As it turns out, it was the big regulated entities, the banks and investment banks, that were the problem, not the unregulated hedge funds

TO BE NOTED: From the NY Times:

Talking Business

Hedge Fund Manager’s Farewell

By JOE NOCERA

Two weeks from now, a seven-year-old hedge fund called Alson Capital Partners will return around $800 million to its investors, and shut its doors for good.

The fund was founded and managed by Neil Barsky, 51, a former Wall Street Journal reporter-turned-Morgan Stanley analyst, who started his first hedge fund in 1998, just as the “hedge fund decade” was gaining steam. He was an old-fashioned stock picker who ran Alson Capital as a classic “long-short” stock fund, meaning that he bought companies he thought had good long-term prospects, while shorting companies he thought were likely to fall off the cliff. At its peak, Alson Capital had $3.5 billion under management, charged a 1.5 percent management fee, took 20 percent of the profits, and, when you include Mr. Barsky’s predecessor fund, produced compounded annualized returns of 12.11 percent a year. It’s fair to say he’s made a pretty penny.

Mr. Barsky is also a source of mine. In the decade or so that I’ve known him, I was able to quote him by name only once. As he explained to me recently, hedge fund managers who become too visible can make their investors wonder, “Why are you spending all your time on TV when you should be managing my money?” But he was one of the people I turned to when I wanted to learn what was really going on in the market. He is blunt, sardonic, funny and passionate, an insider who never lost his outsider’s perspective.

So when I read that he was quitting, I went to see him. I was hoping he would be willing to reflect on his life and times as a hedge fund manager, on the record this time. Happily, he was.

•

A bit of context first. For all the talk these last few years about the risks to investors of “secretive, unregulated” hedge funds, they certainly haven’t turned out to be the big problem, have they? Like most hedge funds, Alson Capital had a rough year in 2008, down more than 20 percent. Indeed, thousands of hedge funds lost, in the aggregate, hundreds of billions of dollars last year, and hundreds have shut down. But nobody in government is calling for a hedge fund bailout because hedge funds losses, however painful to investors, don’t create systemic risks to the nation’s financial apparatus. As it turns out, it was the big regulated entities, the banks and investment banks, that were the problem, not the unregulated hedge funds.

Why did all the fear about hedge funds turn out to be unjustified? One reason is that most hedge funds didn’t have the kind of 30-1 leverage ratios that the big banks had. Mr. Barsky’s fund, for instance, didn’t need much leverage to carry out his long-short strategy. But even if he had wanted to “lever up,” as they say, his prime broker — that is, the investment bank that did his back-office work — probably wouldn’t have let him.

In a wonderful irony, the banks and investment banks that were themselves drowning in debt were fearful of allowing their hedge fund clients to carry too much debt. They still remembered Long Term Capital Management, a hedge fund that a decade earlier had, indeed, brought the financial system to the brink because of its extreme leverage.

The second reason is that, while hedge fund managers could make extraordinary sums, they had far fewer incentives than Wall Street traders to take truly insane risks. “Ninety percent of my net worth was in the fund,” said Mr. Barsky, and that is true of most hedge fund managers. Wall Street traders got rich by making deals that brought short-term profits, even if they “blew up” later. Hedge fund managers who blew up hurt not only their investors but themselves. “As long as the hedge fund manager has his own capital in the fund, the risk equation is different,” Mr. Barsky said.

Although his fund lost money in 2008, it did not blow up; as he put it, the 20 percent loss was “not a disaster but not good.” Although he was forced to make redemptions to investors who bailed out, enough remained that he could have stayed in business. What really caused him to exit the hedge fund business is that he felt ground down by the relentlessness of the job.

“When you manage a hedge fund,” Mr. Barsky said, “the cost is the incredible stress you endure. You can never escape it. You are never free. The thing that is different about running a hedge fund is that your investors own you.”

The goal of a hedge fund manager is not to beat an index, as it is for a mutual fund manager, but to generate positive returns no matter what the market is doing. Failure to do so would invariably mean redemptions, and could often mean the end of the business. “Hedge funds are fragile,” Mr. Barsky said. Over the years, I could always tell when Mr. Barsky was feeling especially stressed; he did not hide it well.

He was also tired of the ways the business had changed. “When I first started in 1998, we used to send out quarterly numbers. Now investors want weekly numbers. Professor Louis Lowenstein” — the iconoclastic and recently deceased Columbia University business law professor — “has a great line in one of his books: ‘You manage what you measure.’ ”

Mr. Barsky shrugged, as if to say: don’t feel sorry for me. “That’s life,” he said. “None of us should ever lose sight of the fact that we were in one of the most profitable industries ever. I’m just saying it became a little less fun. And last year was no fun at all.”

•

Finally, though, Mr. Barsky felt that staying in business would mean having to operate in an investing environment that he no longer quite understood. Making macro bets about the economy was suddenly more important than individual stock picking. And that wasn’t his strength. Besides, at 51, he felt he had another act left in him, and he wanted to find out where life might take him if he were no longer in the business of running money, particularly in the arena of public policy, which fascinates him. “So,” he concluded, “giving people their money back was the best course for everyone.”

Although Mr. Barsky has clearly gotten rich, he was surprisingly clear-eyed about the societal imbalances of hedge fund mania. The industry, he told me, “was part of this huge trend towards the celebration of wealth. Hedge fund managers overearned. It just became too easy. There has been a massive misallocation of human resources. I have so many smart guys here who were making seven figures. And I think it is a fair question to ask: what would they have been doing in 1948 — going into the foreign service? If Obama does anything, the best thing he could do is change a generation’s values.”

He continued: “I have a friend whose son is a senior at Princeton. She said all his friends want to work for Goldman Sachs.” He added, “We have an overground railroad to finance. It is not the best way for a society to be run.”

One of the things that struck him when he first started working on Wall Street, he said, was “how compensation-oriented Wall Street is. When I was a journalist, I could get rewarded in 100 ways, including being on Page 1. Wall Street is the other extreme. There is a singular focus on compensation that is simple, it is clean, but ultimately it is unhealthy.” He thought the outcry over the Merrill bonuses was helping the rest of the country see Wall Street’s skewed priorities more clearly.

Earlier in his career, while still at Morgan Stanley, Mr. Barsky helped edit “Buffett: The Making of an American Capitalist,” written by his good friend, the writer Roger Lowenstein (who is also Louis Lowenstein’s son). As he talked about that experience, I asked him if he had modeled his own investing style on Warren Buffett. He let out a small chuckle.

Then he stood up and walked over to his desk, where he showed me two framed letters, one he had sent to Mr. Buffett, and the Oracle of Omaha’s reply. They were written in the fall of 2000, shortly after Viacom had spun off its Blockbuster unit. Mr. Barsky had bought the stock — and then had written to Mr. Buffett suggesting that he buy the company.

Mr. Buffett sent back a one-sentence reply: “I’ve thought about the business a lot but have never been able to come up with a conviction as to where the industry will be in 10 years.”

“Ten years!” Mr. Barsky said. “I think of myself as a long-term investor and I have a two- or three-year horizon.” He shook his head. “In addition to an outsize intellect, Buffett has something that very few investors have. He has a temperament that makes him suitable to being a great long-term investor.”

