HEDGE FUND NEWS01 February 2007
Hand picked by
Finbar.Taggit@fintag.comFINTAG COMMENT
The fed holds rates (a big mistake), Google triples revenues on the back of my Ad-Sense adverts on FiNTAG and NASDAQ says it will wait until next year before another LSE bid (code words for it will be carrying out another hostile bid this summer); and Bush tells CEO's that they earn too much.
We report on none of this.
Today, Hedge Fund news is flowing out of every orifice of every media outlet and I have no idea where to start. On deeper inspection, most of it is lightweight guff like SVG saying it is going to list a "pocket-money" fund or punters realising Goldman's Alpha fund has more volatility than my wife's mood swings.
A middle aged man goes to prison for making false statements [Editor: You should have been put away years ago] and Merrill Lynch suddenly realises there is money in Prime Brokerage - 15 years after Goldman Sachs and Morgan Stanley cornered the market.
More importantly, the world's greatest regulator, the FSA admits it hasn't a clue what it is doing and hedge fund returns are worse than ever.
VOLATILE GLOBAL ALPHA
Loss at Goldman Hedge Fund Racks Duo at Secretive Global Alpha (bloomberg)Mark Carhart looks out over the packed New York conference and tells investors that Warren Buffett has it all wrong.
Carhart, 40, co-head of the quantitative strategies group at Goldman Sachs Group Inc., uses his July speech to poke fun at the Berkshire Hathaway Inc. chief executive officer's penchant for investing in market-leading brands like Coca-Cola and Gillette. He cites study after study showing that big-name companies with high price-earning multiples or rapid growth rates make poor bets.
Traditional stock pickers like Buffett, a fabled raconteur, do have one redeeming quality, Carhart jokes: ``They tell great stories.''
Carhart himself has a pretty good story to tell. Though he doesn't like to talk about it, Carhart is one of the world's most successful money managers, a mastermind behind Global Alpha, a $10 billion hedge fund for wealthy clients and employees of Goldman Sachs.
In 2005, Carhart and co-manager Raymond Iwanowski, 40, notched a 51 percent gross return at Global Alpha. Posting that kind of gain requires taking risks -- and last year, Alpha lost 6 percent, its first deficit since 1999.
Carhart, a former assistant professor of finance at the University of Southern California, helps oversee other hedge funds, four mutual funds and scores of separate accounts. In all, he and Iwanowski have $101.5 billion at their command. Carhart and Iwanowski use math-heavy trading tactics that fund consultant Sol Waksman likens to counting cards in a casino. The two lead a corps of computer-loving traders, statisticians and finance and economics Ph.D.s.
Behind the Scenes
Their team makes -- and sometimes loses -- millions of dollars a day. At the heart of their empire is Global Alpha, which generated about $700 million in fees for Goldman Sachs in fiscal 2006. This money machine hums mostly behind the scenes. Asked about the fund, Goldman spokeswoman Andrea Raphael declines to confirm even its name.
Carhart and Iwanowski, friends since their days at the University of Chicago Graduate School of Business, oversee about 10 other Goldman hedge funds, too. Together, they trade everything from Japanese stocks to U.S. soybeans, to Israeli shekels.
Global Alpha is part of the richest hedge fund empire the world has ever seen. Last year, Goldman Sachs eclipsed D.E. Shaw & Co. and Bridgewater Associates Inc. to become the largest hedge fund manager, with $29.5 billion in assets as of Dec. 31, according to Bloomberg and Chicago-based Hedge Fund Research Inc., which tracks the industry. That figure excludes Goldman's proprietary-trading funds and its funds of hedge funds.
Goldman Secrets
Working out of a granite-and-glass office tower a few blocks from Goldman Sachs's Broad Street headquarters in lower Manhattan, Carhart and Iwanowski hunt for market variables called risk factors that often lead to excess investment returns, or premiums, according to people familiar with the fund.
Some, such as a measure called the value premium -- the difference between the return of a group of stocks with high book values relative to their prices and that of a group with low book value-to-price ratios -- have been used by other money managers for years. Goldman Sachs has identified more than 20 new risk factors, which it doesn't disclose, even to its own investors.
Carhart never reveals the secrets. Old friends and people who've invested in the fund say they're not really sure how it works.
John Cochrane, one of Carhart's professors at the University of Chicago, says that based partly on what Carhart has told him -- not much, he admits -- Goldman Sachs has devised five or so proprietary risk factors for equity markets.
Inside Global Alpha
Kelly Welch, a Chicago classmate and former portfolio manager at the $2.1 billion Ewing Marion Kauffman Foundation in Kansas City, says Carhart builds computer models that use Goldman and other variables and historical data to decide what to buy and sell.
``Mark has never discussed the specifics of the new factors with me,'' says Welch, now a finance professor at the University of Kansas.
Interviews with Cochrane, Welch and others who are familiar with Carhart, Iwanowski and their fund provide a glimpse into Global Alpha. So do documents that Goldman Sachs has filed with the Irish Stock Exchange for Goldman Sachs Global Alpha Fund Plc, a Dublin-domiciled fund for non-U.S. investors. This Irish fund tracks its U.S. counterpart.
