I had an interesting conversation today. First some background. You may have noticed that, over the last week, world equity markets have undergone substantial amounts of selling that have driven share prices down to a degree where words like “fear” and “panic” and “market turmoil” seemed to be appearing in the press and media with alarming regularity – only to then rise strongly again over the last day or two.
Basically, everyone seems to be freaking out that the Chinese economy is going to implode and pull the rest of the global economy down with it, or maybe not.
But back to my interesting conversation. Somebody asked me what I thought all of the above would mean for the hedge fund industry. This got me to thinking about what a hedge fund actually is. See, I told you this was going to be interesting.
So what is a hedge fund, anyway? Let’s think about this for a minute. Some common ground for almost all hedge funds would be:
- The hedge fund is a legal structure – often a company;
- Investors can put money into the hedge fund from time to time;
- Those investors can request the withdrawal of some or all of their money from the hedge fund from time to time – although, as a result of what happens at point 4 below, the investor’s money may have grown, shrunk or evaporated completely; and
- In between points 2 and 3, a person or group of persons known as the “hedge fund manager” will do something with that money in an attempt to make it grow into even more money.
I suppose there are two other common points also. Firstly, the legal structure will almost always be some formed in a very lightly regulated jurisdiction such as the Cayman Islands or the British Virgin Islands. Secondly, the hedge fund manager will almost always extract fairly high levels of fees. The reason that these latter two points are almost always the case brings us to the essence of what a hedge fund actually is (and, indirectly, to my thoughts on whether recent events would be bad for the hedge fund industry).
The reality is that different types of hedge funds do very different things indeed. So simply saying something is a “hedge fund” is, basically, completely meaningless in determining specifically how it intends to use investors’ money in an attempt to make that money grow into even more money.
However, overwhelmingly, whatever any particular hedge fund most certainly should not be doing is something that simply replicates the returns that could be achieved by investing in an almost zero-cost index fund (or a low cost long-only diversified mutual fund) that would track the returns of world equity markets. Rather, the high fees and the light regulation are supposed to attract a bunch of very smart people and allow them to formulate and undertake all sorts of complex strategies that may be precluded in highly regulated jurisdictions and that generally seek to earn non-correlated returns. In other words, they seek to earn generally positive returns without their ups and downs being tied to the ups and downs of the overall markets.
If global equity indexes are going up day after day it is harder for hedge funds overall to distinguish themselves. At times like those everyone just puts their money in an index fund and looks like a genius. When those broad market indexes are falling, or bouncing around all over the place, the types of non-correlated returns that hedge funds seek to produce begin to add diversification benefits to an overall portfolio. To state this most simply, volatility like we have seen over the last week is actually a good thing for many hedge funds.
If you follow the financial press you will most certainly have heard of Warren Buffett, who is well known for his sage investment views and witty quotes. One of his better known quotes is “only when the tide goes out do you discover who’s been swimming naked”. I don’t know about actual nudity, but there is certainly going to be some pain for some investors. However, most hedge funds are more likely to benefit from the opportunities this market dislocation presents. Call me an optimist, but I expect that hedge fund managers on the whole should be proven to have been wearing their speedos.
 Or you may have been trapped in a cave.
 Actually, they asked me whether and, more specifically, whether I foresaw a wave of “soft wind downs, gates or suspensions” – but that is all a little technical and the above captures their point.
 At least certain investors. Mainly rich or sophisticated ones. There are reasons for this.
 If you were told it was equity long/short, or global macro, or quant you may begin to have some clue as to what it is actually going to do. This is way beyond the scope of the present discussion.
 And immense wealth accrued through savvy investment in both private and public equity markets.
 Although I never generally object – and if you’ve ever been to the “Willy T” in the BVI…well, enough said.