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Absolute Returns – The Risk and Opportunities of Hedge Fund Investing

Absolute Returns - The Risk and Opportunities of Hedge Fund Investing

PART one – The Hedge Fund Industry

CHAPTER 1 Introducing Absolute Returns

HISTORY OF THE ABSOLUTE RETURN APPROACH

Prologue to the Twentieth Century
Most market observers put down 1949 as the starting date for so-called ab- solute return managers, that is, the hedge fund industry. However, if we loosen the definition of hedge funds and define hedge funds as individuals or partners pursuing absolute return strategies by utilizing traditional as well as nontraditional instruments and methods, leverage, and optionality, then the starting date for absolute return strategies dates further back than 1949.

One early reference to a trade involving nontraditional instruments and optionality appears in the Bible.

Apparently, Joseph wished to marry Rachel, the youngest daughter of Leban. According to Frauenfelder (1987), Leban, the father, sold a (European style call) option with a maturity of seven years on his daughter (considered the underlying asset). Joseph paid the price of the option through his own labor.

Unfortunately, at expiration Leban gave Joseph the older daughter, Leah, as wife, after which Joseph bought another option on Rachel (same maturity). Calling Joseph the first absolute manager would be a stretch. (Today absolute return managers care about settlement risk.) However, the trade involved nontraditional instruments and optionality, and risk and reward were evaluated in absolute return space.

Gastineau (1988) quotes Aristotle’s writings as the starting point for options. One could argue that Aristotle told the story of the first directional macro trade: Thales, a poor philosopher of Miletus, developed a “financial device, which involves a principle of universal application.”* People reproved Thales, saying that his lack of wealth was proof that philosophy was a useless occupation and of no practical value. But Thales knew what he was doing and made plans to prove to others his wisdom and intellect.

Thales had great skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with area olive-press owners to deposit what little money he had with them to guarantee him exclusive use of their olive presses when the har- vest was ready.

Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or pathetic and because the olive-press owners were willing to hedge against the possibility of a poor yield. Aristotle’s story about Thales ends as one might guess: When the harvest-time came and many presses were wanted all at once, Thales sold high and made a fortune.

Thus he showed the world that philosophers can easily be rich if they like, but that their ambition is of another sort. So Thales exercised the first known options trade some 2,500 years ago. He was not obliged to exercise the options. If the olive harvest had not been good, Thales could have let the option contracts expire unused and limited his loss to the original price paid for the options.

But as it turned out, a bumper crop came in, so Thales exercised the options and sold his claims on the olive presses at a high profit. The story is an indication that a contrarian approach (trading against the crowd) might have some merit.

Lemmings and Pioneers

One could argue that in any market there are trend followers (lemmings) and pioneers or very early adopters. The latter category is by definition a minority. In the early 1990s, some people were running around with mobile phones the size of a shoe. Having a private conversation in a public place did not seem to be more than a short-term phenomenon.

At the time, the author of this book thought they were in need of professional help, and therefore did not buy Nokia shares in the early 1990s so—unfortunately—cannot claim being a pioneer or having superior foresight. It turned out that those egomaniacs were really the pioneers, and it is us—the lemmings—who have adopted their approaches and processes.

In asset management there is a similar phenomenon. The pension and endowment funds loading up exposure to hedge funds during the bull mar- ket of the 1990s were the exception. They belong to a small minority of investors.

The majority of institutional as well as private investors took for granted what was written in the press and steered away from hedge funds. However, economic logic would suggest that it is this minority, the pioneers, that have captured an economic rent for the risk they took by moving away from the comfort of the consensus.

As the hedge fund industry matures, becomes institutionalized and mainstream, and eventually converges with the traditional asset management industry, this rent will be gone. The lemmings will not share (or will share to a much smaller extent) the economic rent the pioneers captured.

As Humphrey Neill (2001), author of The Art of Contrary Thinking, puts it:
A common fallacy is the idea that the majority sets the pattern and the trends of social, economic, and religious life. History reveals quite the opposite: the majority copies, or imitates, the minority and this establishes the long-run developments and socioeconomic evolutions.