“I don’t feel a sense of defeat,” Mr. Barsky said, as I was preparing to leave. “We have done well by investors and by our employees. We comported ourselves ethically. Three months ago,” he added, “I started to read books on Buddhism. What I learned is how much of what we do is ego-driven. Why do I feel I have to be the best hedge fund manager? I started to have perspective. You probably want your hedge fund manager to eat raw meat. But as we unwind, I’m pretty comfortable with my mind-set.”

Sounds like he’s getting out just in time."

We ended up where banks couldn’t liquidate their risk, and the system tended to freeze up.

TO BE NOTED:

It can scarcely be denied that the supreme goal of all theory is to make the irreducible basic elements as simple and as few as possible without having to surrender the adequate representation of a single datum of experience.

• "On the Method of Theoretical Physics" The Herbert Spencer Lecture, delivered at Oxford (10 June 1933); also published in Philosophy of Science, Vol. 1, No. 2 (April 1934), pp. 163-169. [thanks to Dr. Techie @ www.wordorigins.org and JSTOR]
• Variants: Everything should be made as simple as possible, but no simpler.

"Questions for Myron Scholes
Crash Course

Interview by DEBORAH SOLOMON

This interview is scheduled to appear in our special issue on debt.
That doesn’t sound good to me. I’d like to have one in the love issue.

You’re known as the “intellectual father of the credit-default swap.” Do you accept that label?
Let’s see. If it’s good, yes. If not, no.

In 1997, you shared the Nobel in economics for your Black-Scholes theory. Is the name intended as a riff on the black-hole theory?
No, but a friend of mine did tell me that when he was a physicist and wanted to get a job in finance, he interviewed at a bank, and the bank asked what he was working on, and he did say, “Black holes.” And they said: “Great! You’re working on Black-Scholes? You’re hired.”

Can you define the Black-Scholes theory?
It’s an equation that prices options on common stock and provides a methodology to value options on securities generally. It can be used to measure risk and transfer risk.

In retrospect, is it fair to say that the idea that banks could manage risk was a total illusion?
What you’re saying is negative. Life is positive too. Every side of a coin has another side.

The writer Nassim Nicholas Taleb contends that instead of giving advice on managing risk, you “should be in a retirement home doing sudoku.”
If someone says to you, “Go to an old-folks’ home,” that’s kind of ridiculous, because a lot of old people are doing terrific things for society. I never tried sudoku. Maybe he spends his time doing sudoku.

Some economists believe that mathematical models like yours lulled banks into a false sense of security, and I am wondering if you have revised your ideas as a consequence.
I haven’t changed my ideas. A bank needs models to measure risk. The problem, however, is that any one bank can measure its risk, but it also has to know what the risk taken by other banks in the system happens to be at any particular moment.

What good is a theory of risk management if it applies to one tree instead of the forest?
Most of the time, your risk management works. With a systemic event such as the recent shocks following the collapse of Lehman Brothers, obviously the risk-management system of any one bank appears, after the fact, to be incomplete. We ended up where banks couldn’t liquidate their risk, and the system tended to freeze up.

Why did you retire from teaching at Stanford?
Students were getting too young.

After leaving academia, you helped found Long-Term Capital Management, a hedge fund that lost $4 billion in four months and became a symbol of ’90s-style financial failure.
Obviously, you prefer not to have lost money for investors.

What are you doing these days?
I split my time between giving talks around the world and running a hedge fund, Platinum Grove Asset Management.

Does a place or a city called Platinum Grove exist on any map?
No. One of my partners is Chinese, and he said we needed a name that had one metal in it and one wood.

When will banks resume paying 5 percent interest on savings accounts?
You’re asking me to forecast. These are macroconditions that you are asking about. Macro! We’d have to spend a lot of time setting the predicate to be able to answer that question.

It’s been said that economists cultivate complexity and resist simplicity, because there’s no money to be made if everyone understands everything.
When there is a lot of uncertainty, it takes a lot of effort to understand things. Einstein said at one time, to paraphrase it, that in all science, any model should be made as simple as possible, but no simpler.

Actually, I think that’s one of the many quotations he is likely to have never said.
So what am I supposed to say? The guy’s a schnook? He should have said it.

INTERVIEW CONDUCTED, CONDENSED AND EDITED BY DEBORAH SOLOMON"

possible abuse of inside information by hedge funds and investment banks that have delicate information about new bond offerings

TO BE NOTED: From the NY Times:

"2 Men Accused by S.E.C. in Insider Trading Case

By ZACHERY KOUWE

The Wall Street salesman sounded cryptic: “You’re listening to my silence, right?”

But those few words, spoken to a valuable client in 2006, over a recorded telephone line, have now led to a landmark case of insider trading.

Winks and nods are common currency on Wall Street, but this case, disclosed Tuesday by the Securities and Exchange Commission, is significant because it is the first to focus on the vast, murky market for credit-default swaps, considered by some to be among the most dangerous instruments of the financial crisis.

The S.E.C. claims Jon-Paul Rorech, a salesman at Deutsche Bank, tipped off a money manager at a prominent hedge fund, Millennium Partners, about a deal involving the company that controls Nielsen Media, the television ratings service. Based on that information, the money manager, Renato Negrin, then bought credit-default swaps that rose in value when the deal was made public, eventually earning him a $1.2 million profit, the S.E.C. claims.

“Rorech and Negrin checked their integrity at the door and schemed to engage in insider trading of C.D.S. to the detriment of investors and our markets,” Scott W. Friestad, the deputy director of the S.E.C.’s Division of Enforcement, said in a statement.

Mr. Rorech, 36, through his lawyer Richard M. Strassberg of the law firm Goodwin Procter, denied violating any securities laws. He has been placed on paid leave pending the results of the investigation, which the S.E.C. said was continuing.

Mr. Negrin, 45, through his lawyer, Lawrence Iason, of the law firm Morvillo, Abramowitz, Grand, Iason, Anello & Bohrer, denied receiving insider information and said he would fight the charges.

“We have a zero-tolerance policy toward insider trading and Millennium requires every employee to certify annually that they are aware of and in compliance with our policies,” said Israel Englander, the founder of Millennium, which manages $11 billion. The firm has agreed to put the profits in escrow until the case is resolved.

Deutsche Bank said it would continue to look into the matter in cooperation with the S.E.C.

According to the S.E.C., the trouble began in July 2006, when Mr. Rorech, seeking to curry favor with Mr. Negrin, an important client, alerted the money manager to a coming bond offering. The deal was to finance the leveraged buyout of VNU, the Dutch media conglomerate that controls Nielsen. Many financial companies record the telephone calls of employees, and so the conversations were picked up. The men also spoke via cellphone, the S.E.C. said.

Mr. Negrin then bought credit-default swaps — instruments that serve as insurance policies on the bonds, in the case of default — and profited when the deal was announced a week later, the S.E.C. said.

Regulators also claim that Mr. Rorech was prohibited by Deutsche Bank from soliciting trades for credit-default swaps on VNU and other companies before he called Mr. Negrin. While this is the first time credit-default swaps have been the focus of an S.E.C. insider-trading investigation, regulators have recently called for increased transparency and regulation of the market.

The case also raises questions about the possible abuse of inside information by hedge funds and investment banks that have delicate information about new bond offerings and trade credit-default swap contracts. The contracts are primarily bought and sold through private negotiations between investors instead of on a public exchange, and typically bring in hefty fees for investment banks.

