<http://online.wsj.com/article_print/0,,SB109986653339766981,00.html?mod=opinion> The Wall Street Journal November 8, 2004 BUSINESS EUROPE Hedge Funds Are Bringing Democracy to the Financial World By JEAN-MICHEL PAUL November 8, 2004 Assets under management by hedge funds have reached the $1 trillion mark, having grown at 20% a year since 1990. Hardly a day goes by without a new hedge fund being set up by a former trader or portfolio manager. This is the largest single structural change in the financial world since the coming of age of mutual funds at the beginning of the '80s. What we are in effect looking at is the beginning of a fundamental shift: the disintermediation of the role played by investment banks and their trading floors in particular. As technology allows set-up costs to dwindle and economies of scale to disappear, successful traders and portfolio managers, attracted by higher rewards, will continue to leave the large trading floors to set up shop offering formerly exclusive products to investors at large. In the process, a new market is being created and transaction costs decreased. Why and how is this happening? First and foremost, the hedge-fund revolution has been made possible by new technology that translated into a lower cost base. The sunk cost of starting and establishing a new investment and trading platform fund has literally collapsed -- as day traders well know. The Internet, together with the ever-increased capabilities of ever-cheaper computers and the democratization of programming and software skills, are enabling a few people to team up and create an efficient office at low cost. A team of two or three with a limited budget can now achieve what it would have taken dozens of people to do at considerably higher cost. Second, hedge funds are characterized by their asymmetric payoff. Managers typically get 2% of management fees and 20% of any performance achieved over a given benchmark. This incentive encourages the managers to perform, aligning investors' and managers' interest. It also means that the best traders will have an irrepressible incentive to set up their own hedge funds. The best performers will also have every interest in taking in as much money under management as they can without decreasing their performance. This means that asset allocation to traders and trading strategies is democratized and optimized. Investment banks have responded by embracing what they cannot prevent. They try to limit the brain drain by creating internal hedge-fund structures and to limit profitability decline by increasing the trading capital at risk. But beyond these defensive moves, they are inventing new roles for themselves as "platform provider," "prime broker" and even "capital introducers." This further modifies the financial landscape by allowing hedge funds to capitalize on the banks' distribution networks and customer access while maintaining their investment-decision independence. The keys to the banks' old trading-room environments were economies of scale, high sunk costs -- and professional asset allocation and supervision. Allocation is about optimal allocation of resources, chiefly capital, to the different strategies offered by the trading teams as opportunities come and go as the economic cycle unfolds. Risk control is about a constant independent review of the traders' positions, an ongoing assessment of the risk involved in the strategy. Upstart hedge funds have no risk-management departments but as traders set up independent hedge funds, risk control and asset allocation have been taken over by so-called funds of funds. These funds of funds, which receive funds from institutional investors and private banks, carry out repeated due diligence on hedge funds, looking for best of breeds. They also make regular quantitative and qualitative supervision control, so as to monitor ongoing risk-taking. Thanks to the expansion of the hedge-fund universe, trades and strategies that were yesterday the private backyard of investment banks are now, through hedge funds, available to traditional investors. This in itself creates for investors at large -- and chief among them pension funds and insurance -- a seemingly new asset class, that is a set of financial instruments whose payoff is fundamentally different and decorrelated from the traditional long-only approach. But the hedge fund world is not problem free. A question often associated with the hedge-fund transformation is capacity. By this, it is meant that the ability of a hedge fund to accommodate new investors while maintaining returns will diminish. There is no doubt that for "traditional" investments this is true. Similarly, as more and more "traders" arbitrage the same inefficiencies, these disappear, together with the arbitrage profits. This phenomenon explains a significant part of the lackluster results of the hedge-fund industry as a whole so far this year compared to former years. But because of the lower set-up costs, the lighter structure and higher incentives, ideas for new strategies are appearing and being deployed faster than ever before. This enables a continuous stream of new, if temporary, superior returns as start-up fund exploit new strategies. In other words, the law of creative destruction applies to hedge funds too, ensuring that new "alternative" funds will continuously replace overcrowded traditional alternative strategies. A related genuine concern is the increased level of leverage observed in the industry. As the industry develops to play its role as a significant asset class, some hedge funds, and indeed funds of funds, unable to find new markets to generate the uncorrelated alpha, the industry holy grail, continue to play their traditional market in an ever increasing leveraged way. But a leveraged position is bound to increase volatility. This, in turn, as was shown in the famous LTCM debacle, is bound to translate into failures from time to time. This is all the more the case because most positions will exhibit a strong correlation in a liquidity crisis. Indeed, hedge-fund failures are likely to become more common going forward, if only because the sheer number of hedge funds has increased. Similarly, pressure on hedge-fund margins is bound to increase. These corrections are also part of the market maturing and should be welcomed. Hedge funds are here to stay. The investment-disintermediation paradigm is based on a financial-industry reorganization that offers the prospect for a more efficient and transparent market as well as access to new investable asset classes. Its implications are as important to the financial sector as the appearance of the high-yield market in the 1980s was to the corporate-bond industry. Mr. Paul is a senior analyst at Atlas Capital Group. -- ----------------- R. A. Hettinga <mailto: rah@ibuc.com> The Internet Bearer Underwriting Corporation <http://www.ibuc.com/> 44 Farquhar Street, Boston, MA 02131 USA "... however it may deserve respect for its usefulness and antiquity, [predicting the end of the world] has not been found agreeable to experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'