Thought recent develops in the hedge fund industry such as poor performance, SEC registration, and taxation were unprecedented? Yeah, so did we – until Nicholas Motson of the Cass Business School (see related post), gave us a heads-up about a fascinating FORTUNE magazine article by Carol Loomis (who went on to enjoy an illustrious career in business journalism and remains a Senior Editor-at-Large with the magazine) from the issue. The entire article can be downloaded here on the A.W. Jones & Co. website (yes, that A.W. Jones – the father of the hedge fund industry).
As you will see, the similarities between the hedge fund world of 1970 and that of 2008 and truly amazing – almost eerie in fact. Even the 39 year old Warren Buffett makes a cameo in this piece. As Motson pointed out to us, “…if you re-scale the numbers it could have been printed yesterday.”
The bizarre parallels begin with the article’s very title: “Hard Times Come to Hedge Funds“. It goes on to chronicle the travails of the $1 billion industry (as a point of reference, the US mutual fund sector managed about $50 billion at the time). FORTUNE estimated there were 3,000 investors in about 150 hedge funds by 1970. Most funds were launched between 1966 and 1970 and “the great bulk” were registered in Manhattan (that’s just south of Greenwich, for those who may not remember the old days).
Trouble in Paradise
FORTUNE described these 3,000 investors as mostly “wealthy…important businessmen.” Their returns had been good for a few years. But, wrote the magazine…
“…some today are troubled about their hedge fund investments. Their misgivings are something new, for until recently, the hedge funds looked like an investor’s dream. The records they produced were consistently lustrous, and it seemed as if their structure was ideally geared to success.”
“In general, hedge funds were clobbered by the 1969 bear market…The 1969 experience has been a rude awakening for many hedge fund investors and has left some of them with strong reservations about the whole concept. For the first time in their relatively short history, the funds are not growing; in fact, some have suffered large withdrawals for capital and a few have actually folded.”
“What remains, however, is still a big business, for in the last few years, the hedge funds have both proliferated in number and exploded in size.”
“Hedged Mutual Funds”
In a 2006 paper called “Hedge Funds for Retail Investors? An Examination of Hedged Mutual Funds” (see related post) academics Vikas Agarwal, Nicole Boyson, and Narayan Naik wrote that:
“Fairly recently, a number of mutual fund companies have begun offering funds that use hedge fund-like trading strategies designed to benefit from potential mis-pricing on the long as well as the short side.”
But as the January 1970 FORTUNE article points out, the concept actually has a long history. Wrote FORTUNE:
“…the last couple of years have seen the formation of some twenty-odd mutual funds that are patterned after the private [hedge] funds and that are commonly also identified as ‘hedge funds’.”
When disciples of hedge fund legend Julian Robertson left Robertson’s Tiger Management to launch their own funds, the hedge fund community branded them as “Tiger cubs”. But Robertson wasn’t the first to produce such prodigy. Reports FORTUNE:
“Because he was running private partnerships, [Alfred] Jones was able to keep the dimensions of his success very quiet, and he had no imitators of any consequence until 1964, when one of his general partners – the first of several to do so – peeled off to start his own fund…These funds are sometimes jokingly referred to as ‘Jones’ children’…”
And as incontrovertible evidence that there are only so many hedge fund names in the world to choose from, two of these “children” were called “Fairfield Partners” and “Cerberus Associates”…
Defining the “Hedge Fund Industry”
Recent Congressional testimony referenced our post a few weeks ago on whether hedge funds could be even be defined as an “asset class” (see related post). As critics are apt to say in 2008, hedge funds are a “compensation scheme masquerading as an asset class.” Apparently, that characterization goes way back.
“…there is some disagreement these days as to the definition of a hedge fund…it would appear that they key feature of a hedge fund is neither the hedge nor the leverage, but instead the method by which the general partners are compensated.”
“Investing with the Stars”
Think Britney Spears and Sylvester Stallone were the first celebrities to invest in hedge funds? Think again. FORTUNE also reported that Jimmy Stewart, Rod Steiger, and Jack Palance were all co-investors in one California-based fund.