On any given day, Carhart's team of 50-60 investment professionals uses Global Alpha's factors to deploy 20 trading strategies in markets the world over, according to an investor in the fund and Global Alpha documents. During 2006, the fund's picks ranged from Japanese and Dutch stocks to bets on and against the Polish zloty.
Quant Shop
``It's in everything from commodities to emerging markets,'' says Dan Kapanak, manager of investment strategy at the $26 billion Arizona State Retirement System, which invests in a separate Goldman account.
At the center of the Global Alpha story are Carhart and Iwanowski, devotees of quantitative analysis, or quants, who came to Goldman Sachs from opposite ends of the financial world.
Carhart first turned heads in money circles as a doctoral candidate at the University of Chicago and later as an assistant finance professor at the University of Southern California's Gordon S. Marshall School of Business. Iwanowski, by contrast, has spent his entire career on Wall Street.
What unites them is that they're quants, who put their faith in data, rather than human judgment, when deciding what to buy or sell. To money managers like them, what you think about a company's management or products doesn't matter much.
2006 Losses
Jokes aside, Carhart would do well to heed two Buffett rules. No. 1: Never lose money. No. 2: Don't forget rule No. 1. In 2006, Global Alpha went wrong when just about everything else at Goldman Sachs went right. After a roller-coaster ride that included a 10 percent August plunge, Global Alpha ended the year down 6 percent, according to an investor in the fund.
The loss, the first since 1999, came in a year when Goldman earned $9.54 billion, the most in Wall Street history. The investment bank made headlines by earmarking $16.5 billion for salaries and bonuses, including a record $53.4 million bonus for Chief Executive Officer Lloyd Blankfein. Carhart and Iwanowski declined to comment for this story, as did other Goldman Sachs executives.
It was a rare misstep for Global Alpha. The fund skated through the 2000-02 U.S. bear stock market without a down year and posted an annualized return of 19.75 percent, after fees, from Dec. 4, 2001, to Dec. 31, 2005, according to Global Alpha's 2005 annual report. The average hedge fund returned an annualized 9.1 percent from Dec. 1, 2001, to Dec. 31, 2005, according to Hedge Fund Research. Shares of Buffett's Berkshire Hathaway rose a mere 5.9 percent during the period.
In a Hole
Only now, Carhart and Iwanowski are in a hole. Like most hedge funds, Global Alpha charges an annual management fee of 1.5 percent or 2 percent and takes a 20 percent cut of any profit. Before the fund can take its 20 percent in 2007 -- assuming it makes money -- its quants must first make up the 2006 loss.
The hiccup will cost Goldman Sachs. During a December conference call, Chief Financial Officer David Viniar told analysts to brace for a sharp fall in reported hedge-fund and other incentive fees during the first fiscal quarter of this year.
``It will be significant,'' Viniar said.
Hedge fund managers industrywide face a sober reality: The days of easy money are over. Since 2000, this corner of the financial world has more than doubled in size.
Hedge-Fund Explosion
Worldwide, there are now more than 9,000 hedge funds, which are loosely regulated pools of capital that enable managers to participate substantially in investment returns. So many hedge funds have crowded into the markets that the industry is struggling to generate standout profits.
In Wall Street parlance, the extra risk-adjusted return a fund earns above a benchmark, say the S&P 500, is symbolized by the Greek letter alpha -- as in, Global Alpha. Alpha is getting hard to find. The average hedge fund gained 13 percent in 2006, according to Hedge Fund Research. Investors would have made more money buying a mutual fund that tracks the S&P 500, which returned 15.8 percent.
Waksman, founder of Fairfield, Iowa-based Barclay Group, a hedge fund database and consulting firm, says the odds that a quant fund like Global Alpha will lose money in 2007 are about the same as they were in 2006. No hedge fund manager wants to have to deal with losses. ``When you have a difficult year, the stress of that is just tremendous,'' he says.
For Carhart and Iwanowski, a second down year, especially a double-digit loss, could be trouble.
Pressure Is On
``If you're down significantly for two years in a row, it's likely that an investor will be reconsidering an investment,'' says Theodore Aronson, principal of Aronson + Johnson + Ortiz LP, a Philadelphia-based investment firm with $28.3 billion in assets under management.
Up in 32 Old Slip, the atmosphere is more university tweed than Wall Street pinstripe, people who have been there say. Carhart often rides his Trek bicycle to work from his Upper West Side home seven miles away. He and his team are part of the $676 billion Goldman Sachs Asset Management division, which employed 23 Ph.D.s in portfolio management at the end of 2004, according to its Web site.
Inside the open-plan office, the mostly male quants favor everyday-casual khaki pants and blue-and-white oxford shirts, rather than the suits and ties of Goldman investment bankers. Carhart has a sweet tooth and has new analysts stock a drawer with candy. He likes the strawberry Twizzlers. Iwanowski prefers peppermint Altoids.
`Brilliant'
One of the most-surprising things about Carhart is that for a guy in an industry known for big money and bigger egos, it's hard to find anyone who'll say a bad word about him. Former colleagues, classmates and teachers remember him as one of the smartest people they've known.
``How can you say, `outstandingly brilliant,' in another way?'' says Mary Crago, his junior high school English teacher in Yakima, Washington, where Carhart grew up.
