Editor: Chris, tell us about the experience you and Tim bring to the hedge fund field.
Wells: I have been practicing in the hedge fund area for 27 years and Tim for about 15 years. We both focus on hedge funds. We have other attorneys in our private funds group whose primary focus is on private equity funds and other forms of alternative investment vehicles.
Editor: How would you describe your typical hedge fund client?
Wells: The typical hedge fund client is structured as both an onshore fund for mostly U.S. investors and an offshore fund for mostly non-U.S. investors. Most of the hedge fund managers we represent are in the U.S., which is the largest hedge fund center in the world. But we also do work for Asian- and European-based managers.
Editor: Hedge funds are often assumed to be outside the pale of the regulatory system. What types of regulations govern them?
Wells: A whole host. Among investment funds generally, hedge funds are at the unregulated or less regulated end of the spectrum. At the other end of the spectrum are mutual funds, which are registered under the Investment Company Act and whose shares are registered under the Securities Act. Mutual funds are publicly offered, capable of being advertised and capable of being purchased by the average investor.
Hedge funds are subject to some regulations, but what distinguishes hedge funds from mutual funds is that they are not registered under the Investment Company Act. By operating under exemptions from the Investment Company Act, they avoid a whole host of very detailed regulations that would apply if they were subject to the Investment Company Act. But the recent short-sale rules, and many other rules governing what investors can and cannot do, apply to hedge funds just as they apply to any other investment vehicle.
Clark: And many hedge fund managers are registered with the SEC under the Investment Advisers Act, which means that they are subject to yet another set of rules covering a wide range of topics, including disclosure of information, safekeeping of investors' assets, calculating of clients' fees and the contents of advertising.
Editor: And they are allowed to sell only to sophisticated investors and institutions?
Wells: Yes. Since they are not registered, they can only be sold in a private placement to investors who meet certain tests.
Editor: Hedge funds have traditionally been considered to be a protection against risk. Have they provided protection in the present free-falling stock market?
Wells: Yes and no. The overall market is down a lot. But your typical hedge fund, by all reports, is not down nearly as much as the overall market. The reports seem to be saying that through the end of September the average hedge fund was down 10 percent whereas the market was down about twice that amount. But "average" and "typical" are very dangerous words to use when talking about hedge funds. Hedge funds are not really a distinct asset class in the way that stock mutual funds or fixed income mutual funds are.
Hedge funds can trade in a variety of things, including stocks, bonds, derivatives, futures, currencies, commodities, distressed debt, asset-backed securities, and mortgage-backed securities. Therefore, at any point in time, even under current market conditions, some hedge funds are up - not many at the moment - and many are down. You have a phenomenal variety of strategies and therefore a wide range of results.
The prototypical historical hedge fund was a "long-short fund," which, in theory, means achieving some sort of balance between its long investments in stocks or bonds and short investments, designed to hedge its long exposure. So in a simple example, if you had a perfectly balanced portfolio - for every dollar of long stock positions, you had a dollar of short stock positions - then in theory if the market went up 20 percent or went down 20 percent, your long and short positions should have moved up or down in parallel and offset each other, and you would have been "market neutral."
The problem is that things haven't worked that way over the last month or two because the system has been going through a very broad scale deleveraging. Many managers who ran fairly balanced portfolios found that, as a result of the sudden crash in market prices, the value of their long positions plunged without being offset by increases in the value of their short positions.
Other managers are finding that, because there currently is so much distressed selling as a result of hedge fund managers and other investors unwinding their positions and de-leveraging their portfolios, they lost money on stocks that they had sold short and that soared in price because people were covering their shorts by buying back the stocks. At the same time, many better stocks faced steep declines because people trying to raise cash sold them. Even those hedge funds that have done fairly well year-to-date suffered a lot in September. September was just a very dramatic month, coming on top of what had already been a tough year. That was the month that really seemed to impact, very negatively, a lot of hedge fund managers who, up to that point, seemed to be have been doing a good job at hedging risk and avoiding losses.