“Flat is the new up” applied to 1969 too…
Note to journalists: the following excerpt from the FORTUNE piece can be re-used today. Just cut-and-paste and change “million” to “billion”…
“FORTUNE has been able to find only a very few funds – most of them under $10 million in assets – that were in the plus column for the year. Many of the larger funds had dismal records…”
But on this Thanksgiving weekend, here’s something that US hedge fund investors can be thankful didn’t also happen in 2008…
“…on the first of October , when the New York Stock Exchange composite average was down 13 percent for the year, the two Jones funds and City Associates were down between 30 and 40 percent…During the month of June, when the market dropped by 6.9 percent, eight hedge funds…dropped on the average 15.3 percent. In July, when the market fell 6.4 percent, the funds were down by an average of 10 percent”
Marketing swings into action
Critics of the hedge fund industry are going to love this part…
“Despite the weight of this and other evidence, some hedge fund managers have attempted to persuade their investors that 1969 wasn’t really as deplorable as it might have seemed. Charles E. Hurwitz, who runs three private hedge funds in Texas and also one of the largest public hedge funds, Hedge Fund of America [AllAboutAlpha: What a truly goofy name], reminded shareholders of that fund a few months ago that ‘the hedging feature is designed to reduce losses in a downturn, not eliminate them’.”
This excerpt could have been pulled from nearly any Q3 hedge fund investor letter this year. (We’re not making this stuff up, check for yourself – page 103).
Navel-gazing still in style today
Recently, some of the world’s most successful hedge fund managers have taken it on the chin – causing some of them to take a rather introspective view of their industry and of the problems that made the minus-sign on their computers one of the most used keys (George Soros, for one).
Alfred Jones, the Soros of his day, provided his observations to FORTUNE:
“The trouble began, he says, in the 1966-68 period when the craze for performance swept the investment world and when all sorts of money managers, including those in his own shop, got overconfident about their ability to make money…Even Jones himself was caught up in what he describes as the “euphoria” of the times. He says he began to wonder…whether his hedging strategies, which has aimed as softening the effects of a potential market decline and which had therefore held back his gains in a bull market, might not have been misguided.”
But it wasn’t just the managers who were beginning to question the hedge fund “concept”…
“The debris of 1969 has naturally prompted some hedge fund investors to ask just what it is that the hedge fund concept is doing for them…”
Some might find the managers of the 1960’s were more contrite after their annis horribilis than some of today’s hedge fund managers. FORTUNE notes:
“Talk to general partners of such funds as City Associates and Fairfield Partners, and they will speak ruefully of 1969 and tell you they should have been able to pull out of it with profits. They regard their failure to do so as a reflection not on the hedge fund concept itself, but on their own ability to handle it properly.”
Filling your Shorts
The resulting long-bias for the industry went on to cause significant panic in the ensuing bear market – leading hedge fund managers to fill their shorts. But with the “uptick rule” firmly in place at the time, amassing an off-setting short position could be a challenge. Continues the article:
“Some hedge funds say 1969 had its special problems; among them the existence of too many hedge funds looking for shorts….Nevertheless, the hedge fund’s major problem last year was of a more elementary kind: they simply picked the wrong stocks to short…”
Sound familiar to anyone?
Of course, the emerging field of short selling was also opening the door to potential abuses. FORTUNE notes one particular case:
“One investigation that brought the [SEC] staff in contact with the hedge funds is that which led in 1968 to an SEC proceeding against Merrill Lynch, Pierce, Fenner & Smith and ten of its important customers for their alleged misuse, in 1966, of certain bearish information related to Douglas Aircraft…All (were) charged with having received “insider information” about Douglas from Merrill Lynch and having then made sales and/or short sales of Douglas stock.”
“That 70’s Shakeout”
Note to journalists (II): Simply cut-and-paste the excerpt below into any new story on hedge funds…
“…the hedge fund business seems certain to undergo extensive changes, some of which have already begun to materialize. In a way, the business is at this juncture typical of those industries in which supply has temporarily exceeded demand, and in which some casualties are the inevitable result. No one knows exactly how many hedge funds have folded. But a fair number have.”