The S.E.C. has been examining trades of credit-default swaps since at least 2007 after Ben S. Bernanke, the Federal Reserve chairman, urged regulators to take action to prevent abuses in the market."

an unprecedented transformation exemplified by increased regulation and a heightened risk aversion

TO BE NOTED: From AllAboutAlpha:

"The Ascendancy of Risk Management

Posted By Alpha Male On April 30, 2009 @ 8:36 pm In Today's Post | No Comments

We conclude a week covering hedge fund operations issues with a guest contribution from Abdul Sheikh, CAIA, a Vice President at State Street’s fund administration group. Sheikh makes the case that many attendees of GAIM Ops also made: that independent fund administration may be the only way to fully address investor concerns in the post-Madoff world.

Alternative Viewpoints: The Ascendancy of Risk Management

Special to AllAboutAlpha.com by: Abdul Sheikh, State Street Fund Administration

In the past years, investors used to select fund managers based on three criteria: performance, philosophy and pedigree. But in Deutsche Bank’s annual Alternative Investment Survey released last month (see [1] related post) , “risk management” entered the ranks of the top three selection criteria for the first time, and “pedigree” fell to fifth.

[2]

It’s clear that we are witnessing a paradigm shift in manager selection and asset allocation criteria. Gone are the days of just looking at attributes like track records, top down vs. bottom up approaches, low correlations to markets, and manager size. Recent events have shown that investors need transparency, independent risk analysis, and independent asset servicing.

A State Street study conducted late last year in conjunction with the 2008 Global Absolute Return Congress (see [3] related post) reinforces this - indicating that five out of six institutions (84 percent) expect more disclosure of hedge fund positions and nearly half (49 percent) anticipate more frequent reporting from hedge fund managers. Meanwhile, only a few (19 percent) currently receive some level of consistent transparency across hedge fund holdings. (See chart below from report)

[4]

Institutional investors may believe their portfolios are well diversified. However, do they really know what their concentrations are and what these concentrations mean to them? Depending on the strategy, the managers may be allowed to take on leverage, but only a thorough analysis can determine whether that leverage is accidental or deliberate (and thus beneficial to the overall portfolio). However, this kind of thorough analysis usually requires position-level transparency.

Heightened concerns over transparency and risk management are increasing demand for independent asset servicing. Functions such as securities processing, fund accounting, reconciliations, security settlement and safekeeping are no longer viewed as value-added but necessary. Many industry experts think that the Darwinian processes occurring for the past year will separate the “premier league” of funds from the others. Based on the result of the surveys above, these premier league funds will likely be distinguished by their ability to employ independent asset servicing, provide transparency and use better risk management systems.

Some of these basic asset-servicing functions have traditionally been provided by investment banks and prime brokers. But some are now calling for third party custodians who hold customer assets “off the books” in custodial accounts. Since prime brokers have much more extensive rights in client’s assets - including their ability to rehypothecate their client’s assets - some argue that they expose investors to additional risks.

Without a doubt, we are witnessing an unprecedented transformation exemplified by increased regulation and a heightened risk aversion. As cases like Madoff and Stanford have proven, regulatory oversight sometimes provides a false sense of protection. And that is why investors seem to be saying that fund-level risk management has become more important than ever.

- A. Sheikh, April 2009

The opinions expressed in this guest posting are those of the author and not necessarily those of AllAboutAlpha.com or State Street Corporation.

Editor’s Addendum: Sheikh’s State Street colleagues seem to agree with his assessment as evidenced by [5] this FT piece earlier in the week:

“‘The old system seemed to work pretty well as long as assets grew,’ says Jack Klinck, head of global investment product services at State Street. ‘But now investors are really nervous. There’s a tremendous focus on ‘who’s your counterparty?’”

“Mr Klinck expects to see a number of large US hedge funds, which have until now done all their administration in-house, outsource this function in order to reassure their clients. ‘Self-administered hedge funds are looking like outliers now. They’re having to break their operating model.’”

Finally, before the AllAboutAlpha.com corporate jet departs the Cayman Islands, we thought you might find [6] this recent Hedge Funds Review Cayman supplement to be kind of interesting:

“There is no doubt the global financial crisis and the push for tighter and more onshore regulation of hedge funds will change the industry forever. Cayman’s role in this is unclear but the government, regulator and industry are confident they have the skills and will to keep the jurisdiction as the number one domicile.”

---

Article printed from AllAboutAlpha.com: http://allaboutalpha.com/blog

The shift leaves US pension funds as the hedge fund stalwarts.

TO BE NOTED: From the FT:

"Europe’s rich rush for hedge fund exits

By Deborah Brewster in New York

Published: April 19 2009 23:31 | Last updated: April 19 2009 23:31

Rich Europeans, who were the first to invest in hedge funds and once comprised the majority of investors, have been the first to exit in the downturn, according to a study out Monday.

High net worth individuals last year accounted for 80 per cent – or more than $500bn – of hedge fund redemptions, though they only held two-thirds of the assets. The outflows were disproportionately European, the study by the Bank of New York Mellon and Casey Quirk, a research firm, said.

“The result is not only a smaller industry, but a capital base that is more institutional and more North American,” the study said.

The shift leaves US pension funds as the hedge fund stalwarts. They are likely to account for the single largest source of new capital in the next four years. Pension funds put net new money into hedge funds last year and plan to put more in again this year, according to the study based on a survey of 158 investors and industry members.

Individual investors’ share of hedge fund assets has dropped from 67 per cent in 2005 to 57 per cent at the end of last year.

“Future flows from European high net worth investors are highly sensitive to future returns and represent the greatest source of volatility,” the study said. “Asian high net worth investors also account for a very high redemption rate, in excess of 30 per cent, though the absolute outflow in dollars is smaller than those recorded in the larger European and North American high net worth markets. The widespread use of structured notes with automatic redemption triggers in the Asian and European markets drove these outflows.”

Institutional investors led by Calpers and the Utah state pension fund have begun pushing for fee reductions and trying to renegotiate terms as they review commitments to the asset class.

Copyright The Financial Times Limited 2009"

sound risk management policy should compliment any accounting methodology in place and not be driven by it

TO BE NOTED: From Due diligence and operational risk in hedge funds :

"What happened to FAS 157 for hedge funds?

APRIL 15, 2009

FAS 157 (aka: the fair-value measurement standard) is an accounting standard which first took effect in November 2007. According to the Financial Accounting Standards Board (FASB), FAS 157 “…defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements.”

FAS 157 has a number of ramification outside the hedge fund industry. As an example, here is a recent video examining the effects on banks of relaxing mark-to-market accounting rules.

FAS 157 was a big deal when it was first put into effect. For hedge fund’s (and their auditors) FAS 157 presented a number of unique due diligence challenges. Specifically, the original incarnation of FAS 157 requires hedge funds, in their audited financial statements, to classify assets into one of three levels. The levels are supposed to show indicate to investors the amount of certainty with which they can value an asset.

Level 1 - Assets with readily observable market prices. Inputs for the assets in this level are quoted prices (unadjusted) in active markets.

Level 2 - Assets with no readily observable prices but they have inputs that are based on them. An example of this would be an interest-rate swap whose components are observable points - such as a Treasury bond.

Level 3 - Assets where one or more of those inputs does not have readily observable prices. Level 3 is the most controversial Level.

There is a general perception that investors place a premium on liquidity and that for the vast majority of hedge fund situations the more liquid (i.e. - Level 1) the better. As such, the natural progression of FAS 157 led to a struggle between hedge funds and auditors in the way their assets would be presented to investors.

