May 17, 2006
JS-4270

Remarks of Emil W. Henry, Jr.
Assistant Secretary for Financial Institutions
U.S. Department of the Treasury
Before the Exchequer Club

Thank you for inviting me to speak here today.  It is a pleasure to be here with all of you.  Prior to coming to Treasury last year, I spent the last 20 years on Wall Street, as an investment banker and also founder of investment organizations including a hedge fund business.  As you might imagine, I am honored to address a group of professionals such as yourselves and to be included in such a distinguished list of past speakers.

I thought I would do something slightly unconventional today.

Over the past few months, I have spoken on a few occasions on the subject of hedge funds, with a focus on such matters as the risks presented by credit derivatives, the extent of leverage in the system, the institutionalization of the business and the implications for risk mitigation, the demise of LTCM and how it served as a catalyst for institutionalization, opacity/lack of transparency in the industry, issues for our pension funds and pensioners, and, of course, the potential for financial system shocks.

After my remarks on these important hedge fund topics, I have noticed a curious phenomenon – one that occurs with similar certainty to the sun rising in the east.

Namely, after my formal remarks, I typically receive questions from the audience and press on matters relating to hedge funds that are also formal and revolve around important issues such as systemic risk, regulation, and legislation – issues that you would expect an administration official to field in a substantive public forum such as the Exchequer Club.

When I return to my seat, to my lunch, or to my dinner partner, I receive questions – still surrounding the hedge fund phenomenon, but they are of a completely different tenor.  The questions are typically the same, revolving around a couple of general themes:

• I am repeatedly presented with a reference that hedge funds are a fad, that they are troublesome for our markets, and that in the long run they will disappoint.
• More generally, I receive questions such as:  what societal good are these hedge funds really providing?  Underlying much of this line of questioning lies a general dismay at the level of wealth being generated among the young hedge fund professional community, a curiosity around how exactly such wealth is actually being accumulated, and a suspicion as to whether it is really fair and a good thing for our society that such wealth is being deposited into relatively few hands.

So, this morning I'd like to address these typically "offline" questions.

But first, allow me to ask a most basic question, just so we are all on the same page:  what exactly is a "hedge fund?"  Such a simple question, yet there is much uncertainty and confusion around what these vehicles do, what benefits they provide, and why people invest in them.

In short, a hedge fund is a private pooled investment partnership that i) because of its legal structure falls outside many of the rules and regulations governing mutual funds and ii) has the intention to compensate its general partner (or the legal equivalent) largely based upon performance.

So, the term "hedge fund" does not refer to hedging techniques or strategies deployed – though shorting is the common thread – so much as it does to their status as privately-offered vehicles with unique compensation structures.

Underscoring the notion that there is much confusion around hedge funds is the fact that there is actually a great debate occurring in the investment-related academic community as to what exactly an investor is buying when he or she invests in hedge funds.  For example, is a pension's exposure to, say, a long/short equity hedge fund "hedge fund exposure" (or alternative investment exposure), or what it really is: more equity exposure (where some of it just happens to be on the short side)?  Is exposure to a fixed income hedge fund "hedge fund exposure," or simply additional bond exposure?

There is also a great debate about how investors should classify their exposures to hedge funds.  For example, many like me believe hedge funds are not properly classified when labeled an "asset class."  Hedge funds are not an asset class.  There is just too much dispersion of strategy, leverage, and exposure to codify the group as such.

So with those thoughts as a base, let me read to you a recent Warren Buffet quote:

"Hedge funds are a huge fad.  You can pick any ten hedge funds and I'll bet that on average they will under perform the S&P over the next ten years … so most of these hedge funds will not be able to justify their outlandish fees over the long-term and they will disappear."

Mr. Buffet hits on three concepts here:  hedge funds as a fad, a prediction of underperformance, and high fees. Let me address each of these:

Hedge Funds as a Fad?

A fad is:

"A fashion that is taken up with great enthusiasm for a brief period of time; a craze."

It seems to me the logical place to start to understand whether current interest in hedge funds is a fad or craze (and by definition would disappear as quickly as it came) is to understand the history and context as to how hedge funds came to be.  I think history can give us clues as to whether hedge funds are filling a void in the marketplace – addressing a market need – and perhaps illuminate the rationale for this business's existence.