Editor: Wasn't there also a problem with computer-driven trading?
Wells: There is a subset of hedge funds that relies heavily on algorithmic-driven program trading. Some of those computer programs seemed to pile onto each other to some extent, and that may have contributed to some of the volatility. It's also been said recently that a lot of computer-driven long-short funds have suffered from a whipsaw effect as the markets bounced up and down, with their programs perpetually kicking in and buying securities and selling them and then buying and selling them back. At a certain point, that becomes counterproductive. But again it's very hard to generalize when talking about hedge funds. At the end of the day, the markets have fallen a lot with some hedge funds being hit particularly hard.
Editor: Is there any one formula that hedge funds have used that has been more successful than others?
Clark: As Chris was saying, if you look at different parts of the year, some funds were successful and some weren't. Some commodity-driven funds were extraordinarily successful up until August, when they came crashing down to earth.
Wells: And any one fund manager who's got a great strategy can still bet wrong on a particular thing. Among the managers we represent, there are a couple of currency funds that are still doing spectacularly well. Also, some volatility traders who are trading options and using strategies that benefit from volatility seem to be doing very well. If you were a pure short-fund (most hedge funds are not pure directional plays, going 100 percent long or 100 percent short), you were in great shape while prices were declining.
Editor: And how do you factor into any algorithm what the government's going to do at any given time?
Wells: On top of everything else that's going on, you have the government weighing in with the new short-sale rules. You can argue the merits of requiring public disclosure of short sales, but I can guarantee that the day you do that you are going to cause wild gyrations in the market. If you own short positions, and everybody knows you have a short position, you can be caught out by a short squeeze. That information can be used to bet against you. If managers know their shorts are going to be publicly disclosed, they're going to get out of their short positions. If everyone gets out of all of their short positions simultaneously, then a whole bunch of bad stocks will spike upwards because everyone is running out to buy those stocks to close out their shorts.
The SEC initially said they were going to require reporting. Then they said they would delay public disclosure of the reporting for two weeks; then they said they were never going to require disclosure. The mere fear of that caused some managers to start unwinding short positions.
Similarly, you can debate the merits of the ban on shorting financial stocks, but one of the net effects was that a lot of people immediately got out of both their short and long positions in financial stocks because if you were doing a pairs trading strategy, long on financial stocks you liked and short on financial stocks you didn't like, and you suddenly couldn't do the short side of the equation, then you're not happy where you are. In fact, you would have lost a lot of money if you didn't have the short side of the equation over the last month.
Clark: Any time rules change, the law of unintended consequences always applies. Contributing to the current volatility of the market is the fact that the SEC, the Fed and the Treasury have been pushing out new rules at such a remarkable pace. This introduces an element of uncertainty which also makes life difficult for hedge funds.
Editor: Is the current trend toward deleveraging also adversely affecting hedge funds?
Wells: It definitely can. But again, you can't generalize. There are a lot of hedge fund strategies that do require leverage. If a particular hedge fund strategy is highly leveraged, it's not going to be a very profitable strategy at today's much higher borrowing rates. It is often speculated that quite a few hedge fund strategies that have done well over the last five or ten years have benefited from unnaturally low interest rates. But having said that, some currency and commodity traders are doing spectacularly well. Currency and commodity trading uses lots of leverage but doesn't require any borrowing, and therefore is not harmed by high interest costs.
Editor: Given the adverse conditions that they face today, do you see a future for hedge funds?
Wells: Definitely. We spoke recently to an institutional investor who said, "We're not pulling back. We see this as a good buying opportunity and we're going to go back and talk to all of our fund managers and find out what they're doing and make sure we're getting the best deal when they start renegotiating deals."
Clark : Hedge fund managers are innovative and learn from experience. When markets are operating normally, the traditional strategies work just fine. What they have learned from the current experience is that they must have better strategies to cope with the kind of extraordinary conditions that we now confront - and I have no doubt that, given the competitive instincts of fund managers, the best minds are hard at work perfecting such strategies.
Published November 1, 2008.
