It seems that every big market downturn has its putative villains, and this time around hedge funds are getting the rap. These highly leveraged and largely unregulated investment partnerships for the very rich are suspected of having multiplied the tumult that has gripped global financial markets for the past two months, culminating in the U.S. bond market's recent implosion.
Hedge funds hold about $75 billion in funds, a pittance compared with the more than $2 trillion in mutual funds. But these high-octane investment pools borrow freely, letting them control far larger sums. On top of this penchant for leverage, they tend to concentrate their bets in a few markets, giving them tremendous power. And when they enter or exit as a herd, which they often seem to do, hedge funds can trample other investors.
The secrecy surrounding the most celebrated hedge funds may soon be lifted a bit. The House Banking Committee is scheduled to hold hearings April 13 on the funds' use of derivatives -- futures, options and other financial instruments derived from underlying investments like stocks, bonds and currencies -- and the role this combustible combination may have played in producing the recent market turmoil. "Hedge funds deserve extra scrutiny," says committee chairman Henry Gonzalez of Texas, because they may be destabilizing financial markets.
All-star cast. Getting more information from hedge funds is in the "national interest," Securities and Exchange Commission Chairman Arthur Levitt told the New York Financial Writers Association last week, tipping his hand on his testimony when he appears before Gonzalez's committee along with other regulators, including Federal Reserve Board Chairman Alan Greenspan. Legendary money manager George Soros, who runs the $10 billion Quantum Group of hedge funds, is also set to testify.
Provided they have fewer than 100 U.S. investors, hedge funds currently are exempt from the registration requirements imposed on ordinary mutual funds by the provisions of the Investment Company Act of 1940. It is assumed that anyone wealthy enough to qualify for a hedge fund understands the risks involved. No hedge fund will look at you unless you have at least $500,000 to invest, and the best-known funds won't take anything below $10 million.
Last year was spectacular for the roughly 800 hedge funds, up from only 200 two years ago. Many of the best-known funds, such as Steinhardt Management Corp. and Tiger Management Corp., garnered returns well in excess of 50 percent. And hedge fund managers like Michael Steinhardt and Tiger's Julian Robertson, who generally earn incentive fees of around 20 percent on the gains they produce on top of a 1 percent management fee, pulled down some of the biggest paychecks ever seen in the world of business and finance. But no one topped George Soros, whose Quantum Group registered a 73 percent return. The Hungarian-born investment strategist, already a billionaire, reportedly received $625 million in fees besides what he made on his own investment stake.
This year, however, the funds have taken some staggering hits. Big plays on the direction of the dollar and on interest rates have been far off the mark, producing billions of dollars in aggregate losses as the funds dumped their vast leveraged holdings. On Valentine's Day, Quantum lost $600 million just on a wrong-headed hunch that the Japanese yen would fall against the dollar. Traders estimate that Steinhardt Management's $5 billion portfolio at year-end 1993 is off by as much as 25 percent, due mainly to losses on highly leveraged foreign bond positions.
To be sure, most investors who have had money in hedge funds for the past few years remain ahead. Recent losses pale beside historic gains. For example, Quantum made $1 billion in a few days during 1992's European currency crisis, when the British pound was devalued.
But there has already been one outright casualty, and some suspect other hedge fund operations may currently be in the emergency ward. Askin Capital Group, with $600 million under management, has filed for bankruptcy. The firm, which ran three funds specializing in complex mortgage-backed securities, was liquidated when it didn't repay margin loans because its holdings had plunged when U.S. interest rates soared.
Despite hedge funds' recent notoriety, some experts believe the funds are being made scapegoats for what is a much more widespread dilemma. "More and more money is being concentrated in fewer and fewer hands, and that's the real problem," declares Stanley Jonas, head of FIMA/Societe Generale, the New York based derivatives trading subsidiary of the big French bank.
Banks, too. "The most leveraged players of all," in his view, have been the commercial and investment banks. In addition to managing their own leveraged fixed-income portfolios, some big names like J.P. Morgan, holding company for Morgan Guaranty Bank, and Goldman Sachs, the most profitable investment house on Wall Street, have been attracted by the huge potential returns and the large incentive fees, and have started their own in-house versions of hedge funds. Other aggressive users of leverage who may have contributed to the bond market's recent sell-off include some fixed-income mutual funds as well as corporate treasurers increasingly employing derivatives to maximize the returns on their companies' cash accounts.
Moreover, while hedge funds and other leveraged players may have worsened the fall in bond prices here and abroad, the recent sharp rise in interest rates was finally a matter of fundamentals. The Federal Reserve Board's decision on February 4 to raise short-term interest rates for the first time in five years was obviously a catalyst. Although far less noted, the collapse of the U.S. Japan trade talks a week later jolted the markets, by some accounts, more than the Fed action had. The yen rose against the dollar -- causing the losses at Quantum -- because traders assumed the United States wanted to keep pressure on Japan by making its exports more expensive. Retaliating against the Clinton administration's hard-nosed stance, Japanese pension funds and insurance companies are said to have sold massive amounts of U.S. bonds.
"The Japanese, aware that the president's economic strategy was predicated on low interest rates, dumped bonds to push rates higher," declares William Gross, managing director of Pacific Investment Management Co., a mutual fund firm. The rise in U.S. interest rates spilled over into foreign markets -- to the consternation of the hedge funds, which expected rates in Europe, especially, to keep falling. The funds dumped European bonds, causing the fixed-income prices there to plunge even more than here.
Efforts to pry more information out of hedge funds might drive more of them offshore, where Quantum already does business. The New York-based group doesn't solicit money from U.S. investors and is therefore exempt from government scrutiny. But hedge fund manager Ezra Zask thinks there's nothing wrong with finding out how the big funds operate. "Their use of leverage especially bears looking into," says the head of Connecticut- based Ezra Zask Associates. "If no one need fear them, as they claim, they should be more than willing to provide such information."
