All About Hedge Funds : The Easy Way to Get Started

330 Pages·1999·1.38 MB·English

by  Robert A. Jaeger

ALL ABOUT

HEDGE FUNDS

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TEAM FLY ®
O T H E R T I T L E S I N T H E
“A L L A B O U T. . .” F I N A N C E S E R I E S
All About Bonds
All About Commodities
All About DRIPs and DSPs
All About Futures
All About Mutual Funds
All About Options
All About Real Estate Investing
All About Stock Market Strategies
All About Stocks
All About Your 401(k) Plan
All About Variable Annuities
ALL ABOUT
HEDGE FUNDS
The Easy Way to Get Started
ROBERT A. JAEGER, PH.D.
McGraw-Hill
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DOI: 10.1036/0071415637
C O N T E N T S
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Preface vii
Acknowledgments xvii
Introduction: The Basic Themes 1
PART ONE: THE HISTORICALAND
INSTITUTIONALCONTEXT
Chapter 1
The Historical Context 17
Chapter 2
Hedge Fund Managers and Clients 33
Chapter 3
Hedge Funds and the Brokerage Community 45
Chapter 4
The Lure of the Small 57
PART TWO: HEDGE FUNDS, ACTIVE MANAGEMENT,
AND EFFICIENT MARKETS
Chapter 5
The Hedge Fund Challenge 71
Chapter 6
Efficient Markets, Emotion, and Skill 77
Chapter 7
Efficiently Diversified Portfolios 91
Chapter 8
The Tyranny of the Cap-Weighted Indexes 115
PART THREE: THE TOOLS OF THE TRADE
Chapter 9
Leverage, Short Selling, and Hedging 133
Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use. v
vi Contents
Chapter 10
Futures and Options 151
Chapter 11
AM/FM Investing: The Modulation of Returns 163
PART FOUR: SOME OPERATIONALISSUES
Chapter 12
Legal and Regulatory Issues 181
Chapter 13
Performance Fees 193
Chapter 14
Tax Issues 197
PART 5: THE MENU OF HEDGE FUND STRATEGIES
Chapter 15
An Overview of the Menu 207
Chapter 16
Equity Hedge Funds and Global Asset Allocators 229
Chapter 17
Relative-Value Investing 241
Chapter 18
Event-Driven Investing 263
Conclusion 283
AppendixI The EACM 100®Index 291
AppendixII Suggestions for Further Reading 293
Glossary 297
Index 301
P R E FA C E
W
e all enjoy stories in which extraordinary things happen to ordi-
nary people. An unemployed auto worker wins a $100 million lottery
jackpot. An 85-year-old mother of five and grandmother of 15 final-
ly goes back to college to complete her degree. We take pleasure in
both situations, but the second case is more satisfying since the good
news is not the result of luck, but the result of hard work, grit, and
courage. We love to see virtue rewarded.
We also enjoy stories in which ordinary things happen to extra-
ordinary people. For example, some member of the rich and famous
set has to deal with divorce or major financial reversals. The story is
always more interesting when the bad news is not merely the result
of bad luck, but is the result of too much self-indulgence, too much
power, too much free time, or too much brainpower. Then we can
blame the celebrities for the terrible things that happen to them. We
love to see vice punished.
Reading about hedge funds in the newspaper is often like read-
ing about celebrity divorce and other miseries. Bad things are hap-
pening, but the victims deserve it. After all, hedge funds are general-
ly described in newspapers as secretive, unregulated investment vehi-
cles that enable wealthy individuals to make highly leveraged spec-
ulative bets in the global financial and commodity markets. So the
people who invest in hedge funds are rich people who can afford the
losses and perhaps should have known better. And the people who
manage hedge funds are routinely described as investment cowboys
who take a healthy percentage of the profits earned by their investors.
If a hedge fund is down 50 percent because of bad trading decisions,
or if a fraudulent hedge fund manager siphons off the money to buy
cars and houses, the story can make entertaining reading. The story
is another reminder of the terrible things that can happen to the rich,
but usually the story does not affect us directly. The wicked are get-
ting what they deserve, but we don’t have to worry because we’re in
another category altogether.
Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use. vii
viii Preface
Hedge funds can be very risky. When things go wrong in the
world of hedge funds, they can go very wrong. And when things go
very wrong, the stories are very colorful. But the colorful stories are
not fully representative of the hedge fund business. They ignore the
substantial number of hedge fund managers who labor quietly in the
shadows to produce decent returns for their investors. But this kind
of low-profile work does not make for colorful newspaper articles.
Hence this book, which is designed to present a picture of hedge
