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03 December 2023

Wanted: a view over the hedges

By Paul Murphy


 It’s been a tough few weeks for the hedge fund industry. Very tough indeed. Having largely kept their heads down during the later half of the credit crunch, managers of alternative assets have had to come out and admit that they have had a dreadful start to the new year.


The typical fall, as calculated by Hedge Fund Research, was close to three per cent across the industry during January, with so-called “event driven” and other equity-related investment strategies doing particularly badly.


There have been eye-catching stories. Jon Wood, an ex-trader from UBS, who is well-known for his contrarian bets and has taken a big controversial holding in the stricken British mortgage bank Northern Rock, was reported to have lost at least 18 per cent of his money in the space of one bad month.


And then there was the example of Goldman Sachs.


Back in December the investment bank raised some $7 billion (Dh25.69bn) for Goldman Sachs Investment Partners (GSIP) – the largest single launch in hedge fund history, eclipsing the $6bn raised by Convexity Captial, which was founded by the former head of the Harvard Endowment, Jack Meyer.


For Goldman, the new GSIP fund was a chance to erase the memories of mid-2007, when its then flagship fund – a so-called quantative, or “black box” fund – suffered hugely at the onset of the credit crunch.


Sadly, according to a string of recent reports, GSIP lost about six per cent during the month of January, amid extremely volatile conditions in major western equity markets. One point that was quickly picked up by Goldman’s eager critics was that the six per cent loss suffered by GSIP was more or less the same as the decline on the S&P 500 index.


Now, the S&P 500 is just about the broadest stock measure in its class – measuring the performance of America’s 500 biggest firms.


As such it is a benchmark for what money managers routinely refer to as “beta” – or the “typical market return”.  Beta is passive investment – putting your money in a market-wide fund and seeing what return you get by doing nothing.


But GSIP, of course, is supposed to produce “alpha” – a return for investors over and above the “beta” available from passive investment. That is why it and other hedge funds levy exceptionally high, performance-related changes – for delivering exceptional returns.


So here was Goldman Sachs’ $7bn beta factory – the world’s biggest hedge fund launch coming just middle of the class in its first month of operation. Cue much spiteful laughter.


But is this fair? Is the hedge fund industry just another example of financiers coming up with something impressively complex that, in truth, simply replicates ordinary stock market performance over time? Or, worse, are hedge funds so complex and opaque, that they are actually hiding real risks to both investors and the wider fabric of the financial market place?


The answers, I would venture, are: no, no, and “maybe”.


It is facile to judge Goldman’s performance on its first, single month of operation. The critics really should come back in a year’s time.


As for hedge funds simply matching average performance over time, the figures in the accompanying table from Hedge Fund Research might, at a glance, tend to support this. The performance numbers, across multiple strategies and across five years, are unremarkable.


But these are industry-wide averages. The fact is the hedge industry is highly dynamic – money gravitates quickly to the best performers and those with solid long-term records. Bad hedges funds die quickly.


The actual existence of the hedge fund sector is the result of huge amounts of academic work over a long period – the growth of the sector, which continues to be exponential, reflects the cumulative impact of more and more sophisticated thinking. Like so many other human endeavours, financial markets progress as mankind’s thinking and understanding progress. And it’s not something you can take away. Exemplified by the implementation of hedge fund strategies and other forms of modern investment, such as through private equity, financial markets have simply become more complex. They are not just one day going to become less complex in the same way that the world is not suddenly going to become less scientifically advanced.


Which brings us to the third point: are things now so complex, that the resultant opacity represents a serious risk.


The jury is still out here. Financial regulators will tell you that their understanding of the hedge industry has grown markedly in recent years. But they also expect blow-ups to continue to happen, on an occasional basis and in largely unpredictable fashion.


What we really need then is to get increasingly sophisticated at clearing up the occasional mess.


-- Paul Murphy is Associate Editor of the Financial Times.