Some More Wisdom on "Hedge Funds" that Don't Hedge

Jeff Matthew's piece on Friday, Since When Did "Hedge Funds" Stop Hedging?, reminded me of this piece below by Carlo Cannell, from 1999. Cannell's article is more data-driven, whereas Matthews extrapolated wildly from a conversation he heard at Starbucks (as we bloggers are wont to do). My money says that Matthews is right about as early as Cannell was - which means we've got a great year ahead of us in 2007. Enjoy! - Ed

Bogus hedge funds -- those with no short positions -- will not survive the next market downturn
By J. Carlo Cannell (Red Herring - February 1999)

Phoenician sailors earned a thick slice of the profits from a successful voyage. Today a different risk-taker -- the modern-day hedge fund manager, or "hedgie" -- earns a similar benefit on land.

According to Hedge Fund Research, there are now more than 3,200 hedgies, two-thirds of whom operate in the United States. Estimates of their total capital under management vary from $150 billion to $250 billion.

Hedge funds have multiplied because in a bull market there are few better businesses. Assuming a standard 20 percent profit allocation, for example, a hedge fund general partner who started 1997 with $100 million and matched the S&P 500 would have received a paycheck of more than $6 million the next New Year's Eve -- healthy compensation for matching an index.

The rot in this picture is that most of these hedge funds have little or no short exposure. According to Edward Bowman of Hawthorne, the asset management division of PNC Bank, less than 10 percent of what are today called hedge funds have had any real hedge for the past several years.

This fall provided some vindication for the classic hedge. By early October the Russell 2000 was down more than 20 percent for the year; classic hedge funds were up more than 20 percent, but hedge funds as a whole were down more than 40 percent. During the last "trough" for hedge funds, in the early 1970s, there were fewer than 300 funds managing only a few billion dollars. Going forward, will we see an attrition to this level? Yes.

HEDGE HOGS

When things are good for hedgies, they're really good. Hedgies are the ultimate purchase managers, meeting, playing, and dining with scores of interesting entrepreneurs. Travel and computers are often their biggest expense items.

The hedgie mortality rate, however, is high. A shocking survey published in 1998 by Montgomery Asset Management indicates that the average U.S. investor expects the market to return 34 percent annually over the next ten years. The historical reality is somewhere closer to a 7 percent annual return. Fueled by these inflated expectations, some of the long-only managers masquerading as genuine hedgies will fall into a chasm of margin calls and redemptions like oblivious motorists plummeting off a cliff.

THE LONG AND SHORT OF IT

The Harvard-educated sociologist Alfred Winslow Jones is the father of the true hedge fund. In 1949 he structured a portfolio consisting of common stocks that held both long and short positions at all times -- even in a rising market. Mr. Jones's theory was that one can analyze a particular business even though the stock markets can't be reliably forecast. Buying good, well-respected but neglected companies long while shorting wildly overvalued companies should yield above-average results, he reasoned. By 1966 his fund had nearly doubled the results of the Dreyfus Fund, one of the better-reporting funds of the day. "Hedging," Mr. Jones often said, "is a speculative tool used to conservative ends."

KEEPING THE FAITH

A couple of years ago, as I broiled under the sizzle of short squeezes, a colleague told me that "a hedge fund doesn't have to hedge." What does it mean, then, to manage a hedge fund? Why do I deserve these high fees without undertaking the difficult process of researching short candidates -- a specialized and painstaking task that is usually more than twice as time-consuming as researching long candidates?

It hasn't been easy to be faithful. The longest-running bull market in history has toughened and twisted those true hedge fund managers who have survived it. I know one traditional hedgie who regularly vomited from anxiety during trading. Another has become so skeptical of financial statements that he retains private detectives to verify all information.

Windsurfers on the San Francisco Bay are an apt metaphor for today's proliferating hedgies. Both love to perform acrobatic feats in steady, high summer winds. Those winds, like the last 25 years in the equity market, can seem remarkably predictable. But eventually fluke winds do arrive, and the equipment's lack of keel and buoyancy makes the cold water and strong tides treacherous. The windsurfer's sailboard, like the fake hedge fund, is not an all-season craft.

Thoughts like these make cranks like me feel a little better.

J. Carlo Cannell is the president of Cannell Capital Management, an alternative asset adviser.