures with managers. Implicit in that is the supposition that he could also attract proposals from the best performing fund advisors that would in turn use his allocation and global brand as an imprimatur with other institutional investors. Given that return-focused hedge fund advisors need to balance their fund sizes with their incentives to increase assets managed, public employee retirement systems with 1,000 employees were not likely to walk the same welcome mat as the largest institutions, regardless of legal circumventions on limitations on the number of investors.
Though hedge funds now cover broad geographic domains, the future of hedge funds in the US has some dark clouds with silver linings. Political debate has been held on whether the favorable tax treatment of carried interest in the US will persist for the foreseeable future. It likely will. There is further concern over whether the industry will come under increased regulation. If so, regulatory burden may further eliminate smaller funds.
More auspicious for hedge funds is the US SEC’s lifting of the Securities Act on 1933’s advertising ban on contingent-fee funds of any kind. Under the Jumpstart Our Business Startups Act of 2012 (the JOBS Act), hedge funds and their alternative investment advisors that were under regulatory restraints from advertising can now promote funds to investors at large using any medium, though advisors continue to be required to qualify their investors for financial fitness. The unnoted irony of this JOBS Act provision is that it will likely yield the most benefit at least in the short-term to larger hedge fund advisors with the purse to advertise, potentially further squeezing small and startup advisors without brands.
Despite institutionalization of hedge funds with improved risk management and a broader domestic market to target, there exists a fundamental challenge that can be hardly mitigated. The last three decades have witnessed hedge funds rise from operating in obscurity during the ‘80s (as similar contingent-fee vehicles did the first decade of the 1900s and the 1940s). They then developed a following during the ‘90s (comparable to the experiences of the 1910s and 1950s). They become broadly popular in this millennium’s first decade (as they did in the climactic decade endings of 1920s and 1960s).
With one-year US T-Bills rates at 10 basis point or 0.1%, even if US broad equity markets yield their aggregate historical 9.0% compounded total returns before any fees, investors in most hedge fund may struggle to earn approximately 5.5% without use of leverage. Central banks around the world have supported their economies over the past five years with loose monetary policies and historic low interest rates below their respective rates of inflation. Neither can continue over time.
When the central bank easy monetary policies and real interest rates reverse, the hedge fund industry and related contingent-fee products in the US may repeat their experiences in the 1930s and 1970s and continue descending during the 2010s to revert to obscurity during the 2020s before rebuilding, keeping with the 40-year cycle.
Catallactic has frequently observed that the more things change, the more they remain the same. It may apply this time.
The congruence between Swensen’s “endowment model”, with its promise of high absolute returns for assets with very long durations, and these pension funds’ low return dilemmas pointed to one solution: alternative investments, in particular hedge and private equity funds.