Hedge Funds: A Decade In The Making

Jan 5 2007 | 11:54am ET

by Hung Tran 

The geopolitical and financial world has undergone major changes in the last decade, and investors have been put to the test with the threat of terrorism, the bursting of the tech and housing bubbles, and the proliferation of hedge funds. A panel of economists and investment professionals gathered yesterday for a roundtable discussion, sponsored by the New York Society of Security Analysts, to share their observations on the past decade and their outlook for the coming year.

Musings, Then And Now

Merrill Lynch’s chief U.S. strategist, Richard Bernstein, said the investment environment today is dramatically different from that of 10 years ago. “Ten years ago, people hated equities and the consensus recommended equity allocation from Wall Street strategists was less than 50%,” he said. “Now it is about 65%.”

“Ten years ago, we were still an old-fashioned income-based economy where we actually spent and saved on the basis of what we earned,” recalled Stephen Roach, chief economist at Morgan Stanley. “Today, we’ve discovered the joys of the never ending string of asset bubbles where we spend on the basis of what gets fabricated in the financial markets. So the transition from an income-based to an asset-based economy is a remarkable, fascinating and potentially worrisome development for the U.S.”

Investors, having weathered the equity bubble and a housing bubble, are in for more bubbles as long as liquidity remains abundant, Roach added.

Not all of the panelists focused on differences between the two periods. Ralph Acampora, managing director at Knight Equity Markets, said, “Between October 1992 and July 1998, there were eight years in a row without a 20% correction, and this is going to be our fifth year without a 20% correction.”

Going forward, Acampora is bullish on a few household names. “When was the last you saw Citigroup at an all-time new high, or how about GE making a five-year high?” he asked. “Call your mother up and ask her what Hercules is. That stock is making multi-year highs, and Xerox is about to do that.”

Ian Bremmer, founder and president of the Eurasia Group, a global political risk advisory firm, said that the global community is consuming more energy now than a decade ago and that energy sources are increasingly coming from unstable parts of the world.  He said terrorism’s potential effect on the financial markets is something that wasn’t even an investor afterthought in the past.

“The fact that rogue states, organizations and even individuals’ abilities to roil global markets irrespective of what the international community does is something that the markets weren’t worried about 10 years ago,” he said. 

But what really scares David Wyss, chief economist at Standard & Poor’s, isn’t terrorism, but aging. “The main problem that I have is I’m 10 years older now than I was 10 years ago,” he mused. “What really bothers me is that most Americans are 10 years older and are rapidly approaching retirement, which is one of the reasons you’re going to see consumption and other economic variables depend much more on wealth. Once you’ve retired, you’re spending on your yields from your stock and bond portfolios.”

The Hedge Fund Factor

Panelists also pointed to other notable changes having occurred over the past 10 years, including globalization and the proliferation of hedge funds. “Being a strategist for a firm whose client base is essentially all individual investors, one of the biggest differences is how much more insular we were as investors and how we looked at the economy and markets,” said Liz Ann Sonders, chief investment strategist at Charles Schwab. “I think our economy is more global but our investors are also approaching the landscape in a much less insular way.”

Sonders said she has concerns about investors psychology when it comes to hedge funds. “Part of the reason for the potential for increased regulation on a going forward basis is that many of them are opening their funds to less qualified investors and that only adds to the herd mentality,” she said.

She is also worried about the risks inherent in hedge funds now that they have become lenders and are in the private equity business. “I’m worried more about the things we don’t know than what we know,” she said. “We don’t know [derivatives] correlations, and you can use Amaranth [Advisors] as an example, though I don’t think we have a bunch of Amaranths coming ahead of us, but there is a lot we don’t know about correlations. We don’t know the size of these derivatives or what these derivatives are tied to.”

Jason DeSena Trennert, managing partner and chief investment strategist at Strategas Research Partners, said that the growing number of hedge funds has had a profound effect on the mutual fund space. “As a sell-side analyst, 10 years ago my biggest clients were mutual funds and today they’re hedge funds,” he said. “There are 8,000 hedge funds out there running between $1.2 trillion and $1.5 trillion, accounting for about 50% of institutional commissions, so their influence on bulge bracket firms is quite large.”

Trennert said he isn’t worried about systemic risk stemming from hedge funds because their growth over the last five years has been in the long/short space, where the use of leverage is lower than in other strategies, such as global macro. But the trend of hedge funds underperforming equity indices is a cause of concern.

“I am very worried about performance risks because most fiduciaries have been selling low fee, low valuation assets and moving them to higher fee, higher valuation assets,” he said. “I believe that this would be the fourth year in a row that the average hedge fund has underperformed the S&P 500 after fees.”

He added, “Going into this year because of the underperformance I do think this is going to prompt hedge funds to take greater risks and use more leverage. Eventually, we’re going to have a problem, but I don’t see one just yet.”

Going forward, Trennert predicts that there is going to be a “battle royal” between private equity firms and long-term institutional shareholders for assets, especially in large-cap stocks. “It’s kind of remarkable that an $80 billion company like Home Depot can be discussed as a private equity candidate,” he said. And yet, I think the amount of liquidity out there makes it very much in play.”


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