When FAS 157 first was announced many hedge funds (and their auditors) were unsure which FAS 157 Level certain assets should be classified. It seemed some hedge funds/auditors were set to error on the side of caution. Others seemed more open to assuaging their hedge fund client’s vocal objections to the classification of certain assets.

Some people in the private equity world have classified FAS 157 as “stupid.” The SEC’s former Chief Accountant Lynn Turner, has given FASB a failing ‘F’ grade.

(Others have raised questions about which FAS 157 assets should be classified in when they have no value (such as toxic assets). In light of the recent economic environment it seems that change is in the air to reform FAS 157. In recent Congressional testimony a number of big names (Ben Bernanke, Sheila Bair, Tim Geitner, Mary Schapiro) have suggested reforming FAS 157 (aka: Mark-to-Market) and Fair Value accounting.

Even FASB has acknowledged that FAS 157 needs some work and since issued three final Staff Positions (FSPs) intended to provide additional application guidance and enhance disclosures regarding fair value measurements and impairments of securities - which is accounting speak for clarify what we should have made clear the first time. Maybe FASB should read some this book before making anymore recommendations.

Specifically, the three groups of FSPs are:

1) FSP FAS 157-4 (the exciting sequel to FAS 157-3)- Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly

2) FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments

3) FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments

“The issuance of these final FSPs follows a period of intensive and extensive efforts by the FASB to gather input on our proposed guidance,” states FASB Chairman Robert H. Herz.

Thanks for all your hard work.

So let me get this straight - FASB puts out a rule which confuses everyone and provides little guidance on how to use it. Then works really hard to clarify it while hedge fund’s, investors and auditors twist in the wind in the interim. Why wasn’t all of this work put into gathering input gathered done beforehand? The FSPs are expected to be voted on later this week.

Some have blamed mark-to-market accounting as fueling some of the problems with the economy. Others have claimed there is nothing wrong with the rules but rather other issues such as over leverage should be blamed. FAS 157 is nothing more than a classification system. On face value it will do nothing to effect the actual underlying assets held by a hedge fund manager. It raises a number of issues related to judgment of hedge fund managers and their auditors. It is unclear if different auditors would classify certain assets into levels uniformly.

Hopefully, the new guidance from FASB will remove some of the judgment and discretion for the FAS 157 classification process. At the end of the day I question whether mark-to-market accounting really deserves all the criticism it has received. While there are good arguments on both sides, certainly a sound risk management policy should compliment any accounting methodology in place and not, as it seems had been the case with many hedge funds, be driven by it."

Regulations get gamed. Behaviorally, long term I would trust a lightly regulated system with nervous diligent actors

TO BE NOTED: From Designing Better Futures:

"A visit to the Kingdom Hedge fund contemporenae c. 2009 with Deutsche Bank

Talking about hedge funds collectively is like talking about living things in aggregate. To use a biological metaphor equivelant to the Linnaean system: Asset classes are equivalent to Kingdoms in the Taxonomic world.
One hedge fund is like an "animal" to a degree, unfortunately most commentators on "hedge funds" neglect to see or understand the subtle distinctions between say, a great whale and the common garden slug. As a reader of this blog you of course appreciate such hard to notice subtleties and appreciate that Convertible arbitrage, high frequency forex algo and private equity investments may have subtle distinctions and nuances not quite appreciated by the general media when they utter the term, hedge fund.

With those caveats in mind, let us consider the scope of the Kingdom Hedge fund contemporenae as reported in in the 2009 Alternative asset report courtesy of the Teutonically cheerful Deutsche Bank.

Firstly we notice the purchasers of hedge funds are looking for diversification before absolute returns. As an anthropologist, I would suggest considering, not only the responses in this survey but also the context and time in which they were asked.

Few managers receive a bonus based on a correlation co-efficient, thus stated intention and actual motivations or actions may differ when viewing these survey results. The survey was conducted with over 1,000 professional hedge fund investors, family offices, Fund of funds, pension offices and other sordid types charged with protecting nest eggs, outperforming benchmarks and capturing the bonus brass ring at the end of the year.

The collective hedge fund investors anticipate money flows out of the Kingdom over $100billion, but who knows about the collective actions of the group:

Should you be running a hedge fund or considering it, the size requirements are growing. The allocators like to see $100m or more $100m these days, which is probably a function of wishing to get a feeling of fund operational and platform stability. A surprising number of funds close due to back-office and operational errors, so run a tight ship, there is more to it than buy low and sell high.

This is no time as a manager to be bashful, the fashion these days is transparency, open the kimono.

Allocators buy a long term process, the more they understand the process and what drives it, the more comfort they have. The allocator doesn't have a CYA position if a black box bounces. The allocator needs the CYA for his/her risk committee, give it to them, explain or show what the process they are buying is. The more it is a process and less a person or some abtruse mathematical arcana the better (Rennaissance excepted of course).

Post Madoff a surprising number of people like to see their money, managed accounts are coming into vogue and probably a few more peaks at the books for the PE and CLO funds.

Bets are being made on Global macro. and commodities. That says something about faith or lack thereof in the Dollar and the desire for thinking globally and flexibly. The interest in credit and distressed credit is an interesting countercyclical bet on things turning about soon, a bit too early for my taste, but every dog has his day.

It was a rough year for the Kingdom Hedge fund as most were down, not as down as the equity benchmarks, but down enough to make that 2% management fee a bit awkward to justify. Expect to hear a lot of harumphing and blather about non-correlation and relative return from the 2/20 crowd.

And now for a happy chart to make everyone feel more intelligent and deserving. Performance over the MSCI was promising over the last 10 years. It is probably best not to bring up the bond market returns at this point in the discussion as it could be a bit awkward.

Most are expecting good things in the Kingdom Hedge fundus next year with returns of 10-15%, with a 2:20 structure and the 2008 -18% average return, funds should be back to break even by 2010-11 assuming it all works out. Ah you can practically smell the return of the performance bonus in the air, please don't discuss siegels paradox for those funds 25% below the high water mark, the date of return to performance bonus can starts to feel Jetsons like.

If you manage a merger arb or event drived fund look out, the shrink ray is pointed directly at you.

On the political front, if the money flows are correct and Eastern Europe and Russia are challenged it could get rough. If you live in Germany stock up on Natural gas and jaegermeister to keep warm next winter, everyone knows how Russia has "technical difficulties" with the gas lines when it comes time to renegotiate the gas prices. Eastern Europe's fondness for Swiss Franc denominated mortgages isn't working out so well and the political situation is sadly deteriorating, being filled by an angry far right looking to the past for answers. This is not good for anyone.

If you are an allocator who got stuck with a lock up and want out, a surprising number of fund of funds will take your position off of your hands. You were nice to your fellow allocators weren't you? Humility, ethics & civil behavior are some of the great long term investments one can make in life.

Of course the price for fund liquidity may leave a mild burning sensation in your wallet, funny how those things like "liquidity" never show up in mean-variance and allocation models. It is always important to identify the "oxygen" in a business process, ie. what are we taking for granted but that we will miss a lot if it disappears. Most forms of Oxygen are hidden risk in plain site and fall outside most math models.

Most of the allocators have only been at this game for 7-9 years, that is a youngish industry that was "hot" in the last 5-6 years. Expect the "cool kids" to move on to the next big thing. I started building trading models and studying hedge funds in 1990 in central Iowa, tough to get less cool than that.