Note that trend following is not irrational. In a market where there is un- certainty and where information is not disseminated efficiently, the cheapest strategy is to follow a leader, a market participant who seems to have an in- formation edge. This, however, increases liquidity risk in the marketplace.

Persaud (2001) discusses herd behavior in connection with risk in the financial system and regulation. He makes the point that turnover is not synonymous with liquidity. Liquidity means that there is a market when you want to buy as well as when you want to sell. For this two-way market, diversity is key and not high turnover. Shiller (1990) and others explain herding as taking comfort in high numbers, somewhat related to the IBM effect: “No one ever got sacked for buying IBM.”

In the banking industry, for example, lemming- like herding is a risk to the system. If one bank makes a mistake, it goes under. If all banks make the same mistake, the regulators will bail them out in order to preserve the financial system. Lemming-like herding, therefore, is a rational choice.

In Warren Buffett’s opinion, the term “institutional investor” is becoming an oxymoron: Referring to money managers as investors is, he says, like calling a person who engages in one-night stands romantic. Buffett is not at par with modern portfolio theory. He does not run mean-variance efficient portfolios.

Critics argue that, because of the standard practices of diversification, money managers behave more conservatively than Buffett. According to Hagstrom (1994) Buffett does not subscribe to this point of view. He does admit that money managers invest their money in a more conventional manner. However, he argues that conventionality is not synonymous with conservatism; rather, conservative actions derive from facts and reasoning.

Some argue that history has a tendency to repeat itself. The question therefore is whether we already have witnessed a phenomenon such as the current paradigm shift (as outlined in the Preface) in the financial industry. A point can be made that we have: In the 1940s anyone investing in equities was a pioneer. Back then there was no consensus that a conservative portfolio in- cluded equities at all. Pension fund managers loading up equity exposure were the mavericks of the time.

The pioneers who were buying into hedge funds during the 1990s were primarily uncomfortable with where equity valuations were heading. A price-earnings (P/E) ratio of 38 for the Standard & Poor’s 500 index (S&P 500) (as was the case when this was written) is not really the same as a P/E of 8 (as for example in 1982). Whether the long-term expected mean return of U.S. equities is the same is open to debate and depends on some definitions and assumptions.

However, there should be no debate that the opportunity set of a market trading at 38 times prospective (i.e., uncertain) earnings is the same as the opportunity set of a market trading at eight times prospective earnings.

Some pension funds (pioneers perhaps) have moved into inflation-indexed bond portfolios and are thereby matching assets with liabilities, that is, locking in any fund surplus rescued from the 2000–2002 bear market. What if this is a trend? What if there is a lemming-like effect whereby the majority of investors take risk off the table at the same time? If the incremental equity buyer dies or stops buying there is only one way equity valuations will head and equity prices will go.

The First Hedge Funds
The official (most often quoted) starting point for hedge funds was 1949 when Alfred Winslow Jones opened an equity fund that was organized as a general partnership to provide maximum latitude and flexibility in construct- ing a portfolio. The fund was converted to a limited partnership in 1952.

Jones took both long and short positions in securities to increase returns while reducing net market exposure and used leverage to further enhance the performance. Today the term “hedge fund” takes on a much broader context, as different funds are exposed to different kinds of risks.

Other incentive-based partnerships were set up in the mid-1950s, includ- ing Warren Buffett’s Omaha-based Buffett Partners and Walter Schloss’s WJS Partners, but their funds were styled with a long bias after Benjamin Gra- ham’s partnership (Graham-Newman). Under today’s broadened definition, these funds would also be considered hedge funds, but regularly shorting shares to hedge market risk was not central to their investment strategies.

Alfred W. Jones was a sociologist. He received his Ph.D. in sociology from Columbia University in 1938. During the 1940s Jones worked for For- tune and Time and wrote articles on nonfinancial subjects such as Atlantic convoys, farm cooperatives, and boys’ prep schools. In March 1949 he wrote a freelance article for Fortune called “Fashions in Forecasting,” which re- ported on various technical approaches to the stock market.