Mark Monroe Carhart has been at the head of his class since his days in Yakima, a city in a rural part of central Washington known for its apples and hops. He's the second of three children of Whitfield Carhart, a U.S. Army radiologist who tended orchards, and his wife, Mary, a school teacher.
Students at Eisenhower High School viewed Mark -- math team champ and a trumpeter in the pep band -- as a school brain, Crago says. They called him ``Marcus Aurelius Piscarus Carhartus,'' she says.
`The Inventor'
After he helped devise a contraption that enabled its user to toss a raw egg off the school roof without it cracking, they gave him another sobriquet: ``The Inventor.''
After graduation, Carhart headed for Yale University, where he majored in economics and served as managing editor of the Yale Economics & Business Review. He also began dabbling in the markets as a director of the Yale College Student Investment Group.
Members sometimes learned lessons the hard way, says Stephen Lange Ranzini, former group managing director and now CEO and majority-owner of Ann Arbor, Michigan-based University Bancorp Inc.
One story: a group member forgot to close out a pork belly futures contract. Teamsters showed up with two truckloads of meat. The hapless student-speculator ended up selling the pork to the university dining service at a loss, Ranzini says.
The club, which had about $100,000, shifted about 13 percent of its portfolio into cash a week before the 1987 market crash. Carhart, as a director, would have been involved in that decision, says Charles Tillen, a Yale classmate who's now a partner at Bain & Co., a Boston-based consulting firm.
Future Career
While some members were prone to snap judgments, Carhart analyzed companies' cost of equity, industry growth and stock-price volatility, Tillen says. In the Yale Banner of 1988, Carhart lists his future occupation: portfolio management.
After Yale, Carhart set to work on a doctorate in finance at Chicago. He studied under finance professor Eugene Fama, best known for his work on the efficient-market hypothesis, which holds that prices reflect all there is to know about stocks or other securities.
Fama still recalls how hard Carhart worked on his dissertation, entitled ``Survivor Bias and Mutual Fund Performance.'' Carhart found a company in Des Moines, Iowa, that had kept old data on mutual funds, Fama says.
Carhart had the numbers keyed into a computer by hand -- a process that took several years. Using this database, he found that mutual fund figures artificially inflated returns because fund companies tended to shut laggard funds or merge them into other funds, stripping their performance numbers from totals.
Persistence
``He's one of the most-persistent people I've met,'' Fama says of Carhart. Today, the database lives on at the Center for Research in Security Prices at the University of Chicago.
In the second part of his dissertation, later published as ``On Persistence in Mutual Fund Performance,'' Carhart examined why fund managers who do well one year tend to do well the next. Was it talent -- ``hot hands,'' in fundspeak -- or something else?
Carhart concluded that back-to-back gains mostly reflected the momentum of stocks in a fund, rather than a manager's smarts. It's not exactly the conclusion you'd expect from someone hoping for a career in money management.
Cochrane, who advised Carhart on his dissertation, says that at first he challenged the idea. ``He just quietly explained it to me,'' Cochrane recalls. ``It sticks in my mind because he was right, and I was wrong.''
After collecting his doctorate in 1995, Carhart joined the faculty at USC's Marshall School. Kevin Murphy, vice dean of faculty and academic affairs, says Carhart impressed his colleagues with his teaching -- and with 100 mile-a-day bike rides into the Santa Monica mountains.
Inflating Returns
In his research, Carhart kept hammering away at mutual funds. In a paper entitled ``Leaning for the Tape: Evidence of Gaming Behavior in Equity Mutual Funds,'' which was eventually published in 2002 in the Journal of Finance, he presented evidence that some managers tended to buy more shares of their largest holdings at the end of financial quarters.
Carhart said these purchases drove up the stocks' prices, thereby inflating funds' quarterly results. Higher returns, of course, often mean higher bonuses for managers.
In public, many mutual fund managers denied the practice occurred, says Ron Kaniel, co-author of the paper and now an associate professor of finance at the Duke University Fuqua School of Business. ``Then, when you went off the record, they would admit it happened,'' he says.
Given his published research and classroom work, Carhart was headed for tenure. ``Mark was on a perfect trajectory,'' Murphy says. Then Goldman Sachs called.
Iwanowski's Arc
Ray Iwanowski never had the temperament for a life inside the ivory tower, people who know him say. From the start, he put his head for numbers to work making money.
Raised in Dallas, Pennsylvania (2000 population: 2,557), Iwanowski graduated from the University of Pennsylvania in 1988 with twin bachelor's degrees in math and finance. He promptly went to work at First Boston, now part of Credit Suisse Group, in the fixed- income portfolio strategies group in New York. In 1990 he left, heading to graduate school at Chicago, where he met Carhart.
For Iwanowski, it was a stopover on the way back to the Street. He collected his MBA, began work on his doctorate -- and left before finishing his dissertation. In 1993, he joined Salomon Inc., now part of Citigroup Inc.
Thomas Klaffky, who helped hire then 27-year-old Iwanowski, set him to work writing a series of booklets for clients explaining how complex financial instruments worked. The idea was to educate customers and, in the process, cement client relationships, says Klaffky, who's now managing director at Citigroup Global Markets.
At Salomon
``The difference between an intelligent person and a brilliant person is the brilliant person can explain complicated issues to anyone,'' Klaffky says. He recalls Iwanowski as the latter.
