Hedge Funds – After a Win and Potential Loss


New York – Articles in recent weeks are beginning to get the impact of the new look of Wall Street. Namely, hedge funds, private equity and investment banks are starting to look alike. Investment banks beefing up their private equity funds, and setting up hedge fund hotels seem to be everywhere. This is, of course, the sign of a healthy financial system.

There is, however, one element of these machinations which clearly does not make sense. Commuting into the city this morning, a headline (on a neighbor’s paper) read that the general public was interested in investment in hedge funds. Hedge funds are just not designed for public consumption. By definition hedge funds are involved in risky investment endeavors geared (and leveraged) for only “sophisticated” investors. “Sophisticated”, as we all know, means only those investors that can afford to lose their investments.

Wall Street has been emboldened by the retraction of the requirement for hedge funds to register with the SEC, which has resulted in a large number of hedge funds de-registering. But another trend threatens to ratchet up hedge fund regulation significantly.

On the IPO calendar is Fortress Investment Group – a $26.0 billion hedge fund. There are surely others. If these companies are public, they are available for all investors. We note:

  • If a hedge fund is any good, why go public?
  • If hedge funds go public, regulators will be all over them, since retail investors will have ready access to their shares
  • Subsequent regulation will not only affect the public hedge funds, but also the private ones

By one estimate the number of hedge funds is now about 8,500, perhaps reflecting an approach that is overdone. Given the fees related to AUM (2% AUM), 20% of the profits going to the fund and commissions, hedge funds need to return well over 15% to just cover the cost of investors. A very small proportion of hedge funds can boast returns like this, despite the use of high leverage in their investment ideas.

As such, it seems likely that the hedge fund industry is getting a little top heavy and is getting ready for a consolidation within the next several years.

Comment by Rob Tholemeier:
I’m not sure that investing in hedgefunds is the worse thing for slightly above average retail investors. Certainly investors get to see the costs of investing in these vehicles in black and white. And the invesment manager typically has “skin in the game.”

Meanwhile most retail brokers around here (including the big boys) use shock tactics to pitch high-cost variable annuities or costly mutual funds of mutual funds. The cost disclosures are, of course, never part of the presentation, are buried in the fine print, and typically pass stealthly through to the investor.

The question is what’s worse: getting your head taken off with your eyes wide open or just being bleed to death?

Of course what investors need is less regulations that protect the big brokers and more disclosure and education.

But disclosing how brokers make their money is not in the best interest of the brokers or the politicians that get their campaign contributions.

For example, why not force brokers to transmit the daily VWAP on all trades to retail investors so they can see if the trade really cost them $9.95 as advertised.

Comment by Scott:
Case in point, from a recent Chicago Tribune article:

Pensions betting on hedge funds
Illinois teachers’ plan to invest $1 billion

By Greg Burns
Tribune senior correspondent
Published January 26, 2007

Underfunded and mired in a kickback scandal, the state-run pension for Illinois teachers has settled on a new plan to help resolve its fiscal woes: Sink almost a billion dollars into hedge funds.

In coming years, the $39 billion Teachers’ Retirement System will join as many as 40 percent of the nation’s public pensions in these complicated and lightly regulated investment partnerships.

Comment by Scott:
The “general public” is already more heavily invested in hedge funds than they realize — via pension plans. Just ask the fine public servants from San Diego.


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