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Hedge Funds Returns Are Back, But Is Trust?

There’s an old legend that professional American baseball managers like to recount to young charges when introducing them to the pressures of the Big Leagues. The story starts with a young, struggling pitcher complaining to his coach about his lack of success in his rookie season.

Photo: rpongsaj

“I just don’t get it, Coach,” the kid says. “I used to strike out eight of nine batters in every game when I was in college.”

The old Coach lowers the brim of his hat, squints his eyes and says: “Listen, kid, remember that ninth batter? Well … they’re all here.”

That, in a nutshell, is the kind of frustration that many young hedge fund managers must have felt when they took the few years of investment banking experience they had and set up shop in Greenwich or Mayfair during the halcyon days of the early 2000s. The young traders had beaten the competition in their own backyards, but were now faced with a whole industry of “young guns” to outperform on the outside.

Many, instead, resorted to simply “keeping pace” with industry returns by increasing leverage and putting on basic long/short equity strategies.

Evidence gathering in the opaque world of hedge funds is tricky, but industry insider Ray Dalio, founder of Bridgewater Associates, published a study two years ago that suggested hedge funds had increased leverage by around 70 percent across the board between 2004 and 2007 -- taking them past the thresholds seen before the collapse of Long Term Capital Management in 1998.

At the same time, returns increasingly began to look more and more like those found in traditional equity markets. The correlation between hedge fund returns and the S&P 500, for instance, touched 70 percent just before the credit crisis began in August 2007 (for long/short funds, the most common and popular form of hedge fund, the correlation was an even more dramatic 84 percent).

Returns built on borrowed money and S&P 500 movements aren’t the kind sophisticated investors were prepared to pay the classic “2 & 20” fee structure (2 percent of assets under management and 20 percent of profit above a certain level).

That became even more clear in 2008, when hedge funds around the world handed investors a loss of 18.3 percent (the worst on record) and investors handed hedge fund managers redemption notices worth nearly half a trillion dollars, according to the Chicago-based hedge fund Research group.

But this year things appear to be different. The market is no longer “a sky with 10,000 planes and only 100 decent pilots” as one money manager famously complained a few years ago, but rather a slimmed-down asset class with lower levels of gearing and, seemingly, “leveraged beta” (returns built on borrowed money that mimic the S&P 500.)

Alternative Investing - A CNBC Special Report - See Complete Coverage
Alternative Investing - A CNBC Special Report - See Complete Coverage

To date, Hedge Fund News says the industry is 12.03 percent to the good (compared to a 7.56 percent advance for the S&P 500’s total return index) and have built their asset base back to near record levels with just over $1.8 trillion under management.

There’s even some nascent signs of an industry sea change in terms of reduced lock-up periods, easier fee structures, balance-sheet transparency and regulatory cooperation. And, it has to be said, hedge funds were mere bit players in the multi-act play that was the near collapse of the global financial markets; the highly (some would argue overly) regulated financial institutions were the marquee names on that particular playbill.

Challenges remain, though. The $65 billion scandal of Bernard Madoff (a man who at one time advised the SEC on the monitoring of hedge funds) and the Lehman bankruptcy have put a premium on “trust” in the financial markets that we’ve not seen in a least a generation.

Handshakes mean little now; evidence is everything. Against that backdrop, though, hedge fund managers are adding assets, starting new firms and beating the global equity indexes.

But they’ve still got to face that ninth batter.

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