Salomon named Iwanowski head of its fixed-income derivatives client research group at its 7 World Trade Center offices. He did research and also wrote articles for publications such as the Journal of Fixed Income. One of his pieces published there, co- authored with then colleague Antti Ilmanen, was entitled ``Dynamics of the Shape of the Yield Curve.'' The paper examines how market expectations and other factors affect bond rates.
Janet Showers, who ran fixed-income strategy and worked in the office next to Iwanowski's, says she suspected his destiny lay elsewhere. ``I wasn't surprised that he didn't end up as a career person writing research,'' Showers, now retired, says. ``He wanted to manage money.''
During the mid-90s, as Carhart finished his dissertation and Iwanowski penned research, Goldman Sachs was building out its asset management arm. The investment bank had been reluctant to manage other people's money in part because the 1929 crash virtually wiped out Goldman Sachs Trading Corp., an investment trust.
Building Up
The disaster of '29 cost partners and clients millions of dollars, according to ``Goldman Sachs: The Culture of Success'' (Touchstone Books, 1999) by Lisa Endlich.
In 1995, then CEO Jon Corzine and then President Henry Paulson tapped John McNulty, a former broker who had managed Goldman's Miami office, to build a competitive money management division.
``They said, `We don't need you to contribute anything to the bottom line, but build us something we can be proud of,''' recalls John Casey, a Darien, Connecticut-based consultant whom Goldman hired to help McNulty evaluate potential acquisitions. McNulty died in 2005.
Goldman Sachs snapped up U.K.-based CIN Management Ltd. and Tampa, Florida-based Liberty Investment Management. In 1997, it bought Princeton, New Jersey-based Commodities Corp., a den of Ph.D.s co-founded by Paul Samuelson, a Nobel Prize winner and author of the best-selling college textbook on economics.
Global Alpha Is Born
Inside Goldman Sachs, Clifford Asness, another student of Fama's with a Ph.D. from Chicago, was building quantitative models.
McNulty liked what he saw. ``Isn't this quantitative stuff better than anything else we're doing?'' Casey recalls McNulty asking.
The result was Global Alpha, which Goldman Sachs seeded with $10 million. To help Asness, Goldman recruited fellow Chicago alums Robert Krail and John Liew. In January 1997, Asness hired Iwanowski. That September, he hired Carhart.
Some three months later, Asness quit and took nine colleagues with him to found his own hedge fund firm, AQR Capital Management LLC, now based in Greenwich, Connecticut. He didn't take Carhart or Iwanowski.
``They left Mark high and dry,'' Murphy says. Welch says the departures were tough on Carhart.
``Having his friends leave on him like that was very hard for Mark,'' Welch says. Even so, Carhart realized it was an opportunity, he says. AQR officials didn't return telephone calls.
Taking Over
And so, only months after arriving at Goldman Sachs, Carhart and Iwanowski found themselves at the helm of Global Alpha.
Today, Carhart runs his quant shop like a graduate seminar on steroids. Welch says Goldman Sachs is always looking for current or former academics to add to its brainpower. Once a week or so, the group holds seminars with professors or industry figures such as Vanguard Group founder John Bogle, who visited on May 10, 2000.
Global Alpha doesn't merely bet on the direction of stock or bond prices. It bets on differences between those prices.
Global Alpha employs seven strategies in the bond markets alone, according to Goldman Sachs Global Alpha Fund Plc's June 30 semiannual report. The simplest of them is to buy government bonds of one country while shorting those of another.
Goldman's Gambles
In the U.S. stock market, Global Alpha might buy oil and insurance stocks and simultaneously bet against semiconductor shares. The fund also allocates part of its $10 billion to something called ``global event anomalies,'' according to a November 2001 prospectus. With this strategy, the fund attempts to make money from corporate stock buybacks and divestitures and from changes in how market indexes like the S&P 500 are calculated.
Carhart and Iwanowski also employ a commodities strategy and an asset-allocation strategy that bets on various mixes of investments: stocks, bonds, currencies and beyond.
As its name suggests, Global Alpha is, well, global. In addition to sizing up investments in one geographic market, its quants simultaneously measure how those investments stack up against others around the world.
``In the Netherlands, they are asking whether stocks are underpriced relative to bonds or cash,'' Welch says. ``But they are also asking whether they are overpriced relative to Japanese stocks.''
Global Alpha quants have designed their fund so that if things go wrong, the probability is low that the 20 strategies will lose a lot money at the same time. That, anyway, is the idea.
Returns Sour
In the 2005 report filed with the Irish exchange, Global Alpha reported a gross return of 51 percent for the year. The report says only two strategies -- global anomalies and the country bond selection -- suffered losses of more than 1 percent.
During the first quarter of 2006, Global Alpha rose a net 9.5 percent, according to the semiannual report filed with the exchange.
The next quarter, a bunch of the fund's strategies soured. Global Alpha lost 3.5 percent during the period. Its ``developed equity country selection'' fell 2.5 percent, hurt by bad bets on Japanese and Dutch stocks.
Its developed country currencies strategy sank 1.9 percent, whacked by a wrong-way wager on the dollar and another against the pound. Emerging market currencies strategy sank 1.7 percent, nipped by short positions in the shekel and zloty.