I look forward to being surrounded by people who appreciate the responsibility of acting as stewards of other people's funds and trust rather than just banging out the bonus for themselves. Alternative Asset allocation has an important social function, the bonuses should be an externality of that function, not the other way around.

In human behavior and society the optimal size of human relationships and organization is roughly 150 members and referred to as the Dunbar number.

In allocator land the equivalent is 50 relationships which is too high in my mind as the trade off of knowing something about a thing and knowing nothing about many things appears in action at this level. Purely mathematically and even from a regime change perspective one would assume diminishing returns after 15 allocations, but c'est la vie' de l'allocator.

If you are starting out a fund, expect the initial allocation or toe in the water to be $3-5million.

If you are in the business of replication such as an alphaclone type service or someone using a Principal Component Analysis approach, the hedge fund replicator space is big enough to be interesting at 7% which at a $1.5 trillion industry estimate equates to $105Billion.

Given the drive for transparency and desire for non-correlation, this sector should grow albeit with lower fees. Having developed transparent active indexes for Forex and commodity strategies in the past, I find this an interesting space, if you work with an institution interested in collaboration lets talk.

The industry perceives its challenges as monitoring and managing risk. An index product with a managed account structure could provide a useful solution for allocators looking to buy exposure to a process and not just a "manager" lottery ticket.

Transparency probably speeds the sales cycle for a fund manager. The due diligence process is 3-6 months, but the sales cycle from first contact to close is probably closer to 12-18 months.

When I had hair and was a runner in the 10 year t-bond options pit, a friend asked which commodity was the most valuable on the floor. I immediately replied, it wasn't traded on the floor., it was trust. Trust, is a commodity behavior and relationship that takes time and patience to establish. It is consistency of behavior and actions matching promises. The fund game isn't a get rich quick overnight business and it shouldn't be, it is too important.

In regards to trust, the following chart shows 5-10 full fund redemptions from allocators. With roughly 50 allocations on average per allocator this equates to 10-20% annual turnover, not exactly a high trust business. Allocators under perform the hedge funds they invest in just like retail mutual fund investors. Investor "sophistication" isn't a subset of human behavioral traits.

Allocators invest in a process and need to believe and understand that process in order to weather the storm, transparency increases trust and ultimately fund sustainability. It should be noted that few hedge funds survive the retirement or demise of their founder. It is early in the industry, but as a young industry many of these vehicles aren't built to last a process based index or replicator factory could be.

For all the media hype about Madoff and the perceived evils of hedge funds, they didn't get to too leveraged as an industry (the LTCM boneheads being an exception). Heavily regulated and rated industries such as banks and mortgage monopolies like Fanny and Freddie are another story.

By the way didn't Fanny and Freddie by definition crowd out the local lending green shoots in your hometown years ago, not sure more govt monopolies and regulation make things better. Regulation often provides the appearance of safety allowing the dim or lazy to suspend suspicion and proper due diligence. Regulations get gamed. Behaviorally, long term I would trust a lightly regulated system with nervous diligent actors, than buffoons substituting a regulator or rater's stamp of approval for common sense and wariness.

The average lock-up is 1-3 years which works for some members of the Kingdom Hedge fundus, but not all of them. Hopefully those on the buying and selling end of illiquid assets like PE, CLO's etc. will look into the listed funds business and hopefully the US will offer a sensible regulatory environment for it similar to various European regimes.

If you are managing a group and looking for allocations the magic number is still between $50-100m. A good transparent index might be able to make a go of this or structure itself as an ETF. This cheap alpha if you will may not be at at the top of the Hedge fund Kingdom food chain in terms of performance, but an allocator gets transparency, liquidity and comfort in the process they are buying.

The duration of these processes should also outlast their creators, just like good index funds. Consider the S&P index as such a treatment for what was once considered exotic, namely equities in the 50's. Don't make me bring up the mean monkeys again :)

Now here is something interesting, many allocators indicate they don't need a track record, otherwise it is 1-2 years, not sure what to make of that.

And finally my favorite issue risk. Years ago I testified before the US senate in conjunction with the CIA, World Bank and State Dept. about international banking settlement risk, it has always been a favorite topic of mine. Most allocators indicate risk aversion above a 20% drawdown mark which probably again depends heavily on the fund type.

Buffet has 50% drawdowns, but it worked out OK. Drawdown has a high correlation with Vol, so consider your leverage or exposures accordingly. Swinging for the fences may give you an 80% year, but that 40-50% drawdown might keep the AUM at $50m and volatility plays to Siegels paradox in many types of systematic "non-value" type investments making it very tough to recover.

I would like to mention an "oxygen" type risk that many managers and allocators should be aware of, namely inflation. I wrote about it here. Last night, I sat at the Harvard Field club in Greenwich listening to a presentation to the Connecticut Hedge Fund assocation. The mood was anxious and a thick choking fog of inflation fear was in the air and the Fed acronym machine is redlining, with each new iteration of alphabet soup bailout program tacked to another multi hundred billion dollar figure.

To paraphrase Casablanca, Maybe not today and maybe not tomorrow, but sometime and someday inflation will loom... If you run a fund or FoF's and can think beyond the next quarter, run some regressions on your allocations and approaches with respect to an inflation proxy, don't just rely on the flaky CPI, that thing has been massaged more than Eliot Spitzer.

Low inflation is the oxygen we have all been taking for granted. Today's hot selling Non-correlated 15% returns could rapidly fall out of favor if they don't have a positive correlation with inflation. Remember your game as an allocator and steward of people's money is delivering a long term absolute wealth maximization process."

This is often blamed on a “flight to liquidity” that can have a similar effect across different strategies.

TO BE NOTED: From All About Alpha:

"Study sheds light on mechanics behind “herding” in equity markets

Apr 15th, 2009 | Filed under: Today's Post

A new academic study examines how equity betas jump with the release of earnings announcements. It seems that, as in the hedge fund industry, a dearth of information in equity markets can lead to an over-reaction when news is finally released - even if that news is about a competitor.

It’s a widely-accepted axiom that “correlations go to one” in times of distress. In volatile periods like August 2007 and October 2008, hedge funds using seemingly disparate, unrelated strategies, tend to exhibit strikingly similar performance. This is often blamed on a “flight to liquidity” that can have a similar effect across different strategies. At its heart, such a run for the exits is usually precipitated by investors who extrapolate specific occurrences (e.g. a fund collapsing) across the entire industry. In fairness, this may be a good bet. After all, what affects one fund is bound to affect other funds operating with similar strategies.

A new study by academics at Oxford University and the London School of Economics shed some light on this phenomenon. Michael Patton and Michela Veradero find that individual stocks also experience an increase in correlation with their peers when they announce any news.

This makes intuitive sense. When a company announces news such as earnings, information-starved investors are likely to jump on that as an indication of industry conditions. As a result, the fortunes of competitors, suppliers and other industry participants respond accordingly.

They divide the beta of individual securities into its two components: relative volatility and covariance. While volatility relative to the market is bound to change when news is announced, they find that the lion’s share (80%) of any change in beta can be attributed to a pop in the covariance.

