The recent performance of the stock market and the economy has been painful and well documented. It seems that for the last month or so, it has been difficult to turn on the evening news or open up the morning paper without reading about the faltering global economy. The S&P 500 alone was down 16% in October and is down close to 30% for the year through mid-November. Many have seen their retirement or college savings accounts fall by considerable levels.
When such large amounts of wealth are lost in the market, the natural tendency is to look for someone to blame. Pundits have argued that a host of factors have caused the economic turmoil: sub-prime lending, the housing bubble, credit default swaps, and a lack of government regulation to name a few. Another often criticized and misunderstood player in the downfall has been hedge funds. In recent months, hedge funds have been accused of everything from the high oil prices to the collapse of the financial sector this fall. If hedge funds wield this sort of power, perhaps they should be examined more closely.
What is a hedge fund? The simplest way to think of hedge funds is to compare them to something that many people are more familiar with: mutual funds. Like mutual funds, hedge funds pool investors' money together and invest in a diversified portfolio of assets including stocks, bonds, and derivatives. Like mutual funds, hedge fund investors pay the manager an annual fixed fee (typically 2%) to manage their money. However, unlike most mutual funds, hedge fund managers earn fees on their performance. Hedge funds earn a performance fee (typically 20%) on the annual profits they generate for their investors. Finally, hedge funds do not typically register with the Securities and Exchange Commission (SEC), and as such, are subject to much less regulation
This lack of regulation has caused some in the financial media to blame hedge funds for much of the recent financial crisis; if you can't see what hedge funds are doing, it must be bad. To be fair, there have been some "bad actors" in the hedge fund community. A famous example is Amaranth Capital, a $9 billion hedge fund which lost $6 billion in a week on a bad bet on natural gas futures. The question I pose here is whether this case of hedge fund collapse is the norm or an isolated event. Do hedge funds do more damage than good to our financial markets? Are hedge funds evil?
I wrote a recent article, "Value Creation or Destruction?: Hedge Funds as Shareholder Activists" which appeared in the September 2008 edition of the Journal of Corporate Finance. The paper examines when a hedge fund takes an activist position in a firm. Overall, I find that hedge funds help to uncover hidden value in these firms by advising the firm on ways to improve performance and aligning the interests of management and shareholders. On average, after a firm is targeted by a hedge fund, the firm's accounting performance and stock price outperform both the market and their peers. These gains are enjoyed by all shareholders of the firm, not just the hedge fund.
An example may help clarify shareholder activism and how it can increase the value of the firm. At the end of July 2004, Barrington Capital (a hedge fund) took an activist stake in the shoe retailer, Steve Madden, Ltd. In a letter to the firm, Barrington recommended that the retailer start paying a dividend, reduce the number of stock options that were given to management, and expressed concern over Steve Madden's women's retail business. After the retailer drug its feet on the matter, Barrington further recommended that the CEO of the firm be replaced.
While the CEO was ultimately not replaced, at the prompting of Barrington, Steve Madden, Ltd. did begin paying shareholders a dividend and Barrington was appointed to the firm's board of directors. Steve Madden's stock price increased over 200% in the two-year period that Barrington had an active stake in the firm. While Barrington generated high returns for their own investors and collected large fees for their performance, they were not alone. All shareholders of Steve Madden participated in the firm's success; all the while, Barrington did most of the work.
So how does this all relate to the current financial turmoil in the markets? The purpose of this article is to present another side of hedge funds. Their ability to use leverage, invest in options, and earn performance-based compensation, allows hedge funds to pursue investment strategies that mutual funds and pension funds are incapable of or are simply unwilling to pursue. In the case of shareholder activism, the gains from their efforts are shared by all.
Hedge funds will continue to receive blame for much that happens in the financial markets. Some may be justified, but much will simply be the result of regulators and politicians looking for a scapegoat. Like any business, some hedge funds will fail, but many will succeed. As investors, we need to examine any financial intermediary by their aggregate benefit to society, not just "cherry pick" their failures. While the market is down close to 30% for the year, the average hedge fund is down 16%. I suspect many of us wish our portfolios were "only" down 16% this year.
Chris Clifford, Ph.D., is Assistant Professor of Finance, Gatton College of Business and Economics, University of Kentucky.