Sure you've heard the term tossed around a lot lately, but do you know what it means? Or better yet, who's behind this whole mess? You may never be rich enough to invest in a hedge fund – most require that you have a net worth of $1 million just to look at their websites – but you will never be too lowly to be affected by them.
By Mark Karlson
Wielding an incalculable dollar figure in assets (most estimates peg it in the trillions), the hedge fund industry has an undeniable influence on the economy that can be felt from a global level right down to the interest rate on your personal savings account. Recent high profile booms (Paulson and Co.) and busts (Stanford Financial) are evidence of the startling effect that this shadowy financial elite has on our everyday fiscal atmosphere.
Now, this rundown won't make you an expert, or even an amateur, as far as it comes to understanding how hedge funds work. In fact, many investors – the very same ones sinking millions of dollars of endowment and pension money into these funds – don't even fully understand how hedge funds make (or just as often lose) money. After years of following hedge funds in the news professionally (that's my job, in a nutshell), even I wouldn't be able to fake it over cocktails. However, I have gleaned a bit about the personalities of these titanic money managers.
What follows is a crass, overly broad generalization of the different types of investing style, and who these guys would be if they were a high school stereotype.
Long/Short Investors – The Normal Kids
Before we jump into the quirky bunch, we may as well define the run-of-the-mill type. That is, relatively run-of-the-mill. Hedge funds wildly differ from mutual funds – the comparatively slow and steady vehicles best suited for the road to retirement – in that they are aggressively managed and largely unregulated. Hedge funds are hands-on (portfolio manager) and hands-off (government) for better or for worse, allowing investors to take significantly higher risks for chances at significantly higher returns.
The term “hedge fund” originally came from the concept of “hedging” long bets by shorting the market in an attempt to offset the risk. What does that mean? Well, for example, mutual funds only invest long – they buy securities and hang on to them, hoping that the price increases. But when you take a short position – something that mutual funds cannot legally do – you make a profit when the price of the security goes down. The hows and whys are a bit more complex, mostly having to do with selling stock that you don't own. If you want to learn more, I recommend checking out NPR's Planet Money podcast, which breaks down a hazy practice called “naked short selling.” (The Daily Show also explored short selling, though its presentation is a little bit skewed for the sake of hilarity.)
So the long and short of a plain vanilla long/short hedge fund is that the investors will, theoretically, make money if the market goes up or if the market goes down. You could call this “market neutral.” All a manager has to do is pick which individual stocks are going up and which are going down and be right on a majority of the bets to avoid losing money. This works even if a market – or the entire economy – is tanking. For example, a hedge fund manager might take a long position on General Motors and a short position on Ford. Even if the auto industry as a whole takes a blow, the fund will make money as long as GM performs better than Ford.
Some real world examples of long/short investors include John Griffin of Blue Ridge Capital Management, who made $625 million in 2007 and Stephen Mandel Jr. at Lone Pine Capital who made $710 million. (Figures from Wall Street Journal.)
If you had to peg the long/short investor in your graduating high school class, he'd be the normal kid. Perhaps a little bit more responsible and prepared than the rest – maybe he's a Boy Scout or taking AP classes – but for the most part he takes the straight and narrow course as far as alternative investing goes. The main way he can lose money is if he fails to do his homework and makes the wrong bets. But that's true for anyone.
The Quants – The Mathletes
There are two main fronts for stock analysis: quantitative and qualitative. Qualitative analysis factors in aspects such as a company's management, industry cycles, labor management and research and development prospects. People doing qualitative analysis are the ones getting on planes and taking field trips, visiting company's and looking executives directly in the eye – a practice which obviously requires a hearty helping of social finesse.
Quantitative analysis, on the other hand, is pure numbers. Being the life of the party in social settings isn't exactly a requirement for these guys – and that's perfectly okay as long as they make money, which they do. Think Rain Man. Or maybe the nerdy guy doing calculus homework for the captain of the football team. That's not to say that all quants are pocket protector-wearing savants with tape on their glasses. But I've had more than a few reference calls describe a manager as “Your typical quant: more comfortable with numbers and equations than with handshakes and face time.”
My favorite, and perhaps the most well-known quant, is Ed Thorp. Thorp was a math professor for over two decades before he became a hedge fund manager. During his time at MIT, he developed methods for beating the house at blackjack and roulette using nothing but math and, in the latter case, the “first wearable computer”(no small feat, given it was the 60s).
He ended up bagging $11,000 in one weekend, and, unsurprisingly, getting kicked out of the casinos for life. With that door closed, he turned towards Wall Street, whipping up computer programs designed to identify pricing anomalies in the stock market. His hedge fund racked up $270 million in assets before it was brought down by the Feds in 1988 as part of the collateral damage of the Drexel fallout. That's a whole other story that has nothing to do with Thorp's math wizardy and more to to do with his partner, who was in charge of “interfacing” with Wall Street while Thorp crunched numbers on the west coast.
So, it turns out that all those equations and formulas you learned in math class are useful after all. Too bad there's no Dungeons and Dragons hedge fund model.
