Once again, the New York Times provides an all-too-uncommon rational and clear-headed analysis of the hedge fund industry – without the populist hype that many mass media outlets have come to rely on to sell papers.
Friday’s article “How This Boom Differs From the Dot-Com Days: Hedge Funds Make Money” is insightful for two reasons. Firstly, it draws legitimate parallels between the hedge fund boom and the dot-com boom. And second, it explains exactly where those parallels end. Still, we’d say the article might be a little quick to write off over-valuation risk in the hedge fund industry.
Says the Times:
“The bubble talk derives in part from some of the startling similarities between the technology boom, circa 1999, and the current hedge fund gilded age. During both periods, top Wall Street bankers and traders abandoned their traditional confines in search of big money, casual dress and guaranteed free fresh fruit. Each era included lots of talk about paradigm shifts, much of it from self-interested quarters like Wall Street, which always finds a way to turn the next best thing into a pile of loot. In both instances, small groups of very young people made eye-popping sums of money. And now, add to the eerie similarities the fact that hedge funds are racing to go public.”
No doubt there are striking similarities between these two capital market mega-trends. In fact, one of the first postings on this website made the very same comparison (see “Hedge Funds: E-Business Redux?”)
But unfortunately, to carry this analogy to its natural conclusion is to suggest a similarly violent demise of the hedge fund industry. However, unlike dot-coms, hedge funds aren’t valued solely on a promise of future returns. They are valued based on a (typically) objective NAV (net asset value). As a result, any future industry implosion would most likely take the form of investor apathy and dwindling assets, not a crash precipitated by a sudden realization that valuations were unsupportable.
The Times also makes this point, arguing that if anything is risky, it’s the hedge funds underlying assets not the hedge fund industry as a whole.
“The real question should be how they manage their investments in areas that may themselves be bubbles â€” like the credit market, which still does not properly reflect risk…Bubbles occur when assets are bought and sold for more than they are worth…”
But now that hedge fund managers themselves have become securities – IPO’s valued on the promise of future profits – this argument needs to be revisited. Expectations of future earnings, forecasts, opinions, and human emotion have now entered into the equation. No worries, argues the Times, since unlike dot-bombs hedge funds have proven profit-making abilities.
“With hedge funds going public, we can see how they make money and then guess if they can make more every year. They will do this by attracting a lot more money and ideally, by investing that money well. But unlike Internet companies seeking eyeballs to justify lofty valuations, hedge funds make money. A lot of money. They charge huge fees, make big profits and take huge payouts…Och-Ziff is no Pets.com.”
Och-Ziff makes more money – stock goes up. Less money – stock goes down. Sounds simple enough and free of speculation, right?
Maybe not. Investors in these stocks may assume that the current structure of the asset management industry will remain intact going forward. But the past two years have illustrated that hedge funds cannot lay claim to a natural monopoly on alpha. Hybrid threats like 130/30, acquisition-hungry long-only shops, and portable alpha strategies (not to mention hedge fund replication) are the first signs that that traditional asset managers aren’t going to sit around and watch hedge fund pure-plays clean up in the alpha-centric sweepstakes. Already, for example, the largest managers of US tax-exempt assets are long-only shops with hedge fund-like products, not the stereotypical pure-play hedge fund firms (see related posting).
Sure, there will always be a lot of profit in alpha-generation, but it will eventually be divided across the entire spectrum of the asset management industry. In other words, it may not always exist in the relatively pure organizational form that it does today. Consequently, we may someday look back at the hedge fund explosion as a temporary structural anomaly in the continuous evolution of the asset management industry.
In the end, this eventuality also has parallels to the dot-com world. For about 7 years from the birth of the World Wide Web to about 2001, e-business pure-plays dominated the landscape (e.g. USWeb, Pets.com, Toys.com…). E-business was considered a distinct discipline and service offering. There was even talk of separate e-business MBAs.
But today few pure-pays remain and e-business has become baked into everything we do. To be sure, it continues to be a profitable activity. But it has since been split-up across the entire spectrum of business processes – so much so that identifying it by its own term, “e-business”, now seems almost antiquated.
So while we agree with the Times that hedge funds can’t technically experience a bubble (at least not in the dot-com sense), hedge fund stocks could someday prove to be a different story.