As the authors put it:

“The intuition behind the model is simple, and is based on three realistic assumptions of the news environment and the firm’s stock prices: Firstly, some portion of the earnings of a given firm reflects wider macroeconomic conditions. Secondly, investors use many sources of information to update their expectations about future earnings, not merely news from a single firm. Thirdly, firms only announce their earnings infrequently (e.g., quarterly). In such an environment, investors are able to update their expectations about a firm’s profitability quite accurately when the firm announces its earnings, while in between earnings announcement dates they update their expectations using other pieces of information available to them, such as the announcements of other firms. As an individual firm’s earnings figures contain some information on the wider macro-economy, good (bad) news for one firm represents partial good (bad) news for other firms, and investors update their expectations accordingly. Thus on an announcement date the covariance of the announcing firm’s return with other firm’s returns goes up (regardless of whether the earnings news is good or bad), which also increases its beta with the market portfolio.”

So investors glean precious information from the news surrounding other companies. As you might expect, the propensity to jump on any hard news - no matter where it comes from - is highest in industries where there is a shortage of valuation data points.

For example, the Patton and Veradero find that technology companies tend to exhibit a higher pop in beta around news events than pharmaceutical companies:

Since hedge funds don’t (generally) trade as securities, they have no “price” per se. As a result, the market is only able to place a value on a hedge fund with increased or decreased asset flows. When news regarding one particular hedge fund is announced, adjacent funds may be more likely to experience inflows or outflows. Granted, this is a much slower process. But, like price, quantity also reflects underlying demand.

In other words, while the “herd mentality” shows itself in higher (or lower) prices for securities, it reveals itself in the hedge fund world as higher (or lower) asset flows.

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solely AIG’s CDSes written on structured mortgage-related securities held by banks that led to the collateral calls

TO BE NOTED: From Moneywatch:

"Regulate the Relationships, Not the Institutions and Instruments

By Houman Shadab | Apr 13, 2009 | 0 Comments

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As almost everyone knows now, the financial world experienced a major earthquake when mortgage-backed securities and other types of structured debt crashed and took down with them or badly damaged the world’s largest and most important financial institutions. The earthquake came from banks and insurance companies using the lightly regulated off-balance sheet entities and non-exchange traded financial instruments they controlled and subsidized to take on excessive risks. The result was the creation of large, fragile institutions unable to withstand the nationwide downturn in housing prices.

Yet not all lightly regulated companies and instruments pose the same risks. Hedge funds, for example, did not pose excessive risks to the banks they traded with, and the vast majority of credit default swap derivatives were not written on troubled structured securities. These hedge funds and CDSes did not cause the collapse of financial institutions, but because of their potential to be misused, new rules should ensure that regulated companies use them safely.

Bank regulators should continue to and even increase monitoring of banks’ exposure to hedge funds to guard against the potential that banks may lend too much money to hedge funds or be overexposed to the funds as derivatives counterparties. Regulators should also consider limiting the ability of banks to sponsor and manage their own internal hedge funds to guard against depositors’ money being put at risk. What they should not be doing is adding to the regulations that already apply to hedge funds.

The deeper problems

Hedge funds and CDSes did not themselves create unmanageable risks. As I noted in my testimony before Congress last November, and as likewise recognized by several New York University financial economists, hedge funds did not initiate the financial crisis. Hedge funds have felt and will continue to feel major pain as a result of the crisis, but their lack of direct involvement in the financial crisis suggests that they’re already properly regulated as private investment companies and well governed as limited partnerships. This is reflected in the fact that hedge funds’ average use of leverage in recent years was an estimated 3.9 to 1 and was decreasing before the shakeout in the second half of 2008, whereas major U.S. investment banks kept increasing their leverage which ranged from 20 to 1 to as high as 33 to 1 (see this SEC Report, Appendix IX).

The main problem with CDSes, which allow any party to sell protection against credit risks that the buyer may be exposed to, was that they allowed banks and insurance companies to concentrate too much mortgage-backed security risk in their portfolios. Unmanageable losses from CDSes reflected but did not create the deeper problems in the structured securities owned by banks and the failure of private parties and regulators to diligently supervise that risk.

It was solely AIG’s CDSes written on structured mortgage-related securities held by banks that led to the collateral calls ruinous to AIG and the federal bailout this past September, for example. Those CDSes made up only about 10 percent of AIG’s total CDS obligations at the beginning of 2008. But the Office of Thrift Supervision, which oversaw AIG, failed to prevent the company’s subsidiary from selling too many CDSes. To best prevent the over-concentration of CDS risk of the type that occurred with bond issuers and AIG, regulation should seek to limit the use of CDSes when sold by insurance companies or their unregulated subsidiaries and affiliates.

It would be a mistake to interpret the financial crisis as having shown that there is a simple relationship between risk and regulation. There is not. The task for policymakers is to make sure that sectors of the economy subject to different types of regulation have healthy relationships and creating a system where private risk management is encouraged and not taken for granted."

a type of special purpose vehicle – in which hedge funds can take stakes. These SPVs can then borrow money from the Fed

TO BE NOTED: From the FT:

"Hedge funds seek loopholes in Talf rules

By Aline van Duyn and Michael Mackenzie in New York

Published: April 7 2009 17:08 | Last updated: April 7 2009 17:08

Fund managers were reluctant to take part in the Federal Reserve’s programme to boost consumer lending on Tuesday, as the scheme entered its second round.

The $1,000bn effort at restoring lending in the asset-backed securities market saw demand for loans fall to $1.7bn from $4.7bn, despite the list of eligible securities being expanded for the April round.

The $1.7bn total demand for loans under the term asset-backed securities loan facility (Talf) was split between loans for securities backed by auto loans and loans for credit card asset-backed securities. It is designed to enable investors to seek financing using new bonds backed by auto loans and credit card debt as collateral.

Analysts said the programme was being overwhelmed by investor concerns over restrictions linked to receiving government subsidies, suggesting a near-term recovery in the securitised markets remains distant.

“The unwillingness of private investors to take part either reflects early teething problems or suggests that the Fed will need to find other ways of injecting liquidity into the economy, perhaps via expanded Treasury bond purchases,” said analysts at UBS.

Low issuance and tepid demand for loans under the Talf comes at a time when some investors are seeking ways to circumvent restrictions on hiring skilled foreign workers.

Some hedge funds and private equity investors have balked at borrowing money from the Fed amid concerns it could subject them to scrutiny. The paperwork that accompanies Talf funding is another sticking point.

This comes in spite of the potential returns on some of the securities available under the Talf reaching over 30 per cent in some cases.

By offering cheap loans, the Fed can allow hedge funds to boost the returns available on low-risk securities backed by auto loans and credit card receivables. By buying these securities, banks can take the loans off their balance sheets and make room for fresh lending.

However, authorisation for the Talf is granted through the US’s recent stimulus bill. Inserted in an effort to boost jobs for US employees, the stimulus bill imposes restrictions on recipients of funds on the number of foreign workers that can be employed using H1B visas. The restrictions also apply to investors borrowing money from the Talf.

Lawyers are working on setting up legal entities – a type of special purpose vehicle – in which hedge funds can take stakes. These SPVs can then borrow money from the Fed.

Lawyers said they were unsure whether such SPVs would avoid H1B visa restrictions.

Lawyers are working on setting up SPVs through which hedge funds could invest as a way to avoid scrutiny and wading through documents which accompany the Talf deals."

Maybe the hedgies are finally realizing that the only thing worse than too much regulation is too little.

