Hedge Funds Are Bringing Democracy to the Financial World

R.A. Hettinga rah at shipwright.com
Mon Nov 8 05:59:29 PST 2004


<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 at 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'





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