By Michael Peltz –
In September 1998, Philip Duff left the security of his job as head of Morgan Stanley’s mutual fund group to become chief operating officer at Tiger Management LLC, the hedge fund firm run by Julian Robertson.
On one day, during Duff’s second week on the job, Tiger lost more than $2 billion when the Japanese yen rose against the dollar. Robertson had been betting the yen would decline. Two years later, Robertson, then 67, closed Tiger, which at its peak managed almost $23 billion and was the largest hedge fund manager in the world.
Like others among today’s new breed of hedge fund entrepreneurs, Duff doesn’t make Tiger-size bets. Now chief executive officer of FrontPoint Partners LLC in Greenwich, Duff, 47, is part of an industry that offers less risk and more-stable — and lower — returns than in the past.
Managers of these investment pools, which typically use borrowed capital and sell borrowed securities as they try to make money regardless of the market’s direction, now face more scrutiny from regulators.
This approach appeals to the university endowments, foundations, insurance companies and pension funds that are likely to pour hundreds of billions of dollars into hedge funds during the next several years.
“Institutions want to be comfortable that they can look their investors in the eye and say they’re not giving their money to some crazy cowboy,” said Louis Ricciardelli, 53, chief executive of BPB Associates Ltd., a New York-based consulting firm specializing in hedge funds.
In just four years, Duff’s firm, which he founded with W. Gillespie Caffray, 51, Tiger’s former trading chief, and Paul Ghaffari, 44, who managed money for hedge fund billionaire George Soros, has grown to 127 people and $4.3 billion in assets by offering narrowly defined, moderate-risk investment strategies.
Duff and his partners also put more money into auditing, compliance and risk management systems than old-style hedge funds have.
The hedge fund industry’s returns reflect the more risk-averse approach of its managers. The HFRI Fund Weighted Composite Index, which is based on the monthly performance of more than 1,600 hedge funds tracked by Hedge Fund Research Inc. in Chicago, rose an estimated 7.1 percent in 2004 through November. That compares with a 19.6 percent return in all of 2003 and a 14.4 percent annualized return by the index going back to 1990.
The Standard & Poor’s 500 Index was up 7.2 percent in 2004 through November and has returned 10.7 percent a year on average going back to 1990.
Just as hedge funds are becoming more careful, regulators are bearing down. On Oct. 26, the U.S. Securities and Exchange Commission approved a rule that will require hedge fund managers with 15 or more clients and at least $30 million in assets to register as investment advisers by February 2006, subjecting them to SEC oversight.
The rule will give SEC inspectors the power to conduct periodic examinations of registered hedge funds, which will be required to name a chief compliance officer and implement procedures to prevent fraud.
The rule, which SEC commissioners passed by a 3-2 vote, was a victory for SEC Chairman William Donaldson, a Republican.
“Hedge funds control too much money to be operating without anybody knowing what’s going on,” said Commissioner Harvey Goldschmid, who, with fellow Democratic Commissioner Roel Campos, joined Donaldson to vote for the rule. Republican Commissioners Paul Atkins and Cynthia Glassman opposed it.
Even with its more modest returns and closer regulation, the hedge fund industry has been drawing big investments. In the past three years, $217 billion of net new capital has flowed into hedge funds, which had $890 billion in assets at the end of the third quarter of 2004, according to HFR.
Joshua Rosenberg, HFR’s president, estimates that the number of hedge funds has almost doubled during that period to 7,165 worldwide.
$300B by 2008
Institutional investors will account for more than 50 percent of the annual net new capital flowing into hedge funds globally by 2006, a September 2004 report by Darien-based consulting firm Casey, Quirk & Acito LLC said. Hedge fund investments by U.S. institutions will rise to $300 billion by 2008 from $66 billion at the start of 2004, the study estimates.
Donald Putnam, CEO of Putnam Lovell NBF Securities Inc., an investment bank specializing in asset management, said hedge fund assets might exceed $3.2 trillion globally by 2008.
The size of the opportunity hasn’t been lost on big banks, securities firms and fund companies. In September, JPMorgan Chase & Co., the second-largest U.S. bank, agreed to buy a majority stake in Highbridge Capital Management, a New York-based, multistrategy hedge fund firm.
Highbridge, which was founded by Glenn Dubin and Henry Swieca, both 47, manages more than $7 billion.