His research for this story convinced him that he could make a living in the stock market, and early in 1949 he and four friends formed A. W. Jones & Co. as a general partnership. Their initial capital was $100,000, of which Jones himself put up $40,000. In its first year the partnership’s gain on its capital came to a satis- factory 17.3 percent.

Jones generated very strong returns while managing to avoid significant attention from the general financial community until 1966, when an article in Fortune led to increased interest in hedge funds (impact of the 1966 article is discussed in the next section).

The second hedge fund after A. W. Jones was City Associates founded by Carl Jones (not related to A. W. Jones) in 1964 after working for A. W. Jones.4 A further notable entrant to the industry was Barton Biggs. Mr. Biggs formed the third hedge fund, Fairfield Partners, with Dick Radcliffe in 1965. Unlike in the 2000–2002 downturn, many funds perished during the market downturns of 1969–1970 and 1973–1974, having been unable to resist the temptation to be net long and leveraged during the prior bull run.

Hedge funds lost their prior popularity, and did not recover it again until the mid-1980s. Fairfield Partners was among the victims as it suffered from an early market call of the top, selling short the Nifty Fifty leading stocks because their valuation multiples had climbed to what should have been an unsustainable level. The call was right, but too early. “We got killed,” Mr. Biggs said. “The experience scared the hell out of me.” Morgan Stanley hired him away from Fairfield Partners in 1973.

Note that around three decades later some hedge funds also folded for calling the market too early; that is, they were selling growth stocks and buying value stocks too early.

Jones merged two investment tools—short sales and leverage. Short sell- ing was employed to take advantage of opportunities of stocks trading too expensively relative to fair value. Jones used leverage to obtain profits, but employed short selling through baskets of stocks to control risk. Jones’ model was devised from the premise that performance depends more on stock selection than market direction. He believed that during a rising market, good stock selection will identify stocks that rise more than the market, while good short stock selection will identify stocks that rise less than the market.

However, in a declining market, good long selections will fall less than the market, and good short stock selection will fall more than the market, yielding a net profit in all markets. To those investors who regarded short selling with suspicion, Jones would simply say that he was using “speculative techniques for conservative ends.”

Jones kept all of his own money in the fund, realizing early that he could not expect his investors to take risks with their money that he would not be willing to assume with his own capital. Curiously, Jones became uncomfortable with his own ability to pick stocks and, as a result, employed stock pickers to supplement his own stock-picking ability.

Soon he had as many as eight stock pickers autonomously managing portions of the fund. In 1954, he had converted his partnership into the first multimanager hedge fund by bringing in Dick Radcliffe to run a portion of the portfolio. By 1984, at the age of 82, he had created a fund of funds by amending his partnership agreement to reflect a formal fund of funds structure.

Caldwell (1995) points out that the motivational dynamics of Alfred Jones’ original hedge fund model run straight to the core of capitalistic instinct in managers and investors. The critical motives for a manager are high incentives for superior performance, coupled with significant personal risk of loss. The balance between risk seeking and risk hedging is elementary in the hedge fund industry today. A manager who has nothing to lose has a strong incentive to “risk the bank.”

The 1950s and 1960s
In April 1966, Carol Loomis wrote the aforementioned article, called “The Jones Nobody Keeps Up With.” Published in Fortune, Loomis’ article shocked the investment community by describing something called a “hedge fund” run by an unknown sociologist named Alfred Jones.9 Jones’ fund was outperforming the best mutual funds even after a 20 percent incentive fee.

Over the prior five years, the best mutual fund was the Fidelity Trend Fund; yet Jones outperformed it by 44 percent, after all fees and expenses. Over 10 years, the best mutual fund was the Dreyfus Fund; yet Jones outperformed it by 87 percent. The news of Jones’ performance created excitement, and by 1968 approximately 200 hedge funds were in existence.

During the 1960s bull market, many of the new hedge fund managers found that selling short impaired absolute performance, while leveraging the long positions created exceptional returns. The so-called hedgers were, in fact, long, leveraged and totally exposed as they went into the bear market of the early 1970s. And during this time many of the new hedge fund managers were put out of business. Few managers have the ability to short the market, since most equity managers have a long-only mentality.