funds that is more balanced, and more detailed, than the picture you
would form from reading the newspaper headlines. But it’s natural
to begin with some disaster stories.
Long Term Capital Management (LTCM) was a large hedge
fund that experienced major financial distress in August 1998. LTCM
was formed by an unusually distinguished group of money man-
agers. Many of them had had remarkably successful careers at
Salomon Brothers, the major Wall Street investment bank. Others
were Nobel Prize–winning academics. This group raised several bil-
lion dollars in capital, then used borrowed money to take very large
positions designed to exploit small price discrepancies in the finan-
cial markets. After several years of stellar returns, LTCM came apart
in a very special set of circumstances that unfolded in the late sum-
mer and early fall of 1998.
The problems began in Russia, which defaulted on its debt and
devalued its currency. This created a panic among investors, who sold
anything that had the slightest scent of risk, and then rushed for the
complete safety of U.S. Treasury bonds. This global flight to quality
put tremendous pressure on LTCM’s trading positions, and the unwind-
ing of those positions threatened to destabilize further the financial
markets. The Federal Reserve Board was so concerned about the situ-
ation that it brought together the major Wall Street firms that were
lenders to LTCM and encouraged them to act together in such a way
as to minimize further impact on the financial markets, and further
damage to themselves. The message from the Fed to the lenders was
this: “If each of you pursues your own interests exclusively, the result
will be a disaster for every single one of you and for the system as a
whole. If you act cooperatively, the results will be better for everyone.”
The creditors seized control of the LTCM portfolio, thus essentially
wiping out the equity investors, and organized a very gradual unwind-
ing of the LTCM positions. Importantly, the government did not “bail
out” the investors in the partnership: Those who had money invested
Preface ix
in LTCM lost their investment. What the government did was to orga-
nize the creditors to act with “enlightened self-interest,” rather than a
more narrowly focused self-interest that would have been bad for the
lenders and bad for the rest of us.
The LTCM debacle, like the crash of 1987, created a market cri-
sis that wound up affecting all sorts of people who have no interest
in, or knowledge of, hedge funds. The LTCM debacle was also a
vivid reminder of one of the most fascinating facts about the invest-
ment management business: Brainpower is no guarantee of success.
Indeed, too much brainpower can be a bad thing if it leads the own-
ers of those brains to overestimate their understanding of what is
always an inherently uncertain situation. The Greeks had a word
for it: hubris, excessive pride or self-confidence. The markets always
have ways of making the proud humble.
The markets gradually recovered from the LTCM debacle, but
then the newspapers were filled with the travails of two other illus-
trious hedge fund managers: George Soros and Julian Robertson. In
1999 and early 2000 the U.S. stock market entered a completely manic
phase in which investors became totally enamored with Internet
stocks and anything else connected with “the new economy.” This
mania created a major problem for Soros and Robertson, both of
whom were extremely astute investors who had put together very
long and successful track records. Though both investors are too
smart and too subtle to fit into simple boxes, Robertson often tend-
ed to be a “value investor,” whereas Soros often tended to be more
oriented toward growth, or momentum. Robertson refused to play
the Internet sector in any significant size, his performance lagged,
investors redeemed, and Robertson shut down his various Tiger
funds on a low note rather than a high note.
The Soros organization recognized that the Internet craze was
just a craze but thought that they could make money off the craze
without getting hurt. That turned out to be a fatal mistake. When
the Internet bubble burst, the Soros funds were caught with too much
exposure. The result was big losses, and Soros decided to restruc-
ture his investment funds. Soros’s predicament was analogous to
the predicament of somebody whose house is on fire. You are stand-
ing safely on the lawn, but you want to retrieve a few items of sen-
timental value. You know the risks, but you think that you can rush
quickly into the house, retrieve the few items, then rush out. So you
run into the house. And you never come back.