Is It Fading at Last?

Hedge funds have been cloaked in mystery from the start, starting with the name. “To hedge” means to protect or limit, but in fact the funds have been among the more risky and obscure investment vehicles Wall Street has to offer.

“Hedging” investments was designed originally to protect against loss by counter-investing in alternatives that would rise in value if the original investment declined. Originally, the funds attracted smart and sophisticated managers, as it required considerable savvy to match up such investment pairings. But those managers soon decided that hedging investments was a drag on profits. So the funds discarded their original efforts to hedge their bets, keeping the privacy, exclusivity and mystique of being exceptionally clever.

Capitalizing on their success, they charged a lot: 2% annually of assets, typically, and 20% of profits. Regulators – aware of the increased risk — discouraged ordinary investors from participating, but that seems only to have increased the allure of hedge funds in the eyes of the public and some portfolio managers eager to get into what was, for a time, a very profitable game.

But hedge funds are under no requirement to disclose their trades. Moreover, they often made it hard to cash out. All of that was fine, so long as values went up, but recently they have fallen on hard times, failing to match their past performances. Managers of pension funds have gotten wary, and recently Calpers, the California retirement fund for public employees, decided to divest all hedge fund investments.

That seems like a sensible move, especially as pension funds need to rely on steady income to pay out benefits for retirees. They can’t just wait around for hedge funds to rebound.

Moreover the secrecy clouding hedge funds were increasingly problematic for trustees accountable for investment decisions. One trustee for the Kentucky state pension fund noted recently: “The auditor wasn’t allowed to see the contracts, and the contract review committee for the Legislature was not allowed to look at them, either.” Another retirement system in Tennessee was invested in more than 120 hedge funds, “whose identities, securities holdings, trading costs and custodians are unknown.” Substantial duplication of underlying managers was also found. How did they know what kind of “hedging” – in the original sense of the term — went into the fund at all? Indeed, how did they know that investments in hedge funds were not amplifying risk?

Calpers’ decision to divest came as a shock to the system. No doubt other pension funds will follow suit – and a few investors. But the reaction of Wall Street commentators has been fascinating.

The Times followed up its account by noting that Calpers’ investments in hedge funds was miniscule, and other investors were not likely to follow its example. But in an unusual tone of mockery it commented: “So hedge fund titans, California may just not be that into you, but there are plenty of other starry-eyed, deep-pocketed investors to woo.” Businessweek noted that “the industry’s best period is likely behind it.” But then it gave this parting kick: “No matter how many $100 million Picasso paintings they purchase, hedge fund moguls are not magicians.” And The Wall Street Journal dryly provided evidence that across the board, hedge funds are underperforming the market.

Who knew the extent of the hatred and contempt lurking just below the surface? But whether is springs from resentment over the success of the funds, envy for their performance, or retaliation for their arrogance, the schadenfreude is palpable.