Caldwell (1995) argues that the combination of incentive fee and leverage in a bull market seduced most of the new hedge fund managers into using high margin with little hedging, if any at all. These unhedged managers were “swimming naked.” Between 1968 and 1974 there were two downturns, 1969–1970 and 1973–1974. The first was more damaging to the young hedge fund industry, because most of the new managers were swimming naked (i.e., were unhedged).

For the 28 largest hedge funds in the Securities and Ex-change Commission (SEC) survey at year-end 1968, assets under management declined 70 percent (from losses as well as withdrawals) by year-end 1970, and five of them were shut down. From the spring of 1966 through the end of 1974, the hedge fund industry ballooned and burst, but a number of well- managed funds survived and quietly carried on. Among the managers who endured were Alfred Jones, George Soros, and Michael Steinhardt.

Hedge Funds—The Warren Buffett Way
An interesting aspect about the hedge funds industry is the involvement of Warren Buffett, which is not very well documented as Buffett is primarily associated with bottom-up company evaluation and great stock selection. He is often referred to as the best investor ever and an antithesis to the efficient market hypothesis (EMH).

According to Hagstrom (1994), Warren Buffett started a partnership in 1956 with seven limited partners. The limited partners contributed $105,000 to the partnership. Buffett, then 25 years old, was the general partner and, apparently, started with $100.

The fee structure was such that Buffett earned 25 percent of the profits above a 6 percent hurdle rate whereas the limited partners received 6 percent annually plus 75 percent of the profits above the hurdle rate. Between 1956 and 1969 Buffett com- pounded money at an annual rate of 29.5 percent despite the market falling in five out of 13 years. The fee arrangement and focus on absolute returns even when the stock market falls look very much like what absolute return man- agers set as their objective today.

There are more similarities:
■ Buffett mentioned early on that his approach was the contrarian/value-investor approach and that the preservation of principal was one of the major goals of the partnership. Today, capital preservation is one of the main investment goals of all hedge fund managers who have a large portion of their own net wealth tied to that of their investors. Warren Buffett’s partnership had a long bias after Benjamin Graham’s partnership. Selling short was not central to the investment strategy.
■ Buffett’s stellar performance attracted new money. More partnerships were founded. In 1962 Buffett consolidated all partnerships into a single partnership (and moved the partnership office to Kiewit Plaza in Omaha). The fact that stellar performance attracts capital is not new. Superior performance attracts capital in retail mutual funds as well as hedge funds. However, with some absolute return strategies there is limited capacity. In addition, there are manager-specific capacity constraints next to strategy- specific capacity constraints. Skilled managers are flooded with capital and eventually close their funds to new money.
■ As the Nifty Fifty stocks like Avon, IBM, Polaroid, and Xerox were trading at 50 to 100 times earnings Buffett had difficulties finding value. He ended his partnership in 1969. Buffett mailed a letter to his partners con- fessing that he was out of step with the current market environment:

On one point, however, I am clear. I will not abandon a previous approach whose logic I understand, although I find it difficult to apply, even though it may mean foregoing large and apparently easy profits to embrace an approach which I don’t fully understand, have not practiced successfully and which possibly could lead to substantial permanent loss of capital.

These notions sound like an absolute return investment philosophy. There are two nice anecdotes with this notion: First, in recent years some market observers were claiming that Warren Buffett finally “lost it” as he re- fused to invest in the technology stocks of the 1990s as he had refused to in- vest in the Nifty Fifty stocks three decades earlier. The lesson to be learned is that absolute return managers do not pay 100 times prospective earnings, whereas relative return managers do.

Warren Buffett’s quotation looks very similar to quotes by Julian Robertson. Julian Robertson wrote to investors in March 2000 to announce the closure of the Tiger funds (after losses and withdrawals). Robertson was returning money to investors, as did Warren Buffett in 1969. Robertson said that since August 1999 investors had with- drawn $7.7 billion in funds.

He blamed the irrational market for Tiger’s poor performance, declaring that “earnings and price considerations take a back seat to mouse clicks and momentum.” Robertson described the strength of technology stocks as “a Ponzi pyramid destined for collapse.” Robertson’s spokesman said that he did not feel capable of figuring out in- vestment in technology stocks and no longer wanted the burden of investing other people’s money.