Activist Investors – The Bullies
There are two types of investors: people who buy stocks and pray that the price goes up and those that buy interests in a company and stir the pot a bit to make things happen. You may have heard the latter group described as “corporate raiders,” but they like to call themselves “activist investors.” If we were in high school, we'd call them bullies.
The quickest ways to make a share price jump are by drastically downsizing its operations, shaking up its management or selling it off to a high bidder. As you can imagine, the prospect of firing the board of directors and auctioning off a business's assets isn't appealing to everyone – namely the existing management and the workers in the condemned factories. So, how could someone manage to takeover a company that doesn't want to be taken over? Well, it's a rather hostile affair.
Note that hedge funds don't typically outright buy a company – rather, it's usually in their best interests for a company that they are investing in to be sold off or otherwise restructured. In order to make this happen, they'll often seek election to the board of directors, because it's ultimately up to the board to decide what happens to the company. Getting on the board is a matter of schmoozing and strong arming – both publicly and by proxy – and in come cases, suing the company and/or tinkering with its by-laws. For example, JANA Partners and friends recently launched a bid to oust the directors of CNet, which stubbornly asserted that there was no room on its board for profiteering speculators. So a bunch of hedge funds got together and sued the company in order to force it to expand its board to make way for the new boss. That group of hedge funds had a lot to do with the company eventually being sold to CBS.
Other notable activist investors include Carl Icahn, who recently tried to shakeup Yahoo!, Chris Hohn from The Children's Investment Fund who tried to takeover CSX and Roy Disney (Walt Disney's nephew) of Shamrock Capital who took the opposite track and opposed a takeover of Reddy Ice by GSO Capital. Also notable as Wall Street bullies, though perhaps a different subphylum of activist investor, are vulture funds, such as Elliot Associates, which recently made money by collecting defaulted debts from third world countries.
Some say that activist investors – like high school bullies – actually strengthen companies with their tough love by improving their operations and unseating lazy executives who were grandfathered in by old boy networks (i.e. putting the company in its place). The truth to spin ratio of that argument is still a matter of contention, though – investors typically only care about the company's share price, which isn't always reflective of the more visceral nuts and bolts of the company's actual fiscal health.
Political Activists – Class President Candidates
While some hedge funds like to get hands-on with companies, there are others that attempt to move markets by influencing the law of the land. This type of hedge fund activity affects your daily life perhaps the most. In order to win the hearts and minds needed to enact the change they need to make a buck, these hedge fund managers take their campaign to Capitol Hill and, in some cases, your television set. Watch for these folks at your high school reunion – they'll be the ones who ran for class president (and probably won).
The most recognizable activist hedge fund is run by T. Boone Pickens, namesake of the Pickens Plan. And head honcho of BP Capital (no relation to British Petroleum). He started airing those commercials with all the windmills in 2008, urging the country to free itself from foreign oil interests by embracing wind energy. Upon viewing these commercials, you may have asked yourself, “Why is this republican businessman who helped sink Kerry in the 2004 election such an environmentalist?” Because he's building the biggest wind farm in the history. I won't go as far as saying that his ideals are disingenuous. But it is undeniable that getting the country on the road to alternative power is just good business.
Other hedge funds gone government lobbyists include John Paulson, who made nearly $4 billion because nobody could pay their mortgages but funds the curiously named advocacy group, the Center for Responsible Lending and Dan Abbasi of MissionPoint Capital who is investing in carbon trading (and pushing for a federal cap and trade policy in D.C.). In my opinion, these guys have a lot better chance at getting the laws they like passed since they are profit driven, rather than bureaucracy hobbled. Depending on your political leanings, this may be a good thing. Either way, these big wigs have high stakes riding on political change and aren't accustomed to losing.
The Enigmas – The Unstable Weirdos
And then there is the group that you should be the most wary of: the inscrutable enigmas. Just like the ostracized, anti-social kid with possible violent tendencies is at risk for a blow up, so too are the hedge funds that operate beneath a shroud of carefully guarded mystery. While many hedge funds have regular contact with their investors – providing a detailed breakdown of their strategy and sending out updates on their investment activities each quarter – some hedge funds are inordinately jealous of their trade secrets, claiming that disclosing their methods would cause them to lose their edge. Many investors don't care to know how their sausage is made, as long as they post decent returns. But more often than not, a worm too soft hides a hook.
Watchers of the news will remember the stories of Sam Israel of Bayou Hedge Fund Group, Bernie Madoff of Bernard L. Madoff Investment Securities and Robert Allen Stanford of Stanford Financial Group, who all sent us Googling the words “Ponzi scheme.” Their get rich quick strategy: lie.
Of course, there are some presumably reputable investors who turned a tidy profit in 2008 without fully divulging their secret recipe for success – such as George Soros at Soros Fund Management (a notorious bear) and James Simmons at Renaissance Technologies Corp. (you could call them a quant fund) – but its always a bit more heartening to be able to look under the hood before plunking money down.
This brief list is by no means inclusive. “Hedge funds” has become a somewhat misapplied catchall for the unconventional alternative investors that possess Neo-like superpowers in our Matrix-like economy. It is impossible for laymen like you and me to understand the high octane world of investments and markets, but we should at least be aware of how these colossal money managers are changing the world to suit their bottom line. Keep this in mind the next time you read the news.