The Other Side of the Hedge

A reporter gets inside the heads of superstar managers.

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Katherine Burton began reporting on hedge funds over a decade ago, when the industry, apart from a few stars like George Soros, was still a tiny group of mavericks whose high-risk investing—along with their willingness to short-sell, or bet against, stocks—quietly earned them millions of dollars. (That is, when their risk taking didn't come back to bite them. See: Long-Term Capital Management.) Times have changed. There are now nearly 2,500 single-manager hedge funds around the world, overseeing $1.7 trillion in assets. In Hedge Hunters: Hedge Fund Masters on the Rewards, the Risk, and the Reckoning, published this week, Burton, a reporter at Bloomberg News, spoke with two dozen top-flight managers—from T. Boone Pickens, the Texas oilman turned takeover artist, to James Chanos, the whiz kid who famously shorted Enron in 2000—about how they keep finding ways to beat the market.

Hedge funds averaged 18 percent annual returns in the '90s. One manager you spoke with described investors who didn't short stocks as "It's me and the patsies." Why doesn't everyone do this?

Traditional money managers have a mandate with their clients to be long-only managers, and a lot of people have never been trained as short-sellers. These guys saw an opportunity. They could take advantage of things other people couldn't. Is that why they've become so popular?

They were helped by the [2000-2002] stock market crash, too. Institutions that had 60 percent of their money in stocks lost a huge amount over two years. They realized they needed a better way to make money and preserve their capital during times when the markets were falling. And hedge funds made a lot of money. That's putting it mildly. The fee structure at most funds is 2 percent of investments plus 20 percent of profits.

An average fund in the book is maybe $6 billion. Let's say that fund is up 10 percent. So, you have a 2 percent management fee—that's $120 million. Say 75 percent goes to paying people and running the shop. You've still got $30 million—that's your profit. You make 10 percent that year, so you make $600 million. Twenty percent of that is $120 million. You split that with a few partners, but still, that's a lot of money. At least $25 million a year. Again, why isn't everyone doing this?

Most likely, you're not going to be one of these guys who make $25 million a year. Roberto Mignone [founder of Bridger Capital] said to me, "Do you remember the chapter in Freakonomics about why drug dealers live with their mothers? A crack dealer in Chicago has a 25 percent chance of dying within four years. One out of two new hedge funds goes out of business in the same time span." You have a better chance of surviving the drug-dealer business than the hedge fund business. The investors you spoke with have survived. What makes them good managers?

A lot of it has to do with being at the same time confident and humble. They had to have conviction about their positions, but they're always trying to figure out what could be wrong with their theory. And they're not afraid to make mistakes. Many of them said, "Look, if I'm right 55 percent of the time, I'm a star." Because they know they can make mistakes, it's easy for them to walk away when they've made one. How are they holding up now? The debt crisis has made for an uncomfortable year for hedge funds.

A lot of these interviews took place in February and March, when the subprime news was [first] coming out. It was interesting because these guys pretty much saw it coming. They said credit spreads are way too tight—that they are historically the tightest they've ever been; it's not sustainable. It changed what they invested in. For example, they were only doing senior debt—the highest-quality debt. What do they think will happen long term?

Everyone was very, very conservative because they really felt this was an inflection point. I don't think it was clear how much of a fall we might see, and it's still not clear. What does the future look like for hedge funds? As more wannabes jump in, average returns are falling.