There are also some similarities between Buffett and Soros: Both Warren Buffett and George Soros are contrarians.† There is a possibility that successful investors are contrarians by definition.‡ Hagstrom (1994) quotes Buffett: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”* This sounds (in terms of content, not phraseology) very much like what George Soros has to say:† “I had very low regard for the sagacity of professional investors and the more influential their position the less I considered them capable of making the right decisions. My partner and I took a malicious pleasure in making money by selling short stocks that were institutional favorites.”

Buffett compares investing with a game: “As far as I am concerned the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish. It’s like poker. If you have been in the game for a while and don’t know who the patsy is, you’re the patsy.” There are some similarities with how George Soros sees investing: “I did not play the financial markets according to a particular set of rules; I was always more interested in understanding the changes that occur in the rules of the game.”

Shareholders of Berkshire Hathaway were also exposed to various forms of arbitrage, namely risk arbitrage and fixed income arbitrage. Over the past decades, Warren Buffett created the image of being a grandfatherly, down-to- earth, long-term, long-only investor, repeatedly saying he invested only in opportunities he understood and implying a lack of sophistication for more complex trading strategies and financial instruments. However, there is no lack of sophistication at all.

According to Hagstrom (1994) Buffett was involved in risk arbitrage (aka merger arbitrage) in the early 1980s and left the scene in 1989 when the game became crowded and the arbitrage landscape was changing. In 1987 Berkshire Hathaway invested in $700 million of newly issued convertible preferred stocks of Salomon, Inc.

Salomon was the most sophisticated and most profitable fixed income trading house of the time and the world’s largest fixed income arbitrage operation. Note that Long Term Capital Management (LTCM) was founded and built on the remains of Salomon staff after the 1991 bond scandal.‡ Warren Buffett became interim chairman of Salomon after chairman John Gutfreund resigned.

Hagstrom (1994) argues that “Buffett’s presence and leadership during the investigation prevented Salomon from collapsing.” Had the board, led by Warren Buffett, not persuaded U.S. attorneys that it was prepared to take draconian steps to make things right, it seems highly likely that the firm would have been indicted and followed Drexel Burnham to investment banking’s burial ground.

Warren Buffett’s Berkshire Hathaway was invested in Bermuda-based West End Capital during the turbulence caused by the Russian default crisis in 1998. Berkshire contributed 90 percent of the capital raised in July 1998 to West End Capital, which attempts to profit through bond convergence invest- ing and uses less leverage (around 10 to 15 times) than comparable boutiques.

However, the investment is not sizable when compared to long-only positions. In August 1998 John Meriwether approached Buffett about investing in LTCM. Buffett declined.18 Later Buffett offered to bail out LTCM, an offer that was ultimately declined by LTCM.

Throughout his extremely successful career, Warren Buffett has had some kind of involvement in what today is called the hedge fund industry, that is, money managers seeking absolute returns for their partners and themselves while controlling unwanted risk. Figure 1.1 shows what great money man- agers have in common: a focus on absolute returns.

The Risk and Opportunities of Hedge Fund Investing Figure 1-1

One of the great ironies in the annals of finance is that George Soros is probably the most misunderstood and controversial figure in the money management scene. However, based on realized performance, he is probably the greatest investor the world has ever seen. This is ironic because George Soros’ sterling conversion trade in 1992 is considered as symptomatic of pure speculation.

Soros compounded at an annual rate of 31.6 percent (after fees) in the 33 years from 1969 to 2001. This compares with around 26.0 percent in the case of Warren Buffett in the 44 years ending 2001 and with around 22.4 per- cent for Julian Robertson in the 22 years ending 2001. Note that compound- ing $1 at 31.6 percent, 26.0 percent, 22.4 percent and 7.9 percent (S&P 500) over a 25-year period results in terminal values of $958, $323, $157, and $6.7 respectively. This, albeit anecdotal, can be considered a big difference.

