Hedge funds made easy

Adrian Ash - Fri 27 Jan, 2006

"...Unproven, early 30s, not made any money...Add the word 'bald' to that list, and it would fit your correspondent down to a tee! Except for the 10 years in fund management. But so what? There's a premium paid for 'unproven' right now..."

"Make starting your hedge fund easy," urges a flashing banner ad your editor stumbled upon this morning. "Start a hedge fund here!"

And hey! Judging from the cute young woman grinning out from the advert, starting your own hedge fund could be lots of fun, too...

But how easy would it really be for an under-paid hack at the wrong end of Blackfriars Bridge to get into carry trades, an eight-figure salary, and convertible arbitrage? Well, let's see now...

"The first hedge fund was set up by Alfred W.Jones in 1949," says Dr Philipp Cottier in his book 'Hedge Funds and Managed Futures'. "Jones wanted to eliminate a part of the market risk involved in holding long stock positions by short-selling other stocks. He thereby shifted most of his exposure from market timing to stock selection...

"Jones was the first to use short sales, leverage and incentive fees in combination," says Dr Cottier. "[And] in 1966, an article in Fortune magazine about a 'hedge fund' run by a certain A.W.Jones shocked the investment community. Apparently, the fund had outperformed all the mutual funds of its time, even after accounting for a hefty 20% incentive fee."

Thus the first rush into hedge funds followed...and bust followed boom, of course, as it always will. Fast forward to 2006, and hedge fund bubble Part II may be upon us...

"Fund-of-hedge funds bullish on young, unproven talent," says a headline on HedgeCo.net. "We look at young, unproven managers because we view new funds as having superior risk/reward opportunities than older, proven ones," the website quotes one New York manager. "Our ideal guy is in his early 30s, has been in the business for 10 years, but hasn't made his big money yet."

Unproven, early 30s, not made any money...Add the word "bald" to that list, and it would fit your correspondent down to a tee! Except for the 10 years in fund management. But so what? There's a premium paid for "unproven" right now.

"The Hedge Fund industry has grown at a ferocious pace in the last decade," HedgeCo.net goes on, "from as few as 300 funds in 1990 to more than 8,000 today. The funds have become highly visible in markets and press, and are today estimated to manage up to $1 trillion in capital."

"Hedge Funds," the article adds, "like other alternative investments such as real estate and private equity, are thought to provide returns that are uncorrelated with traditional investments...Investing in Hedge Funds can further diversify portfolios and produce higher returns at lower risk."

Hmmm...higher returns at lower risk, eh? Who wouldn't want that! But many hedge funds had a tough time of it in 2005, according to a report out this week from AMB Amro. Maybe ABN Amro had a tough time of it in 2005, your editor wonders. But no matter. The FT picks up the story...

"Hedge funds specialising in the foreign exchange markets endured probably their roughest year for more than a decade in 2005," the Pink 'Un reports. "A weighted average of dummy portfolios based on the four most common trading strategies...last year lost money for the first time since 1992. Anecdotal evidence also seems to suggest real funds struggled."

Note how the FT neglects to mention it was the hedge funds' clients who actually lost money. But the bleeding hearts of Southwark Bridge go on: "A number of smaller forex hedge funds launched in 2004 bit the dust last year as returns fell...Not even the more established funds were exempt from losses. The three forex portfolios operated by John W.Henry, a large US manager, all suffered sizeable losses last year...falling 5.3 per cent...20.8 per cent...[and] 26.8 per cent."

Here in London, Man Group's AHL Currency fund lost 5.8% in 2005. Like John W.Henry, its system targets strong momentum – "trend following" in other words, picking up the big moves once they're established and sticking with them until after they've turned. But the biggest major currency move of the year, the US dollar's rise from the undead, moved in fits and starts. This knocked many systems, especially those using moving averages to set their stop-losses, out of the trade before the big money rolled in.

"Oh, is that so?" mused Tom Tragett to your editor by phone this morning. "I was the right side of the dollar in 2005," our new friend continued. "It all depends on how you use the [moving] averages to judge your stop-losses. And besides, a lot of funds were caught long of the euro at the start of last year...buying at 1.27 or 1.28...all betting with [Warren] Buffett that the greenback would crash."

"Everyone now says the dollar's doomed in 2006 though," your editor interrupted. "It's a crowded trade again this year, right?"

"I'm very much a long-term bear," Tom replied. "But that's not to say it won't firm up in the short-term. US interest rates and the economic numbers are keeping the dollar up...And all this economic data from Germany's failed to help the euro so far."

"What to do about the dollar then?" your editor asked...on behalf of those risk-loving readers wanting to 'short' the consensus today.

"Well, the euro's fallen from 1.23 to 1.215 in the last three days," came the answer. "The trend looks strong for now. And if we got down to a break of 1.164 you could look to chase it right down to 1.10 fast..."

There you have it, gentle reader. Now go start your own hedge fund!