Hedge Fund Horsepower Centers on Connecticut
Connecticut is one of the top three centers of the global hedge fund industry (the other two are New York City and London), according to a joint survey conducted by the Connecticut Hedge Fund Association (CTHFA) and the University of Connecticut. The CTHFA is a not-for-profit educational association for Connecticut’s growing absolute return investment management industry.
By Russ Jones with Lisa Schroder, Markets Editor
Meet Bruce McGuire, founder of the Connecticut Hedge Fund Association."The manager asks how and when; the leader asks what and why." - Warren Bennis
Bruce McGuire says he was greatly influenced by a 2004 report by Casey, Quirk & Associates of Darien, which “estimated that institutional capital in hedge funds would increase from $60 billion to $300 billion by 2008” and also “predicted that by 2008, institutional capital would account for 50 percent of annual net new flows into hedge fund.”
Most people read, think, and move on. Not McGuire.
He acted upon the information and founded the Connecticut Hedge Fund Association (CTHFA) in 2004. Not typical, that's true. McGuire saw the direct result of the macro trends at work within the global asset management industry, the institutionalization of hedge funds, or the growing demand for absolute return investment management by institutional investors.
“Hedge funds were not as well known, and harder to track. We knew that many otherwise sophisticated institutional investors would need a forum to get to know the players, stay abreast of product innovation and identify emerging talent,” says McGuire. “Similarly, we recognized that since most hedge funds managed money for high-net-worth individuals and/or a select group of foundations and endowments, that they too would need a forum to get to know the institutions and their asset allocation processes better.”
In addition to providing that bridge, CTHFA’s mission includes educating all industry stakeholders, engaging with academia, and promoting philanthropy.
McGuire emphasizes that the CTHFA is not a hedge fund lobby.
“We do have many hedge fund members, but we are a much broader organization that also includes institutional investors, private wealth advisors, academics and service providers. As such, we describe ourselves as an industry cluster association.”
A Hedge Fund Primer
A hedge fund could be defined as a "managed portfolio that has targeted a specific return goal, regardless of market conditions." Hedge funds specialize in gaining maximum returns for minimum risk. Many strategies can be called on to achieve this goal.
Hedge funds trace their roots to Alfred Winslow Jones, a Columbia University Ph.D. working as an editor for Fortune magazine during the 1940s, says McGuire.
“After interviewing market strategists for an article that he was writing, Jones was struck by the fact that all of the experts that he interviewed admitted that it was impossible for them to predict the market’s direction with any consistency. With this insight, Jones was determined to create an investment approach that would take market direction out of the picture.”
“His idea was brilliant in its simplicity,” says McGuire. “He decided to create a balanced portfolio of long investments in undervalued stocks and short positions in stocks that he believed to be overvalued. Jones used his short selling as a ‘hedge’ to protect his long portfolio against a general market decline. Jones launched his new creation in 1949.
Other hedge fund pioneers include George Soros (Soros Management), Michael Steinhardt (Steinhardt Management), and Julian Robertson (Tiger Management).
How do hedge funds different from other investments, such as mutual funds?
Hedge funds are very misunderstood, says McGuire, and he explains the basic structural differences:
“Mutual funds pool investor money and place it under the direction of a professional money manager,” he says. “Mutual funds are publicly offered open-ended investment vehicles. They are public because they are open to all investors regardless of net worth and are freely advertised in print and other media. They are open-ended because investors may invest or redeem their shares during most business days.”
“Hedge funds are mutual funds also because they pool investor capital (or limited partner capital), and place it under the direction of a professional money manager (the general partner),” McGuire continues. “Hedge funds, however, are privately offered, closed-end funds. They are private because they may only be offered to ‘accredited investors’ ($1 million net worth or $200,000 in annual income for past two years). They are closed-end because they set limits on investments and redemptions (usually quarterly after a one-year lock-up).”
McGuire points out that there are a few other characteristics that make hedge funds different. “The first one is tied to the private nature of the funds. Since hedge funds are private and only available to ‘sophisticated investors,’ the law allows them much more latitude in the investment techniques that they may employ,” he says. “For example, hedge funds may make liberal use of leverage, derivatives and short selling—all areas where mutual funds are restricted.”
Another difference is that hedge fund managers typically have a big percentage of their net worth invested alongside their limited partners, and make the majority of their fee from a so-called performance fee, says McGuire.
“The performance fee or ‘carry’ is typically set at 20 percent of the profits over and above a stated minimum return, such as the 90-day Treasury rate.”
High Net Worth, High Risk?
Are hedge funds only for the “rich”?
"Generally, yes," says McGuire, but clarifies that the ‘rich’ may be either an individual or an entity such as a pension fund, foundation or endowment.
“To invest in hedge funds, one must meet the ‘accredited investor’ standard. To qualify, individuals must have a net worth greater than $1 million or $200,000 in annual income. Corporations, partnerships, LLCs, business trusts, and tax exempt organizations must have total assets of $5 million.”
Because pension funds may qualify, even middle class plan participants may now indirectly participate in hedge funds.