Highbridge was one of nine hedge fund firms with at least $500 million in assets that Wall Street banks or money management companies acquired or invested in during the first 11 months of last year, according to Putnam Lovell.
The most recent buyer was Affiliated Managers Group Inc., a Prides Crossing, Mass.-based company that owns majority stakes in 20 money management firms. In November, AMG acquired 20 percent to 25 percent of Greenwich-based AQR Capital Management LLC, founded in 1998 by former Goldman, Sachs & Co. managing director Clifford Asness.
AQR manages $12 billion, including $6.5 billion in hedge funds ranging from aggressive, high-volatility, market-neutral hedge funds, to low-volatility, benchmark-driven traditional products.
The firm, which is headquartered at Two Greenwich Plaza and employs 72 people, approaches its investments scientifically in the belief, according to its Web site, “That a systematic and disciplined process is essential to achieve long-term success in investment and risk management.”
“In addition, models must be based on solid economic principles, not simply built to fit the past, and must contain as much common sense as they do statistical firepower,” AQR said.
Asset gatherers
James Chanos, president of hedge fund firm Kynikos Associates Ltd. in New York, said the hedge fund industry is at the same point in its development that U.S. mutual funds were 15 years ago. Like mutual fund managers before them, he said, hedge fund managers are becoming asset gatherers, more concerned with dollars under management than with investment performance.
“Managers are going to be worried about gathering assets, taking fewer risks, basically trying to preserve franchise value.” said Chanos, 47, who manages $2 billion.
Chanos is a short seller, who tries to profit by borrowing shares of a company from a broker, selling them and later buying new ones on the market to return to the broker in hopes that the price will drop in between.
Limited partnerships
Hedge funds, which are typically set up as limited partnerships or as offshore corporations to receive favorable tax treatment, are exempt from SEC regulation under the Investment Company Act of 1940 as long as they have no more than 99 investors or sell their funds only to “qualified purchasers” who have $5 million or more in investable assets.
Until the SEC’s ruling in October, they were also exempt from registration under the Investment Advisers Act of 1940.
One of the biggest differences between hedge funds and traditional money management is the fees. Traditional managers get paid a percentage of assets under management.
Equity mutual funds in the U.S. charge, on average, about 1.1 percent of assets, while money managers typically receive 40 to 50 basis points for managing equities for pension funds and endowments, said Stephen Nesbitt, CEO of Cliffwater LLC, a pension consulting firm in Santa Monica, Calif. A basis point is 0.01 percentage point.
Hedge fund managers are paid a management fee of 1 percent to 2 percent of assets and a performance fee — typically 20 percent of profit.
“Fees are doing nothing but going up because the demand from institutions and individuals for hedge funds is larger than the supply,” said Christopher Acito, 37, a principal at Casey, Quirk & Acito.
The average management fee of funds in HFR’s database increased to 1.43 percent last year from 1.27 percent in 1998. Performance fees increased to 19.17 percent from 18.19 percent.
Hedge funds were originally intended to be conservative. In 1949, Alfred Winslow Jones, a sociologist and former editor at Fortune magazine, started the first modern hedge fund and used two risky investment tools — short selling and leverage, or using borrowed capital to buy stock — to reduce his vulnerability to broad moves in the market.
Jones offset the stocks he purchased long by selling borrowed shares of other stocks in hopes of buying them back at a lower price. If the market went down, the money he made on his short positions was intended to offset the losses on his long investments.
670 percent return
Jones’s long/short hedge fund outperformed all of the top mutual funds of his day, returning 670 percent to investors from 1956 to 1965. As word spread of Jones’s success, other money managers set up hedge funds.
In 1969, Soros, who was then 39 and managing money at banking firm Arnhold & S. Bleichroeder Inc., started what would become the Quantum Fund with $6 million. Robertson, a former Kidder Peabody & Co. stock broker, was 48 when he founded Tiger in 1980 with $8 million.
By the early 1990s, Robertson and Soros were each managing several billion dollars, investing in stocks, bonds, currencies and commodities around the world.
In 1990, global macro strategies, which attempt to profit from large macroeconomic trends, accounted for 71 percent of the $40 billion in hedge funds.
Macro managers such as Soros made big bets. In 1992, he made $1 billion by betting against the British pound. Even Robertson, who began his hedge fund career as a Jones-style long/short manager, moved into macro investing. In 1993, Robertson was up 64 percent, after fees, by betting against European currencies.