Losses Mount
Piecing together the second half of 2006 is harder. A Global Alpha investor who asked not to be identified says the fund's roughly 10 percent slide last August mostly reflected bad bond market investments. Global Alpha also bet that stocks in Japan would rise while those in the rest of Asia would fall -- wrong; that U.S. stocks would stumble -- wrong; and that the dollar would rise -- wrong again. Global Alpha finished November down 11.6 percent in 2006.
The Arizona State Retirement System's Kapanak says hedge funds such as Global Alpha, which follow various strategies and simultaneously bet that this price will rise while that price falls, are designed to make money when world markets move in different directions.
When markets and economies move more or less in lock step, these so-called multistrategy long/short funds struggle, he says.
That's exactly what's happened lately, Kapanak says. ``You're seeing synchronous growth across the globe,'' he says. The U.S., European and Japanese economies are all growing, which means financial markets have been less volatile than they have been in the past, he says.
For Global Alpha, the big question is, Is all this an aberration, a brief setback on the way to greater heights? Or is it the start of something worse?
What Went Wrong?
One answer may be Global Alpha's 5.5 percent rally in December, which accelerated in early January, according to one investor. The fund has benefited from gains in the dollar, strength in Japanese and European stocks versus those in the U.S. and short positions in global government bonds.
Still, Global Alpha may have a hard time repeating its past glories now that it's grown so big, says David Hendler, a senior analyst at New York-based CreditSights Inc. After Goldman Sachs said it would close the fund to new money at the end of 2005, about $2 billion flowed into Global Alpha. Even though the fund invests in so many markets, size could work against Global Alpha, as it has in the past against once-celebrated mutual funds such as Fidelity Magellan.
``When you're the biggest in a particular style, it's tough to shift your portfolio without everybody knowing it,'' Hendler says. ``There is the question of whether you can continue to perform at the same level.''
In this otherwise heady era for Goldman Sachs -- the richest since its founding in 1869 -- it's worth remembering what the late John L. Weinberg used to say. When times were good, Weinberg, a senior partner from 1976 to '90, would remind colleagues that good times don't last forever. ``Trees don't grow to the sky,'' he'd say. Neither do hedge fund returns.
DURUS CAPITAL PRISON SENTENCE
Owner of Hedge Fund Firm Is Sentenced (nytimes)The owner of a hedge fund management firm was sentenced Tuesday to three years in prison and three years of supervised release, federal prosecutors said.
Scott Sacane, who owned and controlled Durus Capital Management, waived indictment in December 2005 and pleaded guilty to one count of violating the Investment Advisers Act of 1940, Kevin J, O'Connor, United States attorney, said.
FromNovember 2002 to July 2003, Mr. Sacane, of Weston, Conn., manipulated the price of two biotechnology stocks by concealing purchases of the stocks through false filings with the Securities and Exchange Commission, Mr. O'Connor said.
Mr. Sacane, 40, also failed to make required S.E.C. filings and made false statements to prevent others from selling stocks in the two companies, Mr. O'Connor said.
"This prosecution and the term of imprisonment imposed today should send a strong message to hedge fund managers," O'Connor said in a statement.
Judge Alan H. Nevas of Federal District Court in Bridgeport, scheduled hearings for April 4 and April 5 to determine the restitution required of Mr. Sacane.
Durus Capital Management managed several hedge funds. Last March, J. Douglas Schmidt, chief operating officer of Durus Capital Management, was sentenced to one year of probation and a $10,000 fine for a market manipulation scheme. He was sentenced for filing false statements with the S.E.C.
FSA ADMITS IT HASN'T A CLUE
Derivatives: the risk factor is frightening (guardian)Now would be a bad moment for financial markets to have an accident, said the Financial Services Authority yesterday. The shock to the system would be "much greater now than two or three years ago". Regulators are paid to be cautious, so at one level this pronouncement is unsurprising, but "two or three years" is not long ago. Can things really have changed so much?
Well, yes, in spades. The biggest change is the growth of credit derivatives, the process by which securities such as corporate debt, mortgages and shares are sliced, diced, packaged and repackaged. Investment banks house too much creative computing power these days, and the face value of credit derivative contracts is reckoned to be about $30 trillion - yes, trillion. It's an enormous number and about eight times as much as in 2003. So something very big has changed very significantly.
Reading between the lines, the FSA seems to be admitting that it has inadequate insight into this world of "increasingly complex financial markets." Again, that is not a surprise because credit derivatives are the domain of the trading desks of investment banks and specialist hedge funds.
Nor is the FSA alone. Jean-Claude Trichet, president of the European Central Bank, said last week that "there is now such creativity of new and very sophisticated financial instruments ... that we don't know fully where the risks are located. We are trying to understand what is going on but it is a big, big challenge."
Trichet sounded like a man witnessing an accident but unable to do anything, which hasn't always been the attitude of central bankers towards derivatives. Many used to argue that these instruments do important work in spreading risk and reducing the cost of borrowing.
Now, though, there seems to be a change of tone. Timothy Geithner, the US Federal Reserve's man in New York, said last year that the derivatives revolution may make financial crises less common, but more severe when they do occur. You may not be reassured.
