Could you win in the hedge fund casino?

In 1948 Alfred Jones tried his hand at managing money. He raised $100,000, including $40,000 out of his own pocket, and set out to try to minimise his risk in holding long-term stock positions by short selling other stocks. Jones also employed leverage in an effort to enhance returns. Then in 1952 Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and levied a 20% incentive fee as remuneration for the managing partner. He was the first fund manager to combine short selling, the use of leverage, shared risk through partnership and a remuneration structure based on performance. The hedge fund was born.

How big is the hedge fund industry?

The growth of the hedge fund industry was comparatively sedate in the 1950's and 1960's. By 1968 there were only 140 hedge funds in operation. But by the mid-1980's high-flying funds like Julian Robertson's Tiger fund were capturing the public's attention with its stellar performance. Yet even by 1990, hedge funds were still a niche industry with only $50bn under management. However over the last 15 years activity in this area has sky- rocketed.

The hedge fund industry is now massive. At the end of the second quarter of 2006, there were around 9,000 hedge funds in existence managing assets valued at $1,225bn. And because these funds characteristically use substantial leverage, they play a far more important role in the global securities markets than the size of their net assets indicates. In 2004, market makers on the floor of the New York Stock Exchange estimated that hedge funds accounted for more than half of the daily volume of shares changing hands. This is a niche product gone mainstream. So if you are thinking about investing in a hedge fund, you should be aware of the risks.

What risks should hedge fund investors be aware of?

The generic risk disclosure that 'past performance is no guide to the future' is particularly apt with hedge funds for two reasons. First past performance may have been overstated and second, intensifying competitive pressures are driving returns down.

Biases can exist in the published indices of hedge fund returns. Unlike mutual funds, which must report their periodic audited returns to regulators and investors, hedge funds provide information to the database publishers only if they desire to do so. Managers often establish a hedge fund with seed capital and begin reporting their results at some later date if the initial results are favourable, but the results of fund start-ups that are dismal are not submitted. This bias is often called an 'incubation' bias.

Another important bias is known as survivorship bias. Databases available at any time reflect the returns of hedge funds currently in existence. Unsuccessful hedge funds have difficulty in attracting investors and so they tend to close. Burton Malkiel, professor of economics at Princeton University, conducted a study of hedge fund returns from 1996 to 2003. The average annual return of surviving funds was 13.7%, but the average return of defunct funds was 5.4%. But if you take live and dead funds together the average return was only 9.3%, a significantly lower return than the headline number of 13.7%. But not only may past returns be overstated but competitive pressures make it much more difficult to carve out stellar returns than in the past.

The nature of hedge funds has evolved. Alfred Jones was primarily concerned with minimising risk, whereas there is a trend in the industry now to embrace more and more risk. Here is a cautionary tale.

What lessons can we learn from the Amaranth debacle?

A hedge fund called Amaranth made its name trading in the convertible bond market. But then the profitability of 'convertible arbitrage' largely dried up. However rather than close the fund down, as some managers did, its founder Nick Maounis decided to diversify into other asset classes, notably energy. He hired Brian Hunter, a US gas futures trader. In 2005 Amaranth's convertible funds had a bad year and its energy traders, led by Mr Hunter, made most of the profits. He reportedly made $800m for Amaranth in the year. Mr Hunter was rewarded by being allowed to move away from the funds office in Greenwich Connecticut, to his own trading desk in Calgary and being given more leeway.

Until a few weeks ago the fund was up 30% in 2006 and Mr Hunter was the darling of its investors. What investors didn't seem to appreciate was that the flip side of outstanding performance would be extreme risks. And there were warning signs. Mr Hunter was placing huge bets in the volatile natural gas market. In April the funds assets rose by 12% only to fall by 10% in May.

Then as natural gas prices dropped sharply in September Mr Hunter got caught irretrievably. He lost $6bn of the fund's $9.5bn assets. This is a colossal amount of money to lose. It surpassed the losses at Long-term Capital Management (LTCM), the hedge fund that Wall Street banks put up $3.6bn to rescue in 1998.

Yet interestingly the losses caused nothing of the pandemonium that was associated with the rescue of LTCM. There are plenty of banks and hedge funds willing to buy securities at bargain prices. Amaranth sold its energy book at a discount to JPMorgan Chase and to hedge fund group Citadel and sold other positions at a discount to avoid forced liquidation. So the distress caused by huge losses has been absorbed without disruption. In this respect the Amaranth saga is comforting for those who worry about the stability of the financial system.

However we can safely say that Amaranth will not be the last hedge fund debacle. The structure of incentives makes them inherently unstable. The incentives to set up a hedge fund are huge. They typically charge an annual management fee of at least 2% of assets plus a 20% cut of the profits made. The hedge fund industry would argue that hedge funds work in the clients interests because performance fees align the interests of managers and clients. But there are three problems.

What problems do hedge fund managers' incentives cause?

First, performance fees reward managers in fat years, but investors get no compensation in lean years. Unfortunately for the investor there is no reciprocal 20% rebate if the fund incurs losses. It's a sophisticated version of 'heads I win, tails you lose'.

Second, human nature dictates that the high rewards available will encourage managers to take excessive risks. Indeed as more money has flowed into hedge funds and more traders have launched funds, competition has grown fiercer. Funds employing traditional and low risk strategies do not catch the eye and find difficulty in attracting investors, so they get drawn into other forms of trading that embrace bigger risks. This is precisely what happened to Amaranth. A lot of capital has flowed into funds over the last five years and it has to be put to work. The proliferation of funds has made it harder to make big profits without increasing risk. It's hard to get real sustainable returns because every idea is picked over. So the managers that stand out are the ones that take excessive risks. If a fund manager had one year like Brian Hunter had in 2005, he may never need to work again.

The third problem is when performance has been poor the absence of fees and the inability to attract funds often prompts managers to give up. Indeed almost half of hedge funds fold within five years. In short to invest blindly in a single hedge fund can be a recipe for sleepless nights.

Do incentives work?

For many wealthy individuals and pension funds making their initial foray into hedge funds, the fund-of-funds is often the investment vehicle of choice. In return for a second layer of management and performance fees, fund- of-fund managers promise a diverse portfolio of hedge fund investments run by the superstars of the industry. However funds-of-funds operated by Morgan Stanley, Credit Suisse, Bank of New York, Deutsche Bank, Man Investments and Goldman Sachs all had stakes in Amaranth.

Indeed fund-of-funds managers are still influenced by the system of incentives. The pressure on fund-of-funds managers to deliver outsize returns to justify their high fees leads to the temptation to invest in hedge funds making big returns even though they are embracing a dangerous level of risk. A fund-of-funds manager who avoided Amaranth which until last month was delivering 30% returns would have been given an uncomfortable ride by demanding clients.

Investing in hedge funds is akin to flying first class or eating in an expensive restaurant. They charge the earth so the pressure to satisfy customer demands is intense. The main difference is that for most dining at Gordon Ramsey's restaurant or sipping champagne in first class someone else is paying. Investors in hedge funds always pay through the nose. And it is easy to be cynical about the industry. Indeed Warren Buffett who, after observing the lavish fees hedge fund managers paid themselves, described these funds as nothing more than a compensation structure dressed up as an industry.

Perhaps the best alignment of interests of fund managers and clients occurs when the manager uses his own money to take a substantial stake in the fund. No one doubts the motivation of Warren Buffett at Berkshire Hathaway. None of the above proves that incentives never work. But the wrong incentives can do more damage than no incentives at all.

By Brian Durrant for The Daily Reckoning. You can read more from Brian and many others at www.dailyreckoning.co.uk