A decade ago, hedge fund managers were far more adventurous than they are today, said Jonathan Bean, managing director and co- founder of Mellon HBV Alternative Strategies in New York.
“Hedge fund managers had a very loose mandate and could invest wherever they thought the best opportunities were,” said Bean, 41, whose firm manages $1.1 billion by buying distressed securities and shares of companies involved in mergers. “Investors in hedge funds were the same way. They looked at hedge funds as sort of their fun money and said, ‘Let’s see what this guy can do.”‘
When hedge funds were managing money almost exclusively for wealthy investors, managers could get away with disclosing little information as long as their returns were good, said Mark Anson, 46, chief investment officer of the California Public Employees’ Retirement System.
Today, he said, performance isn’t enough for institutional investors such as pension funds, which are pushing hedge funds to provide more detail about their investments and investment process.
Hedge funds have a high mortality rate. The average life span is less than five years, according to data compiled by HFR.
The difficulty lies in the mechanics of hedge fund performance fees, which operate on a meter that’s reset annually. If a hedge fund loses money one year, the manager doesn’t receive a performance fee again until he’s recouped his losses.
About 85 percent of hedge funds have such a provision, according to HFR.
Hard to retain talent
Managers find it hard to retain talent after down years because analysts and traders know it may be some time before their firm starts collecting performance fees. Managers who suffer big losses may have little choice but to close their funds.
“About 20 percent of the funds that started in 2004 won’t make it through 2005,” FrontPoint CEO Duff said.
Duff experienced such a fate at Tiger. Robertson hired him to, among other things, possibly sell a stake in Tiger so that it could survive Robertson’s eventual retirement. As chief financial officer of Morgan Stanley from 1993 to 1997, Duff had played a key role in that firm’s merger with Dean Witter Reynolds Inc.
Duff never got a chance to put a plan into action. As news circulated of Tiger’s October 1998 $2 billion-plus loss on the Japanese yen, investor redemptions came quickly, forcing Robertson to sell other positions to meet them.
Tiger ended 1998 with about $15 billion in assets, down from almost $23 billion that September. The following year, Tiger lost 19 percent, hurt by big positions in a handful of poorly performing companies, including a 22 percent stake in US Airways Group Inc., whose shares fell by more than a third that year.
Closing Tiger
By the time Robertson announced in March 2000 that he was closing Tiger, which at one time had employed more than 200 people, assets had fallen to $6 billion.
“Size wasn’t the only problem at Tiger,” said FrontPoint co-founder Caffray, who ran Tiger’s trading desk from 1993 to 2000. “The real Achilles’ heel was that there was a centralized idea process with only one portfolio manager.”
At FrontPoint, Caffray and Duff have tried to create a hedge fund company with staying power. In mid-2000, they teamed up with Ghaffari, who had decided to leave Soros Fund Management after his boss, Chief Investment Strategist Stanley Druckenmiller, left that April.
By November 2000, the three had written a 19-page business plan outlining how they’d assemble and support teams of managers running specialized hedge fund strategies designed for institutions looking to diversify their traditional equity and bond holdings.
Coming up with a name was one of the hardest things to do, Duff said. “Not only were many of the names we came up with being used by other asset management firms, they were being used by other asset management firms in Greenwich, Connecticut,” Duff said.
His wife, Amy, came up with FrontPoint from a mountain climbing term that refers to scaling a vertical ice cliff using only a pair of metal-spiked boots and two ice axes. Duff started climbing as a teenager while growing up in Minnesota and owns Black Diamond Equipment Ltd., a Salt Lake City, Utah-based maker of mountain climbing and back-country skiing gear.
Duff said FrontPoint’s central premise is to bring in teams of experienced managers, help them raise capital and then provide the trade execution and processing, accounting, auditing, compliance, risk management and other services they need to run their funds.
‘Part of something larger’
“Managers who come on board get to be part of something larger while maintaining their relative independence,” said Ghaffari, who oversees investment team selection from FrontPoint’s Greenwich headquarters in a three-story, granite-and-glass office building designed by architect Philip Johnson. “They can focus on investing, while we take care of everything else for them.”
Ghaffari holds a master’s degree in foreign service from Georgetown University in Washington and worked on the staff of the U.S. House of Representatives Banking Committee before moving to Wall Street in 1983.