THE BOAT HAS BEEN MISSED
Merrill launches hedge fund client recruitment initiative (financialnews-us)Merrill Lynch, which has been growing its prime brokerage operation over the past year, is starting a new initiative to advise hedge funds on recruitment.
Amy Margolis, a 25-year veteran of Merrill Lynch, heads the new initiative. Margolis most recently ran recruiting, hiring, compensation and other human resources issues for the firm's equities division, which includes cash equities, equity derivatives and equity sales and trading.
Margolis has been head of global equities client human resources management for the past six years. Before that, she ran the firm's campus recruiting and entry-level training programs, according to an internal memo seen by Financial News.
Margolis will now help Merrill's hedge fund clients find portfolio managers and other employees at all levels, a source said. She will also advise the hedge funds on retention and compensation.
Right now Margolis is the only person involved in the effort, although she will hire someone in London this summer, according to the memo. She reports to Jeff Penney, co-head of the global markets financing and services division that houses prime brokerage, and Kevin Dunleavy, head of global hedge fund strategy and client relations.
Merrill Lynch's global markets financing and services division, which is co-headed by Jeff Penney and Sylvan Chackman, has itself been expanding over the past year. The bank made a push to add mutual funds to its roster of 400 prime brokerage clients by starting a consulting group to advise big mutual funds which short stocks in order to increase their returns.
Since mutual funds have only started to short stocks within the past 18 months, they depend on prime brokers for advice as well as standard services like securities lending and margin lending.
SVG
SVG to float €200m hedge fund (ft)SVG Capital, the investment group that is the largest investor in Permira's buy-out funds, has launched a hedge fund that is seeking to raise up to €200m (£133m) before listing on the Irish Stock Exchange.
The move underlines the blurring of the lines between public and private equity.
The SVG European Absolute Return Fund is on an investor roadshow to raise third-party funds ahead of a Dublin float planned for April. It will have an initial capacity limit of €200m but could grow at a later stage.
The fund will be structured as a European long/short hedge fund, seeking returns in excess of 15 per cent a year with low volatility. It will target European and UK companies with market values greater than €100m, where it will take long positions, and €500m, where it will take short positions. It will invest in an average of 35 to 40 stocks and be managed by Andrew Goodwin and Jamie Seaton.
"The average holding will be quite large and where we believe that on a private equity basis the company is undervalued," said Mr Goodwin. Preferred investments will include low-geared companies and those with attractive cash flow yields.
"The space between public and private equity is converging," he added.
The fund will form part of SVG's public equity unit and draw on the resources of SVG's strategic advisory board, which includes Sir Clive Thompson, former chairman of Rentokil Initial; Stewart Binnie, chairman of Mosaic Fashions; Alan McKay, a managing director of 3i; Ken Minton, executive chairman of 4imprint and William Nabarro, former chairman of KPMG Corporate Finance.
SVG's public equity team is also in the process of establishing a Europeanstrategic advisory board that will include Friedrich von der Groeben, former managing partner of Permira in Germany.
Tony Dalwood, head of public equities at SVG, said: "By applying private equity investment techniques to European public markets, we aim to capitalise on this opportunity for investors."
AGATHA CHRISTIE
Hedge fund world rapt at tale of PAAM (ft)If it were a pulp fiction murder mystery it would need a snappier title: The curious case of an Ontario-based hedge fund manager, his Philadelphia company, a British-owned brokerage, the Cayman Islands administration arm of a Swiss bank and the missing $179m.
But it makes gripping reading for the hedge fund world.
Lawyers are now wrangling in public about who should pay for the $179m (£91m) of trading losses hidden by Paul Eustace from investors in Philadelphia Alternative Asset Management's offshore fund.
The important question for the burgeoning crowd of would-be hedge fund investors is how they can avoid being caught up in such scams in future.
The unregulated, mostly offshore and secretive hedge fund industry attracted record inflows of $126.5bn last year, according to Chicago-based Hedge Fund Research, and now manages more than $1,300bn. As a result, it has also become a target for con-artists, particularly in the US, where fund managers are not forced to register with regulators.
While the number of frauds remains low compared with the estimated 10,000 hedge funds in existence, that is no consolation for investors who lose out, some of whom are big blue-chip names who ought to have known better. According to calculations by Amber Partners, an operational risk certification firm, losses from fraud since 2002 have exceeded $2.2bn.
Outright frauds include Bayou Management, Lipper & Co, Beacon Hill Asset Management and the notorious Manhattan Investment Fund, whose British founder Michael Berger is still on the run from the FBI.
Less dramatically, there is also a widespread belief among investors that hedge funds massage their numbers to make monthly returns look more stable, and thus more appealing.
Reiko Nahum, chief executive of Amber Partners, says: "Over the past couple of years especially we have seen quite a few hedge fund fraud cases. Very reputable institutional investors have been caught in some of these blow-ups.
"I don't want to colour the industry as being rampant with fraudsters - but there is the potential for many hedge funds managers to smooth returns, and that's an issue right now."
As a result, funds of hedge funds and big institutional investors typically spend a lot of time and money on due diligence, looking for obvious anomalies and poor risk-management practices.
One large fund of funds hires private investigators to look into the top management at every fund it invests in, checking their backgrounds for anything they didn't disclose.