What about the common perception that hedge funds are very risky? The reality isn’t that clear cut, says McGuire. “It is certainly true that many hedge funds are highly speculative and carry the risk of significant or total loss of capital. The accredited investor standard was devised as a means to limit hedge fund investing to only those investors that could ‘afford’ to lose their capital.”
All that said, the original hedge fund launched by A.W. Jones (and many that have followed) are specifically designed to “hedge” against a market drop, and thus have less risk of loss than a typical long-only fund. McGuire offers two examples to illustrate:
Consider if you will the case of two accredited investors Alex and Caroline. Both were seeking to invest in a portfolio of large cap U.S. stocks. Alex decided that hedge funds sounded too risky for him, and so he opted for a large cap stock mutual fund. Caroline, less influenced by headlines, decided that she liked the flexibility given to hedge funds, and so invested in a long/short U.S. equity hedge fund.
In year one, the S&P 500 returned +15 percent. Alex’s fund did well, returning an impressive +18 percent. Caroline’s fund also did well, and after fees she earned a +17.5 percent return.
In year two, the S&P hit a tough patch and was down -15 percent. Alex’s manager, bound as he was by prospectus to invest long in only large cap U.S. stocks, took a beating and after fees was down
-14 percent. In his year-end statement, however, Alex’s manager boasted about his investment prowess because he was able to “beat the index” by 100 basis points! By contrast, Caroline’s manager recognized that holding U.S. large cap stocks was a losing game and, not being restricted in his investment strategy, moved a percentage of the portfolio into cash, and an even larger percentage into short positions, betting that large cap stocks would fall. At year-end Caroline’s manager announced a positive return of +8 percent—not bad in a difficult market environment.
“So, all things considered, you tell me which approach carries more risk,” McGuire poses. “As I said, there isn’t a clear-cut answer.“
Why are hedge funds so popular with investors?
"The first hedge fund investors were looking for (and receiving) skill-based investing and alpha. (Alpha is the word that people in the business use to describe returns over and above the general market or index return.) Hedge funds were designed to have investment flexibility that would allow them to generate a positive return in any market environment," says McGuire.
“As such, hedge funds are described as having an absolute return focus. Absolute return is contrasted by the relative return focus of most long-only mutual funds.”
As the above examples of Alex and Caroline show, the mutual fund manager was happy to be down
-14 percent, as long as the index that he measured himself by was down -15 percent.
"Relatively speaking, he did a fine job," he says. "The hedge fund manager, by contrast, is not content to simply lose less money than the index; he is motivated to produce a positive absolute return—after all, he only earns his big fee if he accomplishes this primary objective. "
As more institutional money has come into hedge funds, the idea of having investments that are negatively correlated to the broader markets is also very attractive, as it tends to dampen the volatility of the overall portfolio, says McGuire, noting that “the CQA research shows that most institutional investors are only seeking a modest 8 percent annual return from their hedge funds, so long as they also receive low correlation and low volatility.”
Hub of the Hedge Fund World
Connecticut is one of the top three centers of the global hedge fund industry (the other two are New York City and London), according to a joint survey conducted by the CTHFA and the University of Connecticut.
“There are approximately 175 hedge fund advisors in Connecticut with assets under management of approximately $300 billion,” notes McGuire. “That is about one-third of the $1 trillion global industry total.” (Those figures do not include the assets of some large fund of hedge funds such as K2 Advisers, SSARIS, UBS and Aetna Capital Management, which would add several billions more to the total.)
In Connecticut, the industry clusters in a corridor between Greenwich and Westport, with Stamford fast becoming a significant center. A primary factor leading to Connecticut’s prominence is the proximity to and the distance from New York, says McGuire.
Other factors include a superior quality of life, great schools, and (at present) a more reasonable state income tax rate relative to New York.
“The first funds to set up shop here did so because their founders, like many Wall Street titans, lived here,” he says. “I think that what’s happened in the last few years is that Connecticut—Greenwich and Stamford in particular—has achieved critical mass and a global reputation as an industry hub. As such, new entrants feel that in order to be a ‘part of the scene’ they must have a presence here. I think the same thing happened in the San Francisco Bay Area’s ‘Silicon Valley’ during the late ‘80s and ‘90s.”
When asked if he thinks other businesses are attracted to Connecticut in order to be near hedge funds, McGuire replies that, starting out, most of the service providers (brokerage, law, accounting, and technology firms) that cater to hedge funds were content to remain in New York.
“This paradigm has started to change, however, and we are now seeing signs that the service industry is starting to follow the funds out to Connecticut.” He cites UBS, which employs a Prime Brokerage team in Stamford; SS&C Technology in Windsor. “One of the most exciting recent examples of this trend is GlobeOp Financial Services, which established a new office with about 100 employees in downtown Hartford."
Is Connecticut, then, becoming the “Silicon Valley” of the asset management industry?