Who is the greatest money manager of all time? Most people would prob- ably agree that it is either George Soros or Warren Buffett. Figure 1.1 would suggest the former, Figure 1.2 the latter. Figure 1.2 shows annualized returns in relation to the standard deviations of these annual returns, that is, so-called risk-adjusted returns (implying that the standard deviation of returns is a sound proxy for risk). The sizes of the bubbles (and the numbers next to the bubbles) measure the Sharpe ratios assuming a constant risk-free rate of 5 percent. Note that the risk-adjusted returns were calculated over different time periods.

 

The Risk and Opportunities of Hedge Fund Investing Figure 1-1

Figure 1.1 and Figure 1.2 also reveal another interesting aspect of business life. According to Hagstrom (1994) Warren Buffett started with $100 in 1957. Figure 1.1 implies that his initial investment of $100 would have grown to only $2.6 million by the end of 2001. However, Warren Buffett is a multi- billionaire and one of the wealthiest individuals on the planet.

The difference between $2.6 million and his X-billion wealth is attributed to entrepreneurism and not investment skill (albeit there is strong correlation be- tween the two). This should serve as a reminder to day traders and other financial comedians: Unambiguous greatness and sustainable value creation are achieved through successfully setting up and running businesses and not through having a go at the stock market.

The 1970s
Richard Elden (2001), founder and chairman of Chicago-based fund of (hedge) funds operator Grosvenor Partners, estimates that by 1971 there were no more than 30 hedge funds in existence, the largest having $50 million under management. The aggregate capital of all hedge funds combined was probably less than $300 million. The first fund of hedge funds, Leveraged Capital Holdings, was created by Georges Karlweis in 1969 in Geneva. This was followed by the first fund of funds in the United States, Grosvenor Partners in 1971.

In the years following the 1974 market bottom, hedge funds returned to operating in relative obscurity, as they had prior to 1966. The investment community largely forgot about them. Hedge funds of the 1970s were differ- ent from the institutions of today. They were small and lean. Typically, each fund consisted of two or three general partners, a secretary, and no analysts or back-office staff.

The main characteristic was that every hedge fund specialized in one strategy. (This, too, is different from today.) Most managers focused on the Alfred Jones model, long/short equity. Because hedge funds represented such a small part of the asset management industry they went un-noticed. This resulted in relatively little competition for investment opportunities and exploitable market inefficiencies. In the early 1970s there were probably more than 100 hedge funds. However, conditions eliminated most.

The 1980s
Only a modest number of hedge funds were established during the 1980s. Most of these funds had raised assets to manage on a word-of-mouth basis from wealthy individuals. Julian Robertson’s Jaguar fund, George Soros’ Quantum Fund, Jack Nash from Odyssey, and Michael Steinhardt Partners were compounding at 40 percent levels. Not only were they outperforming in bull markets, but they outperformed in bear markets as well.

In 1990, for example, Quantum was up 30 percent and Jaguar was up 20 percent, while the S&P 500 was down 3 percent and the Morgan Stanley Capital International (MSCI) World index was down 16 percent. The press began to write articles and profiles drawing attention to these remarkable funds and their extraordinary managers.

Figure 1.3 shows an estimate of number of hedge funds in existence through the 1980s. Duplicate share classes, funds of funds, managed futures, and currency speculators were not included in the graph.

The Risk and Opportunities of Hedge Fund Investing Figure 1-3

During the 1980s, most of the hedge fund managers in the United States were not registered with the SEC. Because of this, they were prohibited from advertising, and instead relied on word-of-mouth references to grow their as- sets. (See Table 1.1.)

The majority of funds were organized as limited partner- ships, allowing only 99 investors. The hedge fund managers, therefore, required high minimum investments. European investors were quick to see the advantages of this new breed of managers, which fueled the development of the more tax-efficient offshore funds.

The Risk and Opportunities of Hedge Fund Investing Table 1-1

Caldwell (1995) puts the date where hedge funds reentered the investment community at May 1986, when Institutional Investor ran a story about Julian Robertson.21 The article, by Julie Rohrer, reported that Robertson’s Tiger Fund had been compounding at 43 percent during its first six years, net of expenses and incentive fees.