"Usually you don't find anything," says the London head of the business. "But we have seen some pretty weird things, to be honest." Undisclosed convictions range from drunk-driving to one hedge fund manager who was found to have set fire to the tents of anti-apartheid protesters while atcollege.
Tracy Pearson, head of alternatives at Forsyth Partners, which specialises in investing in smaller hedge funds, says the firm does four to six months of due diligence before any investment, but rarely finds problems.
But back to King of Prussia, Pennsylvania.
The small town is best known for one of America's biggest shopping malls. It was also home to Mr Eustace's PAAM until June 2005, when regulators swooped. The Commodity Futures Trading Commission accused him of hiding losses that reached 50 per cent in a month in his offshore fund, while also falsely claiming 25 per cent returns for another fund that had never actually traded.
The receiver of PAAM last year sued Man Financial, brokerage arm of London's Man Group, claiming it conspired to help Mr Eustace hide $179m in a secret sub-account. It also claims that Thomas Gilmartin, senior vice president at the broker who was in charge of the accounts for PAAM's offshore fund, was a college friend of Mr Eustace and a shareholder of PAAM. Man denies any knowledge of his shareholding, and is fighting the case.
Man was last week given court leave to countersue UBS's Cayman fund services business, the administrator of the offshore fund. Man claims UBS failed to follow its own procedures and if it had independently checked net asset value (NAV) calculations provided by Mr Eustace his fraud would have been caught almost a year earlier than it was. UBS rejects the claims.
The receiver has filed e-mails with the court that appear to show Mr Gilmartin and a colleague giving UBS explanations, that were provided word-for-word by Mr Eustace, for discrepancies in the accounts.
"Gilmartin and Alavi [a colleague] simply copied Eustace's false explanations verbatim and sent them to UBS without verifying the accuracy of the representations they were making in an effort to convince UBS to back-date certain trades," the receiver told the court.
Man, for its part, claims UBS relied on account statements forged by Mr Eustace rather than requesting direct access to Man's records. The broker also claims the offshore fund's independent directors, who should monitor the fund and protect investors, failed to open post sent to the fund.
"The offshore fund and its directors caused the unopened monthly account statements [it] received from Man Financial . . . to be forwarded to PAAM's offices in King of Prussia," Man said in a court filing.
While much about the case will remain murky until the claims and counter-claims are settled in court, there are lessons for investors.
First, they should check there are proper mechanisms to ensure securities are priced correctly. Ms Nahum recommends ensuring administrators are independent - required of UK-based managers - and that they obtain pricing for investments from sources other than the manager.
Second, they should ensure the controls on cash require at least two signatures so that a rogue individual at the fund cannotsimply run off with the money.
Third, they should look for reputable administrators and auditors and confirm they act for the hedge fund. That wouldn't have helped investors in PAAM but many other fraudsters relied on unknown or fake auditors or administrators.
Finally, most big investors ask around the industry to establish the reputation of the fund manager.
Ms Pearson at Forsyth says with 120 managers in their portfolios, someone almost always knows any new fund manager and can provide an assessment.
Of course, this isn't foolproof - as investors in hedge fund Lipper & Co discovered.
Ken Lipper, a former New York City deputy mayor, wrote the novel Wall Street and was co-producer of Oscar winning film The Last Days, but his funds were closed after Edward Strafaci, his director of fixed income, was found to be inflating their value.
Mr Strafaci is not expected to be released from prison until 2010. Coincidentally, he is serving his time in Ford Dix prison - just across the Delaware river from the Philadelphia courtroom in which it will be decided who, if anyone, is liable to repay PAAM's investors.
NOTES FROM DAVOS
caligula's gallimaufry (rjrcos)AS Stephen A. Schwarzman, the chairman of the Blackstone Group, strolled out of a panel, "Is Bigger Better in Private Equity?," at the World Economic Forum here on Friday, he recounted a recent conversation he had with the chief executive of a public company.
"The guy said to me, 'Geez, I wish you could buy us, but we're too big,' " Mr. Schwarzman recalled.
The size of the company in question?
Only more than $125 billion. (He declined to identify the mystery chief executive.)
Everyone, it seems, wants to be private.
"It's on everyone's mind," acknowledged Richard B. Evans, the chief executive of the giant aluminum producer Alcan, a $24 billion public company, during a lunch discussion about activist investors.
Now that the big private equity firms have hundreds of billions of dollars to spend, many more public companies perhaps even $100 billion companies may soon lose their ticker symbols.
Last year, private equity represented 20 percent of the mergers and acquisitions market, more than double the year before. No one at a symposium on Thursday night that included Stephen G. Pagliuca of Bain Capital, Peter Weinberg of Perella Weinberg and Jeffrey Rosen of Lazard, among others, seemed to be worried about a downturn anytime soon.
Indeed, about 64 percent of the attendees at the dinner said they expected private equity to account for 26 percent or more of the M.& A. market in five years, and some predicted that it would reach one-third of the market or more.
Those, of course, are the people who are making the buyout deals. But even Mr. Evans, the chief executive of a big public company, laid out the case for going private.
"In some cases, there are advantages to being private," he said, ticking off a list of benefits that went far beyond what he described as "compliance overkill" at public companies. He said that the mind-set of public company mangers and board members was often wrong. "There's a preoccupation with risk aversion," he said. "It's the opportunity cost that's lost."
