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If Hedge Funds Go Out of Favor...

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Over the last few years, the rise of hedge funds as an alternative investment vehicle has attracted or, some say, been driven by pension managers feeling comfortable shifting money from mutual fund to hedge fund.

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It used to be that big pension funds invested in mutual funds. The pensions were charged small fees and the mutual funds directed the money almost exclusively to long-side investments. Over the last few years, the rise of hedge funds as an alternative investment vehicle has attracted or, some say, been driven by pension managers feeling comfortable shifting money from mutual fund to hedge fund.

Theoretically, the pension manager can use hedge funds to beat the market and capture outsized returns by investing in a vehicle that can be both long and short stocks. Theoretically, such a strategy insulates the pension from market risk because of the short component of the hedge fund strategy. However, all of this comes at a stiff price. Instead of the single-digit management fees charged by most mutual funds, typical hedge fund fees are 2% money under management and 20% any profit made.

I don't intend this to be a critique of the hedge fund business model. A significant subset of hedge fund managers deserve the fees they charge due to their ability to generate outsized returns. If they didn't charge those fees, the market would correct for that and money would go somewhere else.

Here in the 'Ville the market is sometimes described as 8,000 managers standing around in a circle shooting at each other. That's an apt visual. The thing is, more and more people are crowding into that circle. As with any market endeavor, an increased supply of something means there will be a breakdown. Diminishing returns are guaranteed as too many hedge funds try to secure returns from each other.

The conventional wisdom is the resulting "break" would be disastrous for the markets. You have to listen very closely to that point of view because it is hard to make up lost ground in a portfolio. But there is another path for you to consider.

Imagine a pension fund shifts $5 bln from a mutual fund to a hedge fund. First, that mutual fund has to sell positions in order to raise cash for the redemption. This depresses stock prices. Hedge funds that are popular with pensions usually invest 60/40. 60% long, 40% short. Only 60% of that $5 bln ($3 bln) ends up back in stocks, not making up for the sale of stocks from the mutual fund. The remaining $2 bln becomes short sales, further depressing stock prices. Net selling of equities is $4 bln.

The net effect of the pension fund simply reallocating funds is negative for equities. This has nothing to do with fundamentals necessarily. You can't explain net effect by overwrought debt markets, subprime loans, collapsing housing prices, or any other fundamental metric of your choice. It is simply a result of pension funds allocation strategy.

The need for pension funds to invest will not go away. At some point, too many hedge funds will create a situation where their ability to outperform the market is diminished. Too many people are standing in that circle shooting at each other. As returns more closely mirror the market, that 20% fee no longer looks so good in comparison to the single-digit fees charged by mutual funds. Perhaps then, pension managers will shift.

So what happens when the pensions decide hedge funds aren't worth it any longer?

The pension takes $5 bln out of the hedge fund. This causes $3 bln in sales of equities and $2 bln in buying (closing the shorts). Then the money goes to the mutual fund, which puts all $5 bln into buying equities. When the pension shifts to mutual funds from hedge funds, the net is $4 bln in buying.

That's significant, and something worth thinking about the next time you read that the world is going to end if the hedge fund business collapses.

As usual, when I attempt to simplify something that is horrendously complex, it's easy to nitpick my analysis. The actual magnitude of any resulting shift out of hedge funds is much larger because hedge funds employ significant leverage. They borrow against the funds given to them by pensions, magnifying considerably the amount of capital they can invest. They increasingly use the significant leverage provided by derivative instruments. Unwinding either will create additional disconnects unaccounted for in the situation I describe above.

Ironically, pensions are unlikely to shift back to mutual funds until we see an extended bear market. A pension manager can likely live with paying a hedge fund 20% fees on returns not much better than market averages as long as he/she still believes the marketing concept that their hedge funds will be able to outperform the market in a significant downturn. It's the hedgies' ace in the hole, so to speak – their ability to short.

It will take a sustained downturn for pension managers to learn whether the marketing done by hedge funds ("We're actually safer because we can hedge downturns!") is matched by their performance. If it doesn't, you'll see pension managers leaving them in droves.

The other thing that could cause pension managers to leave hedge funds is a few more significant hedge fund blowups. Arguing that hedge fund blowups are positive for equities is a bit like arguing the sun will burn out tomorrow. The bottom line is, if for any reason pension managers decide to leave hedge funds for mutual funds en masse, the net effect for the equities market is unlikely to be negative – or at least not negative for very long.
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