Hedge funds found their genesis in entrepreneurs reacting to the Investment Company Act of 1940's restrictions and limitations imposed on more traditional forms of money management.  For example, mutual funds typically invest only in "long" positions, must be nearly 100 percent invested at all times, and might be further limited by a fund's charter restrictions – for example, a health care mutual fund may only invest in health care equities.  Other traditional money managers often place these very same restrictions upon themselves.

A hedge fund, by contrast, has virtually unlimited flexibility.  All strategies are on the table – long positions, short selling, leveraged holdings, equities, bonds, currencies, derivatives, multiple industries, et cetera.  All of these approaches are available and widely utilized by the hedge fund community.  Because capital tends to gravitate to where it is least encumbered and restricted, and hence earns the highest risk-adjusted return, it is not surprising that capital migrated from traditional funds to hedge funds.  Of course, like most things in life, one thing's greatest strength can be its greatest weakness.  The great flexibility of the hedge fund structure also lends itself to conduct that can lead to trouble, the most common being outsized risk-taking, concentrated positions, and over-leveraging.

Initially, hedge funds were solely the province of sophisticated high net-worth investors comfortable with the risk profile of such funds and lacking the risk aversion of the institutional investor class.  During the 1990s, however, the growth of hedge funds began in earnest both in the size of the strategy and the profile of investor choosing to access it.  Such growth now has an inexorable feel of inevitability.  It is now a legitimate investment strategy widely sought out by institutions and validated by a vast community of pension consultants.

Why did this happen?  For a number of reasons, all driven by the power of free-market capitalism.  As the rising equity tide of the 1990s lifted all boats, traditional investment vehicles obviously delivered handsome returns, but alternative asset classes such as hedge funds did even better.  It is, after all, not a tall order to beat positive indexes merely by adding leverage.  Also, because of different compensation structures, skilled asset managers left traditional money management shops in droves to open hedge funds – the so-called "brain drain."  These funds required little infrastructure and offered the potential for outsized compensation.

With the bursting of the bubble, and the ensuing three year decline in equities (2000-2002), many hedge fund watchers anticipated the "unclothing" of the legions of newly-minted hedge fund stars – the theory being that all the leverage in the system would amplify returns negatively in the downdraft in mirror fashion to the updraft.

Indeed, the opposite happened for a number of reasons.

First, it turned out that those institutions that invested most heavily in hedge funds during this period turned in the best relative returns. For example, sophisticated university endowments, with significant hedge fund exposure, were rewarded handsomely.  While they did not shoot the lights out, those endowments most heavily allocated to hedge funds actually turned in positive returns amidst the market meltdown.  Their hedge fund managers, it turned out, exploited their natural flexibility to short stocks and, importantly, moved to cash during market dislocations, which limited exposure and mitigated loss.

Secondly, the endowment phenomenon did not go unnoticed by the broader investment community that had experienced losses.  Pension funds with traditional exposures – say, 60 percent bonds, 40 percent equities – were devastated during this period of strain.  The stark contrast of performance between the sophisticated endowment community and pension funds put a white hot light on the protection ostensibly afforded by hedge funds in times of trouble.

Third, the underperformance of pension funds caught the attention of corporate CEOs.  The corner office, often oblivious to sleepy pension activities, suddenly woke up to demonstrably negative returns that impacted that which CEOs hold dear: their income statements and earnings per share figures.

When the smoke cleared and the dust settled, the wrenching dislocation of the early millennium served, in a way, to define hedge funds.  And many in the investment community (rightly or wrongly) drew the following conclusion about hedge funds: they will reward you in good markets and protect capital in bad markets – a recipe for superior risk-adjusted returns.  And based largely upon this premise, capital has continued to flow liberally into the space.

So, that's the fact pattern – the history thus far.  You can judge for yourself whether that sequence will be shown in hindsight to have constituted the building blocks of a fad.

For my part, I am comfortable saying that hedge funds aren't filling some passing fancy of a dilettante investor class – like hoola-hoops or pompadours or disco music – but, to the contrary, are a natural reaction of free markets responding to and gravitating away from the restrictions of certain government-imposed rules and regulations.