Donald J. Gogel, the chief executive of Clayton, Dubilier & Rice, the large private equity firm, agreed. "We have an unfair advantage," he said. Another factor in private equity's favor: the ability to pay enormous pay-for-performance packages without an outcry from public shareholders.
As one buyout king put it over drinks here, "If one of my C.E.O.'s made $100 million, I'd say that's great because it means that we probably just made $2 billion."
What is unacceptable for a public chief executive becomes a powerful incentive in the private sphere.
"You know, it's ironic," said the buyout king, who spoke on the condition that his firm not be identified because he did not want to upset his investors. "Calpers screams when a public company C.E.O. is making a lot of money, but are completely content as a limited partner in a private equity firm to pay him a fortune when the company is private."
(Clark McKinley, a Calpers spokesman, said that his fund considered the same issues in both its public investments and its limited partnerships in private equity funds. Calpers' private equity partners "are apprised of our corporate governance guidelines from the beginning," he said.)
Not everyone is convinced that the entire world will be taken over by private equity.
John A. Thain, the chief executive of the NYSE Group, said that all these "going privates" will soon be "going public" again.
Half of last year's initial public offerings on the New York Stock Exchange, which the NYSE Group operates, represented private equity firms exiting their investments, Mr. Thain said, making buyout shops "our biggest customers." He also suggested that as interest rates continued to rise, low-cost leverage would evaporate, and buyouts of listed companies would look less attractive. "The cycle will change eventually," he said.
And despite the rah-rah talk about private equity here Mr. Schwarzman had a line of well-wishers when he announced on Thursday that he had raised his bid for Equity Office Properties to more than $38 billion there were some concerns that the rise of private equity had been almost too fast and would be closely scrutinized by governments around the world.
"They should no longer consider themselves untouchable," said Philip J. Jennings, general secretary of UNI Global Union, the international association of trade unions, which says it has 15 million members in 150 countries. "They are like a global vacuum cleaner Hoover-ing up assets any place, anywhere, any time and we want to bring them out of the shadows."
While not speaking directly about private equity, Chancellor Angela Merkel of Germany called for more "transparency" in all businesses. "I see the need to catch up with hedge funds," she said.
Still, at least for now, it appears that the call for more transparency may be private equity's best calling card. Mr. Schwarzman recounted how a chief executive at a company he acquired told him how much he was looking forward to board meetings now that the company was private.
What was so different?
The chief executive told him that as a public company, whenever the directors meet "they bring their own lawyers."
WHISKY GALORE
Hedge fund attrition rate continues to decline, says Hennessee (hedgeweek)The attrition rate for hedge funds has been in decline for the past two years and stood at 5.1 per cent in 2006, slightly below the average level over the past eight years, according to New York-based hedge fund consultant and index provider Hennessee Group.
Since 1999, says Hennessee, an average of 5.2 per cent of hedge funds with assets of more than USD10m have been liquidated in any given year. The highest attrition levels were 6.4 per cent in 2000 and 6.2 per cent in 2004, the lowest 3.8 per cent in 2002. In 2005 the attrition rate was 5.4 per cent
Hennessee notes that liquidations typically occur for a number of reasons including a declining opportunity set for the strategy and poor performance, but also career choices, such as the retirement of the portfolio manager. The figures do not include hedge funds that are currently operating, but have closed to new capital.
'Despite the fact that the investment management business is extremely competitive, the attrition statistics do not imply that failures in hedge funds are substantially higher than other industries,' says Hennessee Group managing principal Charles Gradante.
'Furthermore, we are seeing evidence of rising barriers to entry within the industry, including the need for more expensive infrastructure to attract institutional money, which favours larger funds and creates difficulty for start-up and moderately-sized funds to sustain growth and attract top talent.'
These factors, he argues, should eventually push the attrition rate even lower than it is today. 'Long term, we believe the attrition rate will decline as the evolutionary process continues, leaving the industry comprised mostly of funds with larger infrastructure and size, commensurate with institutional needs,' Gradante says.
Hennessee Group is a registered investment adviser that provides consultancy services to direct investors in hedge funds on asset allocation, manager selection and ongoing monitoring of managers.
The group is provider of the Hennessee Hedge Fund Index, which the firm has maintained on a real-time basis since its establishment in 1987. The index is compiled from approximately 1,000 hedge funds drawn from the group's database of more than 3,500 hedge funds, net of fees and unaudited.
Hedge-fund Copycat Disappointing (playfuls)Hedge-fund copycat products are not living up to their billing, often posting smaller gains than the indexes they track, New York hedge-fund managers say.
So-called investable hedge-fund indexes, launched in 2002, follow complex investment strategies like hedge funds, but have generally lagged behind the hedge-fund market, USA Today reports.
The Morgan Stanley Capital International Hedge Invest index of MSCI Barra Inc. gained 7.3 percent in 2006, 4 percent less than the 11.3 percent return of the MSCI Hedge Fund Composite index that the Hedge Invest index is designed to mirror.
A big reason for the poor relative return is, it is hard to build an index that truly mimics the hedge fund universe, the newspaper says.
A hedge fund uses high-risk speculative, often unregulated methods to obtain large profits for institutions and high-net-worth individuals.
Hunter - Gatherer : Trader - Winner. I like it.