The New Hedgehogs
by Barton Biggs
August 12, 2006

For every hedge fund rags-to-riches story, there are at least two to three rags-to-rags or rags-to-riches-to rags tales.

In 2004, an estimated 1,000 funds went out of business. Despite media sensationalism, there are very few spectacular blowups, in which a fund goes down in flames like LTCM or Bayou, but there are a lot of slow, lingering deaths. A couple of guys start a hedge fund and raise $10 million or even $50 or $100 million. Their fee is 1.5% fixed on assets and 20% of the profits, but they can’t survive on the fixed fee.

They have a lot of overhead in space, accounting, computers, back office, and technology. Then they have three analysts and a trader to pay salaries to, plus hard dollars to fork out for Bloomberg terminals and research services.

The fixed fee doesn’t even cover the overhead, so there is no money left for the partners. Unless the partners have some money to begin with, they have nothing to live on. Their future then depends completely on the fund’s performance over the first couple of years. If the fund does well, the partners earn the 20%, get more money, and wear smiles to bed. If they really blow it in the first year, everybody redeems their money, and they’re gone with barely a ripple. But if they just dog along for a couple of years with mediocre performance, then no new money comes in, and it’s tough at the office and austere at home: 20% of nothing is nothing. The New York research firm of Bernstein estimates that the 200 biggest hedge funds have 80% of the total industry’s assets. The rest of the horde are just dreaming of a hot streak that makes them viable.

I personally know of a dozen funds that were started in the past few years by very successful analysts or savvy institutional salespeople. They were the golden children of the great bull market, and they made a lot of commission money in the late 1990s, which they spent with luxurious abandon. They are attractive guys and gals (not many gals, as a matter of fact), but to some extent, they confused charm, a low handicap, and a bull market with investment brains.

Flushed with success, they embraced a voluptuous lifestyle that included everything from wine cellars to jet time-shares. They all seemed to have windblown blond wives, multiple children, starter castles with eight bedrooms and four car garages, ski houses out West (Vermont is déclassé), and a brace of Scottish nannies. Add in private school tuition at $20,000 a crack for even nursery school, annual dues at four or five famous golf clubs, and lots of help, and you get some serious embedded overhead.

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Take the case of three successful guys from private wealth management at Goldman Sachs, who a couple of years ago formed a market-neutral long–short equities fund. They had been big winners at Goldman. One had a real nose for tech stocks, another was particularly good at trading IPOs.

But being successful brokers, which is what private-wealth-management people really are, and making a lot of money wasn’t sufficient. Brokers are a little grubby. Wives aren’t elated to tell another wife that her husband is a broker. So these guys aspired to run a market-neutral hedge fund and be stock pickers. Were they investors or asset gatherers at Goldman Sachs?

Mostly the latter, I suspect. Market neutral means that a fund’s net exposure ranges from maybe 30% net long to 10% net short, volatility adjusted. Market neutral is fashionable because the good practitioners produce consistent, low-risk annual returns in the 7% to 12% range.

Sorry, but I think market neutral is a tough racket, particularly quantitative market neutral. There are too many people doing the same thing. In the 1980s, Morgan Stanley had a series of market-neutral funds that were run off different fundamental and quantitative models. All had boy geniuses at the controls who had made big money on the trading desk or had built a model that worked great on paper when they were dummy back-tested. In live action, none ever produced with real money. One allegedly used a computer to take stock selection to the third derivative and fifth dimension in color. There was color all right.

The color of the P&L was a deep shade of red.

Anyway, this attractive trio from Goldman opened on January 1, 2001, with $100 million and lost only 10% over the next two years, which wasn’t bad considering the bear market. Then in 2003, they were too cautious and bearish, and the fund went up only 5%. So for the first three years, they had no profits to take 20% of, no draw to live on, and families that were still living high on the suburban-New York hog, so the personal overhead was eating them alive.

Then one of the three partners, the one with the big house in Rye and all the nannies, quit and went back to Goldman in private wealth management. The trouble was all his accounts had been reassigned and he had to start all over again. The other two hunkered down. They let go of their two analysts, pared back on overhead, and transitioned their children to the Greenwich public school system. But as their investors heard about the departures and confidence that the firm was holding together began to dwindle, they were slowly but steadily bleeding assets.

The point is that this firm’s portfolio hadn’t done badly at all; nevertheless, it was about to become history.

Good investing,

Barton Biggs

		Editor’s Note: Barton Biggs spent thirty years at Morgan Stanley. By the mid-1990s, Morgan Stanley Asset Management was annually adding more new institutional accounts than any of its competitors. At various times during this period, Biggs was ranked as the
number one U.S. investment strategist by the Institutional Investor magazine poll and then, from 1996 to 2003, as the top ranked global strategist. In June 2003, Biggs left Morgan Stanley and with two other colleagues formed Traxis Partners—the largest new hedge fund of 2003. Traxis now has well over a billion dollars under its management. Biggs has spoken at forums in every major country and has appeared on CNBC and other programs on more than 300 occasions.