Managers who join FrontPoint agree to give up half of their management and performance fees to the firm. In return, they receive a small equity interest. Each year, they’re paid a dividend for their share of the equity from the firm’s pooled revenue after the costs of trading, marketing and other services are deducted.
Most of the managers who’ve joined FrontPoint have at least one thing in common: They’ve tried running their own hedge fund and didn’t like it.
“I have zero interest in building my own firm,” said Giampaolo Guarnieri, 41, who runs FrontPoint’s Japan long/short fund. Guarnieri moved to New York in 2002 after 16 years as a money manager in Hong Kong.
FrontPoint hired a trader for him in New York and one in Tokyo. Most of FrontPoint’s trades go through the trading desk in Greenwich, which is overseen by Caffray, who wrote his undergraduate thesis at Princeton University on options trading.
Options are contracts that give the holder the right to buy or sell a security at a specific price within a certain period.
Since launching its first fund in January 2002, FrontPoint has grown to 10 teams running 12 distinct funds, including one that invests in Canadian distressed debt and a long/short health care fund.
All of the funds are designed to be low to moderate in risk, with volatility, or price fluctuations, about a third that of the S&P 500. They also seek to make money when securities go down.
Merck & Co.
The health-care fund profited in late 2004 by selling borrowed shares of Merck & Co., whose price dropped more than 40 percent after the Whitehouse Station, N.J.-based drugmaker pulled its Vioxx painkiller off the market because of its link to heart attacks and strokes.
In February, FrontPoint began packaging its hedge funds as a multistrategy fund run by Caffray and Michael Litt, 44, who headed up the global pensions group at Morgan Stanley. FrontPoint charges a 1.5 percent management fee and a 20 percent performance fee for most of its funds.
For the first 11 months of last year, the funds had returns ranging from minus 0.7 percent to 11 percent. Duff’s goal is to have 20 to 25 teams capable of managing $30 billion in institutional assets.
Consistent returns
Few hedge fund managers have had more consistent returns than Highbridge’s Dubin and Swieca. Their flagship Highbridge Capital Corp. fund made money in 127 of 143 months of trading from January 1993 to November 2004.
The HFRI composite index was up in 104 months during that period; the S&P 500 was up in 92 months. Highbridge returned 15.3 percent annually after fees to investors compared with 10.7 percent for the S&P 500 — and with about a third of the volatility of the index.
“We would not have bought Highbridge if it had been a wildly successful single-strategy macro firm because it would have had too much concentration of risk,” said Jes Staley, 48, head of JPMorgan Fleming Asset & Wealth Management, the money management arm of JPMorgan Chase.
Staley was the point person for JPMorgan on the deal, the terms of which weren’t disclosed. Staley said the final price JPMorgan pays depends on the future performance of Highbridge. As part of the deal, Dubin and Swieca signed seven-year employment agreements to run Highbridge.
The courtship between JPMorgan and Highbridge dates to 1999, when Staley, then head of JPMorgan’s private bank, met Dubin and Swieca and began recommending their fund to clients.
The three spoke informally over the years about how they might forge a closer business relationship. Those conversations became more serious last spring.
Staley, who took over responsibility for the bank’s New York-based asset management unit in 2001, said he was seeing growing demand for hedge funds from his clients. Dubin and Swieca said they were looking to expand their business.
Friends since they met as toddlers in the Manhattan neighborhood of Washington Heights, Dubin and Swieca first set out on their own in 1984, when they convinced their bosses at E.F. Hutton & Co. to let them start their own firm, Dubin & Swieca, to provide commodities and futures investments for Hutton clients.
Futures are agreements to buy or sell a commodity or financial instrument at a set price and date in the future.
Young futures traders
In 1987, the two launched what was then one of the first funds of funds, investing in young futures traders such as Paul Tudor Jones, the founder of the now $10.9 billion hedge fund firm Tudor Investment Corp. in Greenwich.
In 1992, Dubin and Swieca launched Highbridge with $32 million. They named the company after a 157-year-old aqueduct that spans the Harlem River in upper Manhattan.
Highbridge is unusual among hedge fund firms because its founders don’t make the individual trade decisions. Instead, they’ve recruited successful money managers such as former PaineWebber Inc. merger specialist Richard Schneider to run the fund’s eight different strategies.
“One of the reasons people have always thought it is difficult to create a real business out of a hedge fund is that it’s dominated by one individual,” Swieca said.