1970: Buffett shuts down his “hedge fund” to focus on some screwy textile company
One of the hedge funds that closed its doors around that time was called “Buffett Partnership, Ltd.” As FORTUNE acknowledged, the 13-year old fund didn’t actually hedge. In fact, it was really just a value fund. However, it did involve a hefty performance fee (rich, from a guy who routinely lambastes what he calls the “two and twenty crowd”). Reported FORTUNE:
“Under his quite unusual arrangement, the limited partners annually kept all of the gains up to 6 percent; above that level, Buffett takes a one-quarter cut.”
In any event, the magazine went on to report that the then 39-year-old Oracle was in the midst of throwing in the towel on his quest to become mega-rich:
“But now, to the immense regret of him limited partners, Buffett is quitting the game. His reasons for doing so are several, and include a strong feeling that his time and wealth should now be directed toward other goals than simply the making of more money.”
He quit hedge funds alright. But he had apparently failed miserably at not making more money.
In their Congressional testimony earlier this month, George Soros and other hedge fund billionaires suggested that their performance fees could legitimately be interpreted as “income” rather than “capital gains” – thus bumping their tax rates considerably.
Back in 1970, FORTUNE reported that performance fees weren’t just an incentive, but they actually kept the lights on (there were no management fees). So the managers of the day argued that such extreme risk should be treated more akin to capital gains than income. Thus was born the current approach to taxing the “carry”.
But then a funny thing happened. Faced with the prospect of making $0 when the fund was down, managers began asking for…
“…salaries in those years in which profits are non-existent or very small; ordinarily, these salaries are then considered to be advances against profits to which the general partners may become entitled in future years.”
Today, these salaries are known as “management fees”. But unlike their 1970 counterparts, they are not generally structured as a draw on future bonuses. When you think about it, a draw against future performance fees is sort of like a high water mark that resets each year at the amount of management fees paid out, but not yet recouped.
(Ed: Those who have read Tremont founder Sandra Manzke’s recent proposals for the industry will note that on November 26th, Manzke called for a return to a no-management-fee model with a manager draw against future bonuses if absolutely required.)
SEC: New boss apparently the same as the old boss
Perhaps one of the most interesting parallels between 1970 and 2008 is the ongoing battle between the industry and the SEC. As FORTUNE wrote almost 40 years ago…
“The next disastrous happenings may emanate from the SEC, which for years has been fretting about the hedge funds and which lately has been trying strenuously to arrive at some decision about them. A year ago, the SEC sent out an exhaustive questionnaire to some 200 investment partnerships…”
“…certain members of the SEC staff have already concluded that the Commission must take steps to regulate these funds…One staff member spoke recently of the ‘crisis numbers’ to which hedge funds have grown, and there has been much SE talk about the ‘impact’ of the funds on the market.”
“The Commission’s basic legal bother about hedge funds is that they are unquestionably investment companies, but a variety that is able to wiggle out from under the Investment Company Act…Since it cannot get at the hedge funds through the Investment Company Act, the SE is thinking of trying a couple of other routes.”
Boy, the more things change, the more they stay the same, eh? The SEC is, of course, still “talking” and “thinking” to this day. And managers are still as concerned as they were in 1970. Continues FORTUNE:
“The whole [registration] argument has rather disparate overtones for the general partners, for they cannot tolerate as investment advisers.
“It is hard to say what the SEC will do, and it is even harder to form an opinion on what the SEC should do. Probably the hedge funds deserve to be regulated in some way, but whether they should be ravaged is another question. If wealthy, sophisticated investors wish to pay 20 percent of their profits for investment management – or, as one dejected investor put it – are “foolish” enough to pay 20 percent – they quite possibly they should be allowed to do so.”
Those words – along with pretty much every other in this bizarrely prophetic article – echo to this day. Anyone who says that history doesn’t repeat itself ought to seriously revisit that position.