From Reuters:

"When hedge funds embrace regulation

Post a comment (1)

Posted by: Felix Salmon

Tags: hedge funds, regulation

Paul Singer, the ardent Bush supporter and laissez-faire capitalist who runs the $13 billion Elliott Associates hedge fund, has an astonishing op-ed in today’s WSJ:

Now we must create a new regulatory infrastructure that will meet three fundamental tests… finally, it must bring all investors and traders — regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual or government agency — under the regulatory umbrella…
I understand the inclination among free-market conservatives to dismiss the government’s regulatory efforts as misguided. Some government actions over the past year have been reactive and incomplete. Yet these actions have been large and reasonably fast, which were the critical elements for the survival of the system.

The op-ed comes in the wake of the G20 meeting which agreed that hedge funds should be regulated, so maybe Singer is simply bowing to reality here. But this is still something of a watershed moment. Singer is one of the most politically astute hedge-fund managers in America, and where he goes the rest of the industry is probably likely to follow.
So if you thought there would be a lot of pushback from the hedge-fund industry against proposals to regulate it, think again. The industry will want a say in how any legislation is worded, of course. But it has also lost hundreds of billions of dollars over the past couple of years as a result of insufficient regulation of the global financial system. Maybe the hedgies are finally realizing that the only thing worse than too much regulation is too little."

Me:

It’s an excellent post:

“But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.”

Bingo!

“Government action could easily spill over into gross over-reach (like the bonus-tax fiasco). But a combination of private responsibility and practical government regulation will help ensure that the capitalist system continues to be a source of opportunity and prosperity for people throughout the world.”

Can you say “libertarian Democrat”?

Here’s a comment from long ago:

“Saturday, October 4, 2008
The Path To Re-Regulation
Gross on regulation resulting from this crisis:

“In the meantime, a surge in regulation of the financial sector will be unleashed, probably an inevitable result of the problems and rescues of recent months.

“Twelve to 24 months down the road, all of these high-flying investment banks and banks will be reregulated and downsized,” Mr. Gross said. “They won’t become arms of the government, but they will be supervised and held on a tight leash.”

The greater regulation should draw investors back to the market and away from what seems to be their current financial strategy — stuffing their cash in mattresses.”

One of the probable downsides of a crisis like this is the problem of over-regulation resulting, which is why I favor enough regulation to keep this kind of crisis from occurring. However, as even Gross admits, some regulation is necessary for investors to re-enter the market. Let’s hope we strike a better balance this time.”

In other words, you actually need regulation in order to:
1) Get people investing again
2) Get people to buy into our system at all

I also agree here:

“Reform must begin with a regulatory regime focused on “behavior” instead of “systemically important institutions.” Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.”

Choose Human Agency Explanations over Mechanistic ones if you want to do some real good.

Finally, congratulations on your new venue. Reuters is terrific. For one thing, they had some of the earliest reporting on the possible social disruptions and dislocations in this crisis.

As well, their page on African news is the best I’ve found. Try it:

http://af.reuters.com/

- Posted by Don the libertarian Democrat

From the WSJ:

"By PAUL SINGER

President Barack Obama took his proposed financial regulatory reforms to London this week for the G-20 meeting, while free-market advocates objected. While many of Mr. Obama's ideas warrant skepticism, conservative opposition to any expanded role for government is a mistake. There is an urgent need for a new global regulatory initiative that addresses the primary cause of the financial collapse: highly leveraged and concentrated positions.

Reform must begin with a regulatory regime focused on "behavior" instead of "systemically important institutions." Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.

It's true that monetary policy was too lax for too long, and the government encouraged lending to people who were unlikely to repay their loans. But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.

In the past decade, most global financial institutions built highly leveraged balance sheets -- sometimes as high as 30 to 1 -- that were stuffed with risky assets. These institutions also bought on a large scale for their own accounts the same securities they sold to their customers. Our anachronistic regulatory framework didn't catch the problems, and warped incentives and compensation schemes fueled the risk-control failures that eventually brought on the crisis we face today.

Now we must create a new regulatory infrastructure that will meet three fundamental tests. First, it must assess and measure risks accurately, including the compounded risks of herding (traders being similarly situated and forced to unwind simultaneously). Second, it must impose significant margin requirements on all exposures. And finally, it must bring all investors and traders -- regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual or government agency -- under the regulatory umbrella. These three measures will diminish volatility and reduce the likelihood of a future financial collapse.

Creating a regulatory system that reflects the modern-day realities of financial markets is not as difficult as it may appear. The financial structures that destabilized our markets have definable characteristics. They are either long or short (and have a particular exposure to) the movement of an underlying asset, index, or instrument (such as a tranche of mortgage-backed security).

It is critical that any new regulatory initiative have a global mandate and contain mechanisms to prevent "risk infection" by countries that try to dodge risk controls. There are legitimate concerns about the time needed to devise a global risk-management system and staff it with individuals with the requisite sophistication and experience. But there are relatively simple solutions.

First, the government can hire private firms to assist in assessing risks posed by complicated financial instruments. Despite the failure of financial CEOs to understand the wizardry invented by their own "rocket scientists," there are independent firms such as Duff & Phelps that can make sense of these products and serve as objective advisers.

Second, interim steps can be adopted to immediately rein in leverage and risk, such as increasing margin requirements for certain types of instruments. For example, in order to initiate credit default swaps, all parties (including dealers, who currently put up little or nothing) should be required to post deposits or reserves of at least 15%, if hedged against a credit instrument of the same company, and 30% otherwise.

And, given that there are many long-standing programs of position reporting, it would not be revolutionary to implement globally-enforced reporting for large positions related to equities, real estate, currencies, commodities and interest rates. But this would only be effective if these positions were accurately analyzed in terms of their exposure to the movement of the underlying reference assets, regardless of the form of the positions or existing regulatory coverage.

I understand the inclination among free-market conservatives to dismiss the government's regulatory efforts as misguided. Some government actions over the past year have been reactive and incomplete. Yet these actions have been large and reasonably fast, which were the critical elements for the survival of the system.

Government action could easily spill over into gross over-reach (like the bonus-tax fiasco). But a combination of private responsibility and practical government regulation will help ensure that the capitalist system continues to be a source of opportunity and prosperity for people throughout the world.

Mr. Singer, founder and CEO of Elliott Management Corp., is chairman of the Manhattan Institute and on the board of Commentary magazine."

"Hedge funds know how to trade toxic assets, and that expertise is helpful right now."

TO BE NOTED: From Business Week:

"Hedge funds stand to gain, but also face oversight

By STEVENSON JACOBS

Hedge funds are being offered a sweet deal to help the Obama administration rescue the U.S. banking system: A low-risk opportunity to scoop up soured bank assets that could one day make them a killing.

But the deal could make for an uneasy partnership.

The government also wants to closely police hedge funds, some of which have been accused of placing irresponsible bets that helped trigger the financial crisis. Such regulatory overhaul could reshape an industry known for secrecy and little oversight.

"It's certainly problematic because we don't know where the current political fervor is going to end up," said Kjerstin Hatch, portfolio manager for Madison Capital Management, a $550 million hedge fund specializing in distressed assets.

Several big investors have already voiced interest in joining the administration's effort to buy up banks' bad assets. That task is considered crucial to propping up teetering banks, restarting lending and ending the recession.

But with anti-Wall Street critics seething in Washington and elsewhere, Hatch and other hedge fund managers say they want assurances that they won't be hit with heavy-handed restrictions if they were to take part in the bank-rescue plan.