This compared to 18.7 percent for the S&P 500 during the same period. The article established Robertson as an investor, not a trader, and said that he always hedged his portfolio with short sales. One of the successful trades the article mentioned was a bet on a falling U.S. dollar against other major currencies in 1985. Robertson had bought an option, limiting downside risk by putting only a fraction of the fund’s capital at risk. Rohrer showed the difference between a well-managed hedge fund and traditional equity management.

Another fund worth mentioning was Princeton/Newport Trading Partners. Princeton/Newport was a little-known but very successful (convertible) arbitrage fund with offices in Princeton, New Jersey, and Newport Beach, California. Some practitioners credit the firm with having the first proper option pricing model and making money by arbitraging securities; this included optionality that other market participants were not able to price properly.

For two decades up to 1988, Princeton/Newport had achieved a remarkable track record with returns in the high teens and extremely few negative months. Un- fortunately, Princeton/Newport was hit by overzealous government action that led to an abrupt cessation of operations in 1988.

The 1990s
During the 1990s, the flight of money managers from large institutions accelerated, with a resulting surge in the number of hedge funds. Their operations were funded primarily by the new wealth that had been created by the un- precedented bull run in the equity markets. The managers’ objectives were not purely financial. Many established their own businesses for lifestyle and control reasons. Almost all hedge fund managers invested a substantial portion of their own net worth in the fund alongside their investors.

One of the characteristics of the 1990s was that the hedge fund industry became extremely heterogeneous. In 1990, two-thirds of hedge fund man- agers were macro managers, that is, absolute return managers with a rather loose mandate. Throughout the decade, more strategies became available for investors to invest in.

Some of the strategies were new; most of them were not. By the end of 2001, more than 50 percent of the assets under management were somehow related to a variant of the Jones model, long/short equity. However, even the subgroup of long/short equity became heterogeneous. Figure 1.4 compares some alternative investment strategies with the traditional long-only strategy with respect to the variation in net market exposure.

The horizontal lines show rough approximations of the ranges in which the different managers are expected to operate. It will become clear in later chapters that the superiority of the long/short approach is derived from widening the set of opportunities (and the magnitude of opportunities) from which the manager can extract value.

The graph highlights a further aspect of hedge fund investing: Not all equity absolute return managers have the same investment approach. This diversity results in low correlation among different man- agers, despite the managers trading the same asset class. Low correlation among portfolio constituents then allows construction of low-risk portfolios.

The Risk and Opportunities of Hedge Fund Investing Figure 1-4

The 1990s saw another interesting phenomenon. A number of the established money managers stopped accepting new money to manage. Some even returned money to their investors. Limiting assets in many investment styles is one of the most basic tenets of hedge fund investing if the performance expectations are going to continue to be met.

This reflects the fact that managers make much more money from performance fees and investment income than they do from management fees. Due to increasing investor demand in the 1990s, many funds established higher minimum investment levels ($50 million in some cases) and set long lock-up periods (three to five years).

Both Julian Robertson’s Tiger Management and George Soros’ Soros Fund Management reached $22 billion in assets in 1998, setting a record for funds under management.22 Both organizations subsequently shrunk in size, and Tiger ultimately was liquidated. Today, there are dozens of organizations managing more than $1 billion.

Based on data from Hedge Fund Research, Inc. (HFRI) the hedge fund industry grew in terms of unleveraged assets under management of $38.9 billion in 1990 to $456.4 billion in 1999 and $536.9 billion at the end of 2001.

Conclusion
Some investors in the hedge fund industry argue that the pursuit of absolute returns is much older than the pursuit of relative returns (i.e., beating a benchmark). This view can be justified if we allow for a loose interpretation of historical deals.

One could conclude that the way hedge funds manage as- sets is going back to the roots of investing. What Charles Ellis (1998) calls trying to win the loser’s game, therefore, could be viewed as only a short blip in the evolution of investment management. Put differently, both the first and third paradigm of investment management were about absolute returns.

Irrespective of the history of hedge funds or whether hedge funds are leading or lagging the establishment, the pursuit of absolute returns is probably as old as civilization and trade itself. However, so is lemming-like trend following.

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