Swieca and Dubin focus on strategies through which they can identify an investment process that can generate returns not dependent on the talents of a single trader.
Early on, they gravitated to strategies such as convertible arbitrage, which involves buying a company’s bonds that can be converted into common stock while simultaneously shorting its shares.
“Convertible arbitrage should be seen as a real business,” Dubin said. “In its simplest form, it’s a business of lending money to corporations in the form of convertible debt and collateralizing that loan with common stock.”
It’s Swieca and Dubin’s job to allocate Highbridge’s capital among the different strategy groups. They look at the asset allocation every day and meet more formally once a month to go over it.
Dubin said the process is part science, part art. He and Swieca look at quantitative measures such as return on assets and return on capital, as well as how the strategies perform compared with each other.
They discuss current and prospective market conditions and assess how they want to weight the strategies by using the statistics as a guide.
When 2004 began, 70 percent of Highbridge’s capital was invested in convertible arbitrage and other credit-related strategies and 30 percent in more equity-based strategies.
By the end of the third quarter, the split was even, as Dubin and Swieca had shifted capital into equity strategies.
Highbridge made money buying French drugmaker Aventis SA, which France’s Sanofi-Synthelabo SA acquired, and software maker Peoplesoft Inc., which on Dec. 13 accepted a hostile bid by rival Oracle Corp. The fund was up about 6 percent for the year through November, which Dubin said was Highbridge’s most profitable month ever in terms of total dollars made.
‘A big undertaking’
Among the estimated 2,750 hedge fund firms in the world, about 160 have $1 billion or more in assets, HFR’s Rosenberg said. At the same time, the cost of running a fund is increasing.
“You have to set up the operations, the legal structures, talk to investors, raise capital, put in the technology,” Tribeca CEO Beder said. “It’s a big undertaking. It used to be that you could start a hedge fund with $10 million or $20 million. You can’t do that in the current market environment very easily.”
Tribeca was formed in 1996 under the Travelers Group Inc. umbrella before the merger that created Citigroup. The company, whose investors are largely institutions, had about $600 million in mostly convertible arbitrage strategies when Beder joined.
She said Citigroup plans to use $2 billion of its proprietary capital to seed Tribeca’s new strategies and spend up to $50 million to put the systems and technology in place to support them. The goal, she said, is to create a multistrategy hedge fund firm capable of managing as much as $20 billion.
Tribeca is part of Citigroup Alternative Investments, which oversees all of the bank’s hedge fund and private equity operations. The group is run by Michael Carpenter, 57, the former CEO of Salomon Smith Barney Inc.
Once a top lieutenant of Citigroup Chairman Sanford Weill, 71, Carpenter was replaced as head of the investment bank in September 2002 by Charles Prince, 54, now CEO of Citigroup, after investigations into how Salomon Smith Barney had allocated shares of initial public offerings.
SEC inspection
The traders in today’s hedge fund industry will face far more regulation than in the past. The SEC began looking into hedge funds more closely after Donaldson, 73, took over as chairman in February 2003.
That September, the SEC staff issued a 113-page report, Implications of the Growth of Hedge Funds, recommending that the commission consider requiring hedge fund advisers to register, which would open them up to SEC inspection.
The same month, New York Attorney General Eliot Spitzer announced a probe of several mutual fund companies, including Bank of America Corp. and Strong Capital Management Inc., for giving hedge fund companies late trading access in exchange for investments in their mutual funds.
Paul Roye, director of the SEC’s investment management division, said at least 400 hedge funds were involved in the scandal, including those managed by Canary Investment Management LLC in Secaucus, New Jersey.
Canary settled with Spitzer, agreeing to pay a $10 million fine and return $30 million in profit from purchasing mutual fund shares at the 4 p.m. price after the market had closed in New York.
‘Behind the eight ball’
Starting in February 2006, hedge fund advisers must file annually with the SEC, providing their names, addresses and the amount of money they manage.
“Chairman Donaldson doesn’t want to wait for there to be a crisis or a problem,” said Roye, 51. “He doesn’t want the commission to get caught behind the eight ball the way we have in some situations in the past.”
Goldschmid, 64, who voted with Donaldson on registration, agrees. “Hedge funds were a major corrupting influence on the mutual funds,” Goldschmid said. “We might well have known what was going on at the mutual funds if we had been going in to inspect hedge funds like Canary.
— Business Editor Jim Zebora contributed to this story.
Source: Greenwich Time
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