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The Case for Hedge Funds

 

An excerpt from a report by Tremont Partners Inc, of Rye, New York, and TASS Investment Research Ltd of London

Since 1949 when Alfred Jones established the first hedge fund, the hedge fund industry continues to be one of the most misrepresented and misunderstood areas of finance.

The often trumpeted spectacular successes of the likes of George Soros and Julian Robertson over the past two decades, contrasted with the dramatic losses of Long-Term Capital Management and others in 1998, have done little to advance understanding of an industry frequently shrouded in mystery.

Indeed these examples have only fuelled wild speculation and misconceptions, much of it press-driven, that hedge funds represent the ultimate roulette table for a chosen few. This perception, however, is inconsistent with the reality that hedge funds have remained one of the fastest growing financial sectors, experiencing unprecedented growth throughout the 1990s.

Growth Segment

Hedge funds currently represent one of the fastest growing segments of the investment management community. Over the past 10 years, the number of funds has increased at an average rate of 25.74% per year, showing a total growth of 648% (these figures include fund of funds).

The reason for the unprecedented growth is simple. Money follows talent. Having attained significant personal wealth as fund managers or proprietary traders, the talented managers are leaving large companies to manager their own money. They are establishing simple corporate structures with limited employees and forming funds with absolute and risk-adjusted return objectives.

These funds typically charge performance fees, usually 20% of profits. By limiting the size of assets under management, these companies can react quickly to events in the financial community, trading without impacting share prices. With fees earned as a percentage of profits, a company can earn as much money on a $100 million asset base as a traditional money manager earns on $1 billion.

Size of the Industry

There is much confusion within the industry about the total number of hedge funds. Having recently completed the internal merger of the Tremont and TASS databases, we estimate that there are 5,000 funds in the whole industry. However, in excess of 90% of the $325 billion under management in the industry is managed by some 2,600 funds (figures do not include CTAs).

Hedge funds are not homogeneous. While 72% of the total assets under management in the industry are invested in the equity markets, the investment disciplines used are diverse and distinct. As defined by Tremont and TASS, there are 11 primary investment categories in the hedge fund industry. These are: Long/Short Equity; Equity Market Neutral; Equity Trading; Event Driven; Convertible Arbitrage; Fixed Income Relative Value/Arbitrage; Global Macro; Short Sellers; Emerging Markets; Managed Futures; Funds of Funds.

The Outsourcing of Proprietary Trading

Historically, large financial institutions were the only organisations with the capital, infrastructure and access to conduct the trading and investment activity now common to hedge funds. Senior positions on proprietary trading desks represented the top of the career ladder for professional traders.

With the advent of hedge funds, there was added another rung to this ladder. Traders who could establish a history of profitability and proven expertise could now ply their craft with investor assets, potentially earning both higher incomes and the opportunity to control their professional destinies.

Over the last decade, two trends have developed. The hedge fund structure is drawing top-flight talent off the trading desks at an accelerating pace. Further, in this era of shareholder value, financial institutions’ appetite for risk and the sometimes, uneven return stream of proprietary trading has diminished, causing cutbacks and decreased trading lines.

In broad terms, the risk capital funding the market making and speculative activities of the largest proprietary traders is increasingly coming from private sources in the form of hedge funds. There is a general perception that hedge funds are dangerously high-risk vehicles designed only for the elite. The majority of statistical and intellectual evidence suggests otherwise.

There is an inherent return in hedge funds which exists partly because there is excess profit to be earned from consistently dealing in the world’s capital and derivative markets on superior terms. However, by adding the positive selection of alpha, intrinsic in the structure of all hedge funds, the inherent return is enhanced. Hedge funds are paid, and have the incentive, to trade and invest when others cannot, will not, or need to be on the other side.

For information on how to receive a copy of the full report, phone TASS on +(44) 171-233-9797and ask for Florence Holzhausen or Tremont on +(1) 914-925-1140 and ask for Marie Bertram

Profit & Loss

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