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The Case Against Hedge Funds
FINANCE by Francis X. Gilpin | Associate Editor
James S. Riepe may be stepping down as vice chairman of T. Rowe Price Group Inc., a Baltimore investment firm that specializes in mutual funds. But the mutual fund executive's recent remarks in Tampa about his industry's latest rival for investor cash weren't the least bit retiring.
Hedge funds are largely promoted by word of mouth, according to Riepe, with breathless pronouncements about outsized yet sometimes hard-to-verify investment returns. Riepe proposes a slight revision to the friendly come-on.
"Somebody's saying I've a great investment idea for you," Riepe says. "It's got a very short-term focus. It's got very limited, if any, liquidity. It's got very high fees. It has a real lack of transparency. The guy won't tell me what he's doing with your money. But, believe me, he'll make money for you. And they have no meaningful track record. He was a trader with Goldman Sachs last week and now he's just raised $2 billion."
Riepe ends the pitch with mock enthusiasm: "Don't you want to be in this?"
The 62-year-old's withering critique of hedge funds, the largely unregulated investment pools for institutions and wealthy individuals, drew liberally from the headlines of the past eight years. From the gigantically excessive borrowing of Long-Term Capital Management LP to the alleged outright thievery of Atlanta-based International Management Associates LLC, Riepe predicted a day of reckