WSJ: Circular Hedge Fund

I’m thinking of starting a hedge fund that only invests in the stocks of other hedge funds. Who’s in?

Most people think of hedge funds as secretive pools run by a bunch of cowboy traders shooting for the moon. Think again. Fortress Investment Group, a hedge fund managing $26 billion, is about to go public and raise over $600 million. This ain’t Pets.com. Hedge funds are money machines, keeping 20% or more of investment profits: Fortress made $240 million last year. So why go public? Perhaps to distribute earnings as tax-advantaged dividends, or maybe, like the rest of Wall Street, there’s nothing like stock options to attract talent. Most likely, they want to get a lot bigger fast.

The institutionalization of hedge funds has begun and there are trillions of dollars at stake. Either way, think of Lays Potato Chips (or cockroaches, depending on how you feel). You can’t have just one. Goldman Sachs, the lead underwriter for the Fortress deal and the lead source of the Fortress talent pool, is also probably their biggest competitor. Strange, huh?

Not really. Wall Street has forever been circular. Remember, there are more mutual funds—over 8,000 of them—charging 1%-2% fees investing in stocks than there are stocks on the New York Stock Exchange and NASDAQ combined. I might as well start another crop circle—a hedge fund buying and shorting other hedge funds (I’ll start with those that fund Hollywood movies). How cool is that? I only wish I had the chance to short failed hedge fund Amaranth.

It seems like a new hedge fund opens every eight seconds. Up from maybe 500 hedge funds in 1990, there are over 7,000 of them today managing over $1 trillion. Crowded? Not yet. The hardest part is raising money, but we’ve come a long way. It’s no longer a Max Bialystock-like hitting up of rich widows; Citadel Investment Group in Chicago has $13 billion in assets and 1,000 employees in six offices worldwide. It turns out they also are one of the largest market makers in options, taking Wall Street on at their own game. Lots of hedge funds make a market in currencies, too, long a profit center for banks. Circular indeed.

At stake are the $10 trillion in various mutual funds and $7 trillion in banks. Hedge funds want to end up managing all this loose capital. Fortress, it seems, has a model that scales to manage a lot more capital. But so do others. There are more publicly traded hedge funds out there than you’d think. It’s become cliché to say Goldman Sachs is just a giant hedge fund in Wall Street clothing; and it is. Some say 15% or more of their earnings come from a $10 billion slush fund doing proprietary trading. Their “prop desk” is the farm system for future hedge funds. Trading for (ahead of?) clients was almost two-thirds of earnings and a big reason for their $622K bonus per employee. With their smarts and historic success, Goldman can easily raise arbitrarily large sums of money. They are fair game for my imaginary fund.

But so is JP Morgan. They realized it’s a capital-raising game and have added $12 billion in assets over a year since buying hedge fund Highbridge. Morgan Stanley, slightly late to the game, bought FrontPoint Partners and a minority piece of Avenue Capital Group. Lehman Brothers owns 20% of Osparie. It’s too lucrative a game to pass up.

Are there more hedge funds out there? How about the NYSE? You bet. Their neutron-bomb strategy of removing people and leaving the exchange intact is progressing. With a publicly traded stock and the protection from the trade-through rule, they’ll soon put their own capital up and profit almost every time someone else trades. Now they want to duplicate this in Europe and Japan, and who can blame them? NASDAQ is in close pursuit and the two may look more like hedge funds than exchanges over the next few years.

Private equity giant KKR raised $5 billion by listing a fund on the Euronext exchange in Amsterdam. That would be a fun stock to short. Other private equity firms may package themselves up instead of their funds and hit up the public for cash. Anyone else? Ever look at General Electric real close? GE Capital has $500 billion in assets for loans, leasing, factoring, equity finance, insurance and commercial management. If I can hedge out turbines and jet engines, I can make their stock smell just like a hedge fund. Same with Berkshire Hathaway.

Wall Street, hedge funds, private equity, mutual funds and probably insurance companies and the financial arms of giant conglomerates are all in the same game, accumulating assets they can generate returns on. But be careful, these are big tectonic plates shifting around that are both working with and crashing into each other.

Of course, as these public hedge funds get huge, their ability to find great investments diminishes. Look at Fidelity Magellan. That’s where I’ll come in: As they balloon, I’ll short all these public hedge funds, who will inevitably disappoint and whose stocks will blow up, improving my returns, so I’ll end up with huge assets in my own hedge fund. Then in a final act of circularity, I’ll go public and short myself. I love this game.

 

Comments

good stuff. you're crackin me up

[MD]

I know this post is meant to be humorous, but a hedge fund that only trades the equity of other hedge funds isn't necessarily ridiculous...it's relatively in-line with what's already going on privately (whether it's ridiculous on an absolute level, well that's a matter of opinion).

If you think of a traditional Fund of Funds (of which there are thousands) as being in the LP business (investing in funds), then a FoF in the GP business (investing in the equity of funds) is not that different (of course many FoF's group already do private investment in GP equity, aka seeding new funds). In many ways trading public equity in HFs is a more attractive business than the private LP business (which is burdened with onerous terms, lack of transparency, etc etc)...or the private GP business for that matter. There are two problems: 1) there aren't that many public funds to trade (at least not in the US) and 2) valuation. Issue 1 will change over time, but the main problem is always going to be valuation (and that's where a FoF trading public equity would claim "alpha"). With regard to valuation, at 40x earnings, Fortress does seem pretty ridiculous.

[Phil]

"NYSE's...neutron-bomb strategy of removing people and leaving the exchange intact is progressing. With a publicly traded stock and the protection from the trade-through rule, they’ll soon put their own capital up and profit almost every time someone else trades."

I haven't been following this - what have they been doing and how could they make this extra money? Could you explain please Andy?

[mattpaul]

I believe Andy's neutron-bomb comment may pertain to the controversy surrounding ex-CEO Richard Grasso's deferred compensation:

http://en.wikipedia.org/wiki/Richard_Grasso#NYSE_compensation_controversy

[c0d3]

Sounds good, i'm in the process of starting my own also, but mine is going to be 100% automated across all global stocks, futures, equities, forex, etc, basically any random instrument. I'm new at all of this, but i do want to collaborate, drop a note.

[AJ]

I'm actually in the process of starting a publicly traded hedge fund a la pink sheets, with liquidity for investors without the regulatory costs of being a reporting company.

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