EFFICIENCY CAPITAL AND THE ROLE OF HEDGE FUNDS

Hedge funds have been in the financial news a lot recently, perhaps most noticeably in the metals markets where they are often deemed to be the source of sharp sell-offs. They can also be the source of sharp rallies, but as we tend to prefer rallies to falls, the market, and thus the media, likes to point an accusatory finger only when something adverse occurs.

The truth is hedge funds have a tarnished reputation. In the last two decades, hedge funds have been attacked as the reason behind everything from stock market crashes to currency collapses. On occasion, hedge funds themselves have spectacularly collapsed, causing their financiers to lose significant amounts of money.

In 1998, a US hedge fund by the name of Long Term Capital Management went to the wall with financial market exposures of over US$200 billion. The fund had financed its trading with leveraged funds provided by some the world’s largest and most respected investment banks. The banks got the shock of their lives, and ended up having to bail out LTCM in order to stave off potentially significant damage to the world financial system.

While hedge funds have now been around for a long time, even as early ago as 1998 they were not overly numerous. The total amount invested in hedge funds a decade ago was fairly insignificant. Today, however, investment in hedge funds exceeds US$1 trillion.

The obvious question must be that if hedge funds can be so frighteningly dangerous, why have they become evermore so popular? In order to find an answer, it is necessary to define exactly what a hedge fund is. Hunt Taylor of HedgeWorld provides us with a little history.

The first merchant banks originated in Italy in the Middle Ages, when merchants would lend money to farmers against their crops. They would open for business by simply setting up a bench in the local piazza. The word “bank” derives from “banco” which is the Italian for “bench”. “Banco rotta”, or “broken bench”, gives us the word “bankrupt”.

Soon the merchant banks began to settle loans from other merchant banks, thus creating a financial “market”. As the charging of interest was deemed as usury – a cardinal sin – the merchant banks would discount the interest from the principal. Debt markets still use this method today in instruments such as Australian bank bills.

What these early merchant banks achieved was to make the grain market more efficient. They provided liquidity. Without such liquidity the grain market would have been a lumpy business with sporadic payments and specific risk.

The simple concepts of the early merchant banks evolved into evermore diverse markets and financial instruments which spurned the great banking houses of Europe such as Rothschilds, Schroders, Warburgs and Barings. Later years saw the likes of Goldman Sachs and Morgan Stanley in the US, and Jardine Fleming in Asia. These banks made their money by facilitating the provision of investment capital to wherever it was needed at the time – from railroad bonds in the 1880s to Japanese warrants in the 1980s.

They provided liquidity and risk capital. Hunt Taylor describes this as “efficiency capital”.

As the operations of merchant banks became more diverse, and financial transactions became more complex, merchant banks set up “proprietary” trading operations. Again, this was in order to provide liquidity for clients. They would make short term markets in anything from government and corporate bonds to equity instruments and foreign exchange.

Prior to the deregulation of the banking industry in Australia in the eighties, the existing trading banks – those operating under the auspices of the Reserve Bank such as the Commonwealth or ANZ, would provide finance under strictly controlled terms and with inflexible conditions of maturity and size. This led to the emergence of merchant banks which would provide those facilities the trading banks wouldn’t, such as, for example, an overnight money market.

After deregulation the Australian merchant banks became trading banks under RBA control, and the existing trading banks slowly expanded their own operations to facilitate proprietary operations. We now generally label them all as “investment banks”. One such example of a merchant bank which received a license from the government was Hill Samuel Australia, which in 1985 changed its name to Macquarie Bank.

There is possibly no better illustration of a proprietary trading operation than foreign exchange. As one of the early leaders in foreign exchange trading, Macquarie Bank would offer buy/sell prices to clients in US dollars and other major currencies. Miners were among some of the biggest users of this market.

Macquarie’s foreign exchange desk did not, however, link those clients wishing to buy US dollars with those wishing to sell (as a broker would) but rather took on the client’s position and traded it in the market with other banks and proprietary operations with the intended purpose of making a profit. Today, of all the billions of dollars that is traded in foreign exchange markets, only about 10% involves a legitimate client such as an exporter. The other 90% is speculative trading by the banks.

While those outside the market are often aghast to learn such figures, deeming the 90% speculation for the pursuit of profit to be somewhat offensive, the reality is that the foreign exchange market provides liquidity. Without such liquidity, the likes of exporters and importers would find their businesses far more risky.

Financial markets have expanded exponentially to include all manner of instruments, from a simple share to derivatives such as futures and options, all sorts of securitised credit such as mortgages securities, and just about anything imaginative bankers perceive a need for. In nearly all cases these instruments are “traded” by proprietary operations in the pursuit of profit and the resulting provision of liquidity.

The eighties and nineties were the glory days of proprietary trading, and in the case of banks like Macquarie, proprietary trading contributed a significant proportion of the profit. Such banks around the world were leaders in complex financial instruments and their derivatives, and leaders in managing the risk inherent in such instruments (although not always).

Because such instruments were deemed to be very risky, traditional investors such as large institutional funds shied away, content to provide unspectacular but stable returns through index-tracking and low-risk debt. But the fact that proprietary traders were reaping huge rewards in innovative financial strategies was not lost on all in the market, and smaller investors, particularly what we tend to call “high net worth individuals”, were thirsty for better returns.