McGuire believes that’s an accurate comparison. “We have already discussed the funds and service industry that is coalescing here. The final piece of the puzzle is something that I and the other CTHFA directors are very passionate about, and that is the connection to academia,” he says. “Just as Silicon Valley has its Stanford and Cal-Tech, we have Yale, UConn, and Fairfield University.”
The Yale Investment Office, which oversees Yale’s $15.2 billion endowment, was an early adopter (and beneficiary) of hedge funds. Inside the Yale School of Management, and under the direction of Professor Will Goetzmann, Yale runs a Hedge Fund Research Institute. Yale Professor Owen Lamont, a leading expert on the topic of short selling, moderated a CTHFA symposium last year that was attended by more 200 industry professionals.
Getting Together in Real Time
The University of Connecticut (UConn) and Fairfield University are likewise strengthening their connections to the industry. The CTHFA and UConn co-hosted a well-attended hedge fund conference in 2005. In addition, a joint CTHFA/UConn team is currently engaged in a mapping survey of the entire Connecticut hedge fund industry.
In late 2005, UConn created its very first hedge fund management course, under the direction of Dr. Shantaram Hegde (and no, that is not a typo, just coincidence in spelling) .
Fairfield hosted an outstanding hedge fund symposium in 2005, and last year they became the CTHFA’s latest academic partner. In late 2006, Fairfield University’s Dolan School of Business and the CTHFA co-hosted an important symposium at the New York Stock Exchange to discuss systemic risk and the growth of the hedge fund industry. That event brought together large hedge funds, investment banks, members of the IMF and Federal Reserve, helping to catapult the CTHFA into the ranks of the other leading think tanks.
McGuire says the state of Connecticut generally is very supportive of the industry.
“While the industry began here without any proactive move from the State, leading State officials, including Governor Rell, Department of Economic & Community Development (DECD) Commissioner James Abromaitis, Barbara Fernandez (also from DECD), and Secretary of the State Susan Bysiewicz have all grasped the economic development opportunity that exists, and to their credit have responded with tremendous enthusiasm.”
A landmark event in 2007, the CTHFA, the DECD, and the Governor’s office collaborated to host the First Annual Connecticut World Hedge Fund Forum. A primary objective is to showcase the state as a premier domicile for this dynamic and entrepreneurial industry.
Financial Frontier
When asked about the perception that hedge funds are operating in a “Wild West” frontier environment, McGuire shares his views on the current regulations status, noting that hedge funds have historically avoided SEC registration requirements because of an SEC exemption for private funds.
“Recently, the SEC attempted to bring larger funds (14 clients and $25 million AUM) under its registration jurisdiction,” he says. “However, that attempt was challenged in court and was defeated.” So at present, he says, there is no requirement for hedge fund advisors to register as investment advisors—although some do so voluntarily.
McGuire emphasizes that registration is not the same as regulation.
“While it is true that hedge funds do not have to register with the SEC,” he explains, “it is not true to say that hedge funds are not regulated—this is a common myth. The reality is that hedge funds in the United States are regulated or supervised directly or indirectly by seven U.S. government agencies (the Federal Reserve, the Department of Treasury, the SEC, the CFTC, the National Futures Association, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation). Can more be done to improve operational transparency and investor disclosure? Sure. But I would rather that those decisions be made at the federal level by people with the expertise to fully grasp the issues and the ramifications of the ‘solutions,’” says McGuire, adding that he thinks “the worst thing that could happen is for a handful of states to implement their own patchwork regulatory requirements.”
The latest Fortune 400 list of the wealthiest Americans includes 15 or so hedge fund billionaires, which brings us to another common perception. While McGuire acknowledges that “the hedge fund business has generated some tremendous wealth for some people,” he emphasizes that “not every hedge fund manager is a billionaire.” He points out that as the number of funds has exploded, it has become more competitive and much harder for managers to differentiate themselves and attract investors.
“We do live in a ‘People magazine, Lifestyles of the Rich & Famous’ culture, and so people are fascinated by all this money.” (Case in point: a 2006 spread in Vanity Fair magazine included aerial photos of some of the Greenwich hedge fund managers’ homes).
"Passion for Philanthropy"
Big houses and art collections may be part of the scene, but equally important, McGuire says, is the “passion for philanthropy.”
He cites plenty of examples of great generosity in the hedge fund community: Warren Buffett gave a big percentage of his net worth to the Bill & Melinda Gates Foundation (Buffett’s first entrepreneurial endeavor was as a hedge fund manager).
One of the best local examples is Paul Tudor Jones and his Robin Hood Foundation, which Jones founded to help disadvantaged children in New York City, and to date has distributed about half a billion dollars to fight poverty. Then there’s CTHFA’s relationship with Paul Newman’s charity The Hole in the Wall Gang Camp (Greg Brousseau, a Hole in the Wall director, is a member of the CTHFA Board). Together, we are planning a major philanthropic push in 2007,” says McGuire. “The Connecticut Hedge Fund Association plans to harness some hedge fund wealth and put it to work—right here in Connecticut.”
Resources:
For more information about CTHFA and events in the region, visit www.cthedge.org.
