Hedging Their Bets

Funds now see lagging the S&P 500 as a sign of prudence


Ethan Silverman is nervous. The 39-year-old New Yorker runs the Not Born Yesterday Fund, a hedge fund that tries to make money anticipating the buying habits of the 55-and-older crowd. Last year, the fund racked up an impressive 75% net gain, more than double the Standard & Poor's 500 index's 34% return. In the first quarter, its 15% advance puts it slightly ahead of the S&P's 14% and considerably in front of most hedge funds, as a glance at the accompanying table of the quarter's returns shows.

What's more, Silverman achieved his results by going both long and short stocks, the classic hedge-fund strategy that has been all but forgotten in the bonhomie of a 15-year bull market.

What's making Silverman so jittery? Apart from having almost his entire net worth in his $20 million fund, he thinks the Asia crisis will have a second act -- and a third. Then there's the tight U.S. job market, a glut of stock from insiders exercising options, too many stories involving fraudulent accounting, stock-for-stock deals -- no cash -- and the disturbing news of banks buying brokerage houses. Banks, he observes, have a knack for buying at the top -- real-estate investment trusts in the 1970s, leveraged buyouts in the 1980s and junk bonds in the 1990s. Silverman trimmed his equity exposure 50% last week, cutting back on drug retailers and manufacturers, financial services and some home furnishings.

In general, hedge funds picked up the pace at the end of the first quarter after a dreary start. In a preliminary sample of hedge-fund performance, more than three-quarters posted positive returns in March, according to Managed Account Reports, the New York publishing firm that tracks the performance of hedge funds, commodity trading advisers and fund-of-funds. (A full report on hedge-fund performance will appear May 11.)

A decade ago, hedge-fund managers would have been frustrated by their failure to outpace the stock market. It's true that investors could have done better in plain-vanilla index funds, while paying a small fraction of the 1% management and 20% incentive fees charged by hedge funds. But investing in an index fund is one big bet on the bull market.

These days, however, underperforming the stock market seems almost prudent -- the assumption being, of course, that the flip side of lower returns is lower risk. "Some people, mostly offshore investors, still want to look at their hedge funds as turbo-charged portfolios," comments Tom Kirkpatrick, an adviser to a fund of funds managed by Lookout Mountain Capital in Chattanooga, Tennessee. More sophisticated investors, he says, don't care about beating the market.

One of the biggest winners was Julian Robertson, whose Tiger Capital Management funds soared 17% in March, versus the S&P 500's 5%, as big bets against the Japanese stock market and the yen paid off. Some of Tiger's $16 billion under management was also invested on the long side in Europe, where shares have been reaching new highs recently. One of his biggest holdings is UPM-Kymmene, the Finnish paper company whose stock price rose 31% during the quarter. Tiger needed its late-quarter gains to offset the losses it suffered in January and February. The group finished the quarter in positive territory, up 8.4% after fees.

Soros Fund Management, the biggest macro player, with $21 billion in five funds, also scored large gains in the quarter. Quota Fund, whose $3.5 billion in assets has been placed with outside portfolio managers, was up a crackling 27%. Quantum Fund, the group's flagship, with nearly $10 billion in assets, gained 10%. Only Quantum Emerging Growth posted a loss, of nearly 5%. Emerging markets put more than the Soros group to the test. While it was possible to make money holding Polish or Portuguese stocks, some of the quarter's biggest losers were hedge funds specializing in Russian securities. Renaissance Russia Growth lost 20% and Hermitage was off nearly 18%, according to MAR's preliminary figures. Only a year ago, these fiery funds posted unworldly gains of 150% and more.

Firebird Management in New York, on the other hand, nimbly sold and then shorted Russian securities in January and returned to buy in March. Firebird Fund posted a 10% gain for the quarter, Firebird New Russia was up 14% and a fund that invests in former Soviet Union republics lost 3%.

As a group, however, short-sellers once again turned in the worst performance, off more than 11%, according to an index compiled by Evaluation Associates Capital Markets in Norwalk, Connecticut. Near the bottom was Rocker Partners in New York, which lost nearly 10%. Kirkpatrick of Lookout Mountain concedes that shorting stocks has been an expensive strategy in this momentum-driven bull market. Its two portfolios are traditional hedge funds, with concentrated positions on the long side, shorts, and leverage. When a bear market comes, hedging will "be like calling up to buy insurance in the middle of a hurricane. You can get it, but it's going to be very expensive."

Underperformance hasn't affected the ability of hedge funds to raise money. In an offering that still has tongues wagging, Convergence Asset Management in Greenwich, Connecticut, raised $700 million in three weeks this spring. Moreover, Global Convergence Fund, which will trade in the fixed-income and currency markets, requires a $10 million minimum investment, charges a 1.5% management fee as well as the 20% incentive fee, and makes clients agree to keep their assets with Convergence for at least four years -- regardless of performance. Convergence's ability to dictate such tough terms is a good indication of investors' demand for portfolios that can, theoretically at least, deliver reasonable returns that have nothing to do with ups and downs of the Dow.

No one knows the total assets under management in hedge funds -- estimates run to as high as $200 billion -- but it's too much for some portfolio managers. Martin Gross, a fund-of-funds manager who specializes in low-risk, event-driven funds, reports that eight of the 12 hedge funds in which he invests have recently been closed to new money. Gross has been sounding the alarm over the so-called capacity issues for years -- too much money and too few competent hedge-fund managers. "It's the industry's biggest problem," he warns.


  1. Why would a hedge fund look more cautious in a strong up market than in a flat or down market?
  2. How would you explain the fact that investors are still willing to invest in hedge funds even though they lagged the market during this period?