Thus was born the hedge fund. Hedge funds were set up to allow investors to participate in a share of the profits from the same types of proprietary activities that many investment banks were active in.

The word “hedge” in hedge fund probably seems like a misnomer. It seems incongruous when associated with such supposedly high risk/high reward activity. But the reality is that hedge funds get there name from engaging in “hedged” trades.

Examples of such hedged trades might be short/long stock positions, index futures “arbitrage” (eg long stocks and short SPI futures or vice versa) or short/long positions in sovereign debt. By taking supposedly offsetting positions hedge funds were playing valuation margins while in theory keeping risk in check.

Because such trades were seen as hedged trades, investment banks were happy to lend money to hedge funds by accepting deposits and lending a multiple amount back in order to facilitate leverage in tight margin plays. The reality is, however, that the supposed hedges did not constitute riskless positions. If, for example, a fund is short one stock and long another one might consider the fund to be hedged against market risk, but clearly it is not hedged against stock-specific risk.

The aforementioned hedge fund, Long Term Capital Management, lost all its money by being long Russian bonds and short US bonds. In cases where hedge funds have confounded bankers by losing vast amount of leveraged money it has usually been a case of ignorance, where overly enthusiastic bankers have been keen to lend to funds with previously impressive track records without really appreciating the nature of trades conducted.

Such ignorance has also been all too obvious in cases of proprietary trading operations in investment banks themselves, and bankers are slow to learn. .A “rogue trader” brought down Barings Bank last decade through unaudited option positions, and this decade National Australia Bank had a scare of its own for all the same reasons.

Of course, we only ever hear about the disasters, and the reality is that the disasters are few amongst hedge funds that do make above-market returns. That is why investment in hedge funds is now estimated to be about US$1.1 trillion, and small hedge funds are abundant.

But that’s just the money invested. Hunt Taylor suggests, without any means of actually knowing, that this capital is leveraged about 4 times. That makes $4.4 trillion. Then consider a hedge fund may turnover its global book about four times a year. That’s $17.6 trillion being played in the market – a rather significant figure.

Traditional investment capital seeks to profit from investing in markets and companies that we might call “real”. Companies that source raw materials, manufacture goods or provide services. If a large percentage of superannuation funds is invested in the stock market, it is invested in something that the average Joe can see as being beneficial to the world.

Hedge funds, on the other hand, are not providing investment capital in such supposedly worthy pursuits. They are simply trying to make money out of money. They have no qualms in, for example, short-selling some of those same stocks in your superannuation portfolio and hoping their prices fall.

What hedge funds are providing is efficiency capital – exactly the same efficiency capital that Italian merchant bankers long ago sought to provide. By being active in searching for perceived valuation discrepancies and turning over millions of dollars each day in diverse margin trades hedge funds are flooding the market with liquidity.

Such liquidity actually serves to reduce market volatility. This may seem hard to accept if the business news is blaming “hedge fund selling” for a particular sharp down day in metals, for example. But hedge funds don’t all line up on the same side of the field. Given their present abundance it is possible that one group of hedge funds is holding exactly the opposite set of positions as another group of hedge funds.

The chances of one particular hedge fund causing major world financial grief is now much less than it was in earlier days of fewer players and less experienced lenders. Hedge funds will certainly go under, buy they will be smaller players in a much bigger pool.

Most hedge fund managers earn their own profits by charging performance fees. Hedge fund investors are only paying these managers a percentage of positive performance. Some of these deals are quite lucrative, but obviously hedge fund managers have to get it right.

The performance fee is the mantra of a new age in financial markets. In the last ten or so years, the growth of proprietary trading and increased sophistication of investors and clients has meant that pioneering investment banks no longer reap the same sorts of rewards they once did in a fledgling market. The introduction of limited partnership structures has also meant that trading in such markets is no longer the domain of privileged few who could afford stock exchange seats or the like.

In many cases, hedge funds have been set up by those who cut their teeth working in an investment bank, and who decided they’d much rather earn a living from directly charging a fee for their expertise, than relying on a bonus payment from their employer.

Hunt Taylor notes that this decade efficiency capital in the US has migrated from one set of partnerships to another. From the the Goldman Sachs and Salomon Brothers to names like Moore Capital, Citadel and Renaissance and “hundreds of others built in their image”.

Proprietary trading no longer plays such a dominant part of investment bank profits. Fee-based activities, similar in structure to those of hedge funds, are now the new big thing. And some players have realised there is no end of opportunity to profit from managing investors’ money.

Again playing a role as pioneer is Macquarie Bank, which realised inefficiencies existed in many diverse areas of business that if managed more sensibly could reap rewards for both investor and manager alike. It started with toll roads, and has moved on towards realms as diverse as radio stations and bowling allies. Hedge funds may have moved into the domain of proprietary trading, but investment bank innovation has spread into wider fields.

Not surprisingly, as hedge funds have crowded the financial market (and in so doing, reduced individual returns), new players have entered into the relatively new field of, for example, infrastructure funds. It is the nature of financial markets that inefficiencies will always be sought out, and exploited for mutual gain. Efficiency capital will always be at work.

Updated February 2006

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