Recognize that much of the core activity of the hedge fund community has been imbedded in the proprietary trading desks of Wall Street's largest investment firms for decades.  Merger arbitrage, fixed income arbitrage, convertible arbitrage, paired trading, distressed debt, leveraged investing – these are all strategies exploited by Wall Street for years and years.  Their main difference from hedge funds today is that they didn't charge external fees, and that they weren't embedded in separate legal vehicles.  These activities – like water finding its level – have migrated to a place where the profit motive is best realized and maximized.  People respond to incentives, and the economic incentives of hedge funds, today, are enormous.

So I would generally disagree that hedge funds are a fad.  Lightly regulated pools of capital, enhanced by imminent flexibility to address multiple markets and asset classes with the ability to rapidly shift strategy and exploit inefficiencies based upon the prevailing climate, steered by an able investment practitioner describes, in totality, a recipe for an industry that should have a permanent home in our investment lexicon.

Hedge Fund Performance

Some have questioned the long term return potential of hedge funds versus the broader equity indexes.

I checked on hedge funds' performance versus the S&P 500 index.  Here are some interesting numbers:

For the period  ending 4/30/2006:         CSFB/Tremont/Hedge Fund Index       S&P 500

Past three years                                                           41%                             36%

Past five years                                                              57%                               4%

Past 10 years                                                                192%                           96%

2000-2002                                                                   13%                             -37%  

(One caveat to these numbers:  Using these hedge fund indices is fraught with peril.  They are inexact at best due to survivor bias and self-selection.  But for illustrative purposes they are useful. I am trying to make a point of directionality here.)

The data suggests that hedge funds have been fine performers indeed – more when you consider that they have done so with lower volatility and with only modest correlation to the equity markets (though I note they correlate more closely today than in the decade past).  Indeed, when the equity markets declined for 3 years in a row (2000-2002) – something unseen since the depression – hedge funds created value.

However, Mr. Buffet is probably right because the elephant in the corner for marketers and managers of hedge fund products today is that hedge fund returns of the last few years are demonstrably lower than they were in the 1990s.  In the past 12 months, with capital pouring into the space, hedge funds have returned about 16% compared to about 10% for the S&P 500.  In 2005, hedge funds as a group delivered only about 9%.

The core question is whether this trend will continue and whether returns of hedge funds over the long term will actually exceed long term equity returns.  Why would investors pay such large fees charged by hedge fund managers simply to deliver what can be achieved via an equity index for mere basis points in fees?  (If hedge fund returns do not exceed broad equity benchmarks, I note that the sole legacy of the hedge fund boom will have been a massive wealth transfer to a group of fortunate entrepreneurial souls born of the late 20^th century.)

I think there is evidence to support different answers to this question:

On the one hand, it would seem logical that because the hedge fund practitioner has many more investment opportunities and a more robust tool kit than his long-only competitor, he should be able to earn higher long-term returns.  As I have discussed, unlike his long-only mutual fund brethren, the hedge fund manager enjoys the flexibility to short, to deploy varying amounts of leverage, and he is not bound to invest in any one industry or security in the manner that a mutual fund's charter might impose.  Importantly, he also has the flexibility to disinvest and go completely to cash to mitigate loss.  Many long-only managers, of course, must stay close to 100% invested at all times.

On the other hand, consider the following:

• As risk is reduced through the institutionalization of hedge funds, returns should, by definition, be reduced as well;
• It would seem logical that the steady flow of more and more capital will increasingly crowd out return;
• There is evidence that finding pure shorts – single stocks – is getting much harder and that increasing levels of short exposure are being accomplished through exchange-traded funds and other pooled vehicles.  Single stock shorts tend to produce return while shorted pooled funds tend to hedge exposure and mitigate risk; and
• Many funds, finding an absence of public opportunities, are investing in private equity and private debt securities and the jury is out as to whether hedge fund practitioners have the skills necessary to create adequate returns in the private space.

So on balance, this prediction is correct.  Returns will come down.  They already have started on such a path.  Capital continues to crowd out return.  The question is how far down, but I don't think any of us is in a position now to make that determination.  I note that part of the reason returns are lower today is that spread strategies key off a risk free rate and rates, of course, have been low.  Low volatility as well has had a dampening influence on return.  Once rates and volatility rise, I would expect returns to increase as well.

