Masters of the Universe fall to ground

By Neil Behrmann

August, 2007:- THE ground is slipping under the Masters of the Universe. These are the billionaire and multi-millionaire hedge fund gunslingers who have grown rich from managing other people's money, as depicted in Tom Wolfe's 1987 novel, The Bonfire of the Vanities.

The dodgy US sub-prime mortgage market chasm and widening junk bond cracks have tested hedge fund traders. These are the so-called stars who charge at least 2 per cent a year on money that investors place with them and a further 20 per cent performance fee.

But there are stars and stars. Some have ridden on the back of the global bull market that began in 2003, invariably underperforming the indices. Others invested money in packaged dodgy mortgage debt and junk high-yield bonds. And then there are the few who are truly shrewd and talented operators. They are so popular that they close their doors to new investors after they raise a few billion. That, of course, adds to their mystique.

Past performance no guarantee is market cliche for good reason

That old market saying and legal warning is a cliche for good reason: Past performance is no guarantee for the future. Take as an example Jeff Larson. He helped manage Harvard's endowment successfully, left in 2004 to start Sowood, his own hedge fund firm. The US$29 billion Harvard endowment invested US$700 million in the firm. Over a dozen other American academic institutions followed Harvard. Their trustees believed that stellar performance of the star managers at Harvard would be repeated at Sowood. The firm managed to raise US$2.4 billion in 2004 and earlier this year funds under management totalled US$3 billion.

Mr Porter, though, is no longer associated with Sowood. He now runs the private equity firm of Denham Capital Management.

In the past two months, however, Sowood has been caught in a market downdraft. The value of Sowood's investments in junk bonds and other credits sank. The hedge funds had borrowed to lever performance. But banks threatened to call in the loans or sell the collateral at fire-sale prices. In the end, Sowood had to sell its portfolio to Citadel Investment Group, a large hedge fund. Losses were 50-60 per cent, leaving Sowood with around US$1.5 billion. The universities who worshipped the former Harvard investment gods are chastened.

A sanguine market changes tack and becomes risk averse

Global investors are now witnessing what happens when a sanguine bull market that generally ignored risk changes tack and becomes risk averse. It happened in 1998 when Long Term Capital Management (LTCM), a highly sophisticated hedge fund devised by brilliant mathematicians and options experts, came a cropper.

It didn't occur when a wild trader of hedge fund Amaranth lost almost US$7 billion last year. But it has happened now. Two Bear Stearns leveraged credit funds with combined investor assets of US$1.6 billion and estimated borrowings of up to US$20 billion knocked over the first domino. Bear Stearns told the funds' investors that their holdings were virtually worthless and this week the funds sought bankruptcy protection.

Hardly a day goes by without reports of steep hedge fund losses and rumours of closures. Besides American, several Australian, UK and French hedge funds are in trouble. Bear Stearns is encountering a run on its hedge funds. It has suspended investor redemptions from a third fund that manages US$900 million. The turn in sentiment has not arrived without warnings. Back in June, the Bank for International Settlements (BIS) flashed amber lights; other central banks and analysts held up yellow cards some time ago.

Reverse gearing

The lesson of the latest hedge fund debacle is that promised high returns and heady performance targets come in tandem with an increase in risk. The thousands of hedge funds that manage around US$1.5 trillion and borrow 2-3 times that amount, trade in markets ranging from stocks and bonds to currencies, commodities and derivatives.

A simple example explains what can happen when markets turn. A fund borrows $100 million for each $100 million that investors place in the fund. Its investments, totalling $200 million rise by 10 per cent. The fund thus makes $20 million. If the money is borrowed in yen, the interest is minimal. But say, for argument's sake, that after interest and brokerage charges, the gain is $15 million or 15 per cent. Wipe off $5 million in annual management and performance charges, and the net annual return for the investor is around 10 per cent. But if the fund loses 10 per cent, reverse gearing, or leverage works with a vengeance. Losses are $20 million and, with borrowing, brokerage and annual management charges, rise to $27 million or 27 per cent.

Of course, hedge fund investors often try to bail out in troublesome markets. That in itself is difficult as hedge funds have clauses that lock investors in. The current unravelling should be a lesson for those who allowed themselves to be dazzled by the money men of Wall Street.

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