"You don't want to paint a bulls-eye on your back," said Steven Persky, managing partner of Dalton Investments, a Los Angeles hedge fund that's already invested $400 million in toxic mortgage-backed assets. He wants more details on the government's plan.

"The potential returns are attractive, but you have to be aware, more than ever, about the regulatory risks," he added.

Hedge fund insiders expect the reforms to be the most sweeping since the high-flying and thinly regulated industry's birth two decades ago.

"The era of lack of regulation for hedge funds is over," said Sol Waksman, founder and president of Barclay Hedge Ltd., a firm based in Fairfield, Iowa, that tracks and invests in hedge funds. "The question is how intrusive will the new rules be."

Strict rules would be a new experience for hedge funds, which are large investment pools that cater mainly to the rich. They've long toiled in Wall Street's Wild West.

With high-tech trading models and a gambler's instinct, hedge funds have generated outsized paydays that dwarf those of other investment funds. They've also swelled the ranks of the world's billionaires, making stars out of top fund managers including John Paulson and George Soros.

Unlike mutual and money market funds, hedge funds don't have to register with the Securities and Exchange Commission. That means they don't have to disclose such details as who runs the fund, how much money they manage and what securities they buy.

Hedge funds have fended off past attempts to regulate them. They sued, for example, to overturn an SEC push to register them in 2005. Today, hedge funds are barred only from advertising or courting investors worth less than $1 million or a yearly income of $300,000.

"Basically, nobody regulates hedge funds today," said Nadia Papagiannis, a hedge fund analyst at research firm Morningstar.

That seems sure to change.

The Obama administration is pushing the idea of a regulator-in-chief. That role might be given to the Federal Reserve -- to oversee and, if necessary, take over nonbank financial entities like hedge funds and private equity groups whose failure could upend the U.S. banking system.

Treasury Secretary Timothy Geithner, who is expected to detail the overhaul plan soon, last week urged Congress to enact legislation that would give the government sweeping oversight power.

"One of the key lessons of the current crisis is that destabilizing dangers can come from financial institutions beyond banks, but our current regulatory system provides few ways to deal with these risks," Geithner said during a speech in New York.

The push for reforms coincides with the administration's revamped financial rescue plan. It seeks to entice hedge funds and other investors to buy banks' toxic assets so they'll start lending again.

The plan uses cheap government financing to offer would-be buyers of toxic assets the potential for juicy double-digit returns. Taxpayers are left to shoulder most of the risk.

Hedge funds could sure use the business. A record 1,471 hedge funds -- or nearly 15 percent of the industry -- closed in 2008, with half of them vanishing in the fourth quarter alone, according to Hedge Fund Research. The average hedge fund lost 18 percent last year.

But not all hedge funds fared poorly.

The top 25 highest-earning hedge fund managers got paychecks totaling $11.6 billion last year, industry magazine Alpha announced last Wednesday. The top spot went to James Simon, who took home a cool $2.5 billion.

Some worry that onerous government regulation could bring an end to the good times.

Critics of hedge funds have called for tighter rules on everything from how much the funds should be allowed to borrow, to what kind of securities they can trade and what information they must disclose publicly.

Such reforms are designed to tame what some see as hedge funds' gorilla-sized influence on financial markets. Last year, hedge funds were blamed for causing huge gyrations in the stock market and oil's record run above $140 a barrel.

The hedge fund industry says there's no evidence to support such claims.

"We want to dispel, once and for all, this misconception that the hedge fund industry is opaque and uncooperative," Andrew Baker, chief executive of Alternative Investment Management Association, a hedge fund lobby group, said in a statement.

His group pledged to support calls for more hedge fund transparency. But it hasn't endorsed more stringent reforms sought by some investors.

Many argue that fees charged by hedge funds are out of whack and should be changed. Hedge funds typically charge investors a management fee equal to 2 percent of their assets and a performance fee equal to 20 percent of profits. That's several times the fees charged by mutual funds and most other investment firms.

That fee structure, critics say, disproportionately rewards hedge fund managers in good times while disproportionately hurting their investors in bad times, such as last year's market crash.

"The incentives are completely misaligned," Morningstar's Papagiannis said.

Others caution against over-regulating the industry, saying it could backfire and undercut the government's financial rescue plan.

"You don't want irrational regulation," said Thomas Donaldson, professor of legal studies and business ethics at the Wharton School of the University of Pennsylvania. "Hedge funds know how to trade toxic assets, and that expertise is helpful right now."

"I'm still not telling taxi drivers that I work in the hedge fund industry. Give it a couple more days and I might."

TO BE NOTED: From Reuters:

"Unloved hedge funds battle public anger

Thu Mar 26, 2009 1:45pm EDT

By Olesya Dmitracova

LONDON (Reuters) - The secretive hedge fund industry is battling to dispel public "hysteria" over its role in the global financial crisis and faces an uphill struggle to mend its battered image.

Criticism of hedge funds has got louder in recent months stoked by controversy over the profits made from short-selling bank stocks and the largest investment fraud in Wall Street's history, committed by money manager Bernard Madoff.

Last year the industry delivered its worst performance, with the average portfolio losing 19 percent.

"There is hysteria about hedge funds, with hedge funds being the fountain of all bad things," Hugh Hendry, chief executive of Eclectica Asset Management, told the Reuters Hedge Funds and Private Equity Summit in London this week.

Because of the investment techniques hedge funds share with other firms, they have been unfairly associated with the financial industry's pariahs such as Madoff and troubled U.S. insurer AIG (AIG.N: Quote, Profile, Research, Stock Buzz), said Andrew Baker, the head of the Alternative Investment Management Association (AIMA), a global hedge fund trade body.

"When the last hedge fund is closed ... those issues will still persist because they are not part of the hedge fund universe," he said, adding this is the message AIMA has been "pushing very hard ... in policy-making circles."

Hedge fund executives admitted they had to take part of the blame for their poor public perception.

"The industry has done itself no favors. The large majority of people haven't performed that well. One or two have performed really very, very poorly," said Mark Kary, chief executive of Polar Capital.

The funds' reluctance to talk to the media didn't help their image either, speakers at the summit said.

"Hedge funds are by and large rich and British and therefore kind of confused about being rich and kind of apologetic about being rich and they don't talk," Eclectica's Hendry said.

Another problem is a lack of understanding about short-selling as "part and parcel of any capital market," said CQS Chief Executive Michael Hintze.

VITAL PLAYERS

The $1.4 trillion sector did not cause the credit crunch, the International Organization of Securities Commissions said earlier this month, adding that hedge funds helped market liquidity, price efficiency and global market integration.

AIMA's Baker said hedge funds manage people's savings and provide capital in economic downturns and so are a vital economic player, especially now that institutions such as pension funds and university endowments account for more than half of the industry's assets, surpassing wealthy individuals.

For example, high-profile Toscafund earlier this month launched a fund to buy and repackage mortgages, which have fallen sharply in value since the start of the subprime mortgage crisis in 2007.

Private equity is also suffering public ire even though it can ease the recession by investing in and turning around struggling companies, industry insiders said.

"There is clearly no political goodwill toward financial services in general and everyone within financial services is being lumped into the same bucket," said Andrew Newington, managing partner at BC Partners.

But Barker sees a glimmer of hope. "There is hope of rehabilitation and redemption somewhere down the track," he said.

"I'm still not telling taxi drivers that I work in the hedge fund industry. Give it a couple more days and I might."

(Editing by Erica Billingham)"