Outlandish Fees?

But what about these fees?  Are they outlandish?

It would seem very logical that, to the extent returns to hedge funds come down and approximate those of long-only equities, fees for hedge funds will come down as well.  I note, however, in the market today, hedge fund fees are actually rising.  Management fees used to be 1% system-wide, while today 1.5% is the average and it is not unusual to see 2 to 3% management fees.  For performance fees, which used to be 20% system-wide, it is not unusual to see 25 to 30%.

But does that mean that fees today are outlandish? First, a little arithmetic might help us make such a determination.  Let's take a look at fees from a few angles – at micro and macro levels, if you will.

First, micro: How do these fee scales actually translate into actual compensation for a hedge fund manager? Here is a hypothetical example:

About 65% of all hedge funds have assets between $100 million and $1 billion.  In my experience, the average hedge fund in this category of, say, $500 million charging a 1.5% management fee and a 20% profits' interest, may have typically a fixed expense base of only a few million dollars that it must cover before distributing profits to the founder or other partners.  Under these assumptions, annual profits under various return scenarios are as follows:

0% Return:       annual profits of $4.5 million;
10% Return:     annual profits of $14.5 million;
20% Return:     annual profits of $24.5 million.

For clarity, this, of course, is all to say that a hedge fund practitioner managing a $500 million portfolio who delivers what feels like a ho-hum result of 10% (i.e., approximating long-term equity returns) might pay himself about $15 million – just in one year.  And, by the way, I note that if the firm implodes in the following year, he still keeps his $15 million.

Now, let's now look at hedge fund compensation on a macro basis.

The New York State Comptroller reported that total bonus compensation for all Wall Street firms for 2005 was $21.5 billion.  This does not include hedge funds – just the securities firms.  (By the way, this was a new record – exceeding the bonus compensation of about $19 billion during the bubble in the 1990s – another indicator of our superb economic environment).  This total compensation was distributed among nearly 175,000 financial services professionals, with the highest going to the investment bankers.

But investment bankers look like paupers next to the hedge fund crowd.

To compare such statistics to the compensation within the hedge fund community in 2005, you need to do a back of the envelope estimate because of the private nature of the data.  This will be a very rough estimate, but, again, I am trying to make a directional point.

First, assume there was roughly $1 trillion of hedge fund assets under management at the beginning of 2005.  Further assume a 10% return for the year.  From such calculations it is not a stretch to come up with a total of about $30 to 35 billion of revenue for hedge fund practitioners with distributable profits of at least $20 billion (especially if you include fees attributable to the fund-of-funds business), or, roughly, an amount equal to the bonus compensation of the entire Wall Street financial services community.  This is even more astonishing if you consider that such distributable profit accrued to a fraction of 175,000 professionals.  There are only 10,000 (or so) hedge funds, and one adviser often manages several funds.

(I note that it has been reported that roughly 50 to 60% of the revenues attributable to those assets might be realized within a fifty-mile radius of New York City, i.e., the area encompassing New York City and Greenwich, Connecticut, the region in which most U.S.-based hedge funds are located).

So, back to the question: Is this all outlandish?  I would say maybe – it depends – and that it is too early to tell.  According to the returns I have discussed – and I note that those returns are net of all fees – hedge funds have been better performers than equities.  In that context, why should we care what fees are associated with delivering a superior net result?  Speaking hypothetically, imagine you invest with a manager who delivers 50% returns net of his fees, year in and year out.  Do you really care what his fees are with such stellar performance making you wealthy in the process?  The market clearly doesn't think fees are exorbitant since they have actually been rising in recent years even with the influx of capital (though of late, anecdotally they appear to have leveled out).

But like most businesses with such intense new competition, fees must certainly come down.  This phenomenon is already occurring in businesses tangential to hedge funds – such as the fund of funds business.  Perhaps this means that fees are outlandish, but isn't it a truism of modern day capitalism that the greatest financial rewards tend to flow towards innovators, early entrants, idea generators, and entrepreneurs?  It is my belief that the promise of such rewards are exactly what will spark the creative energies and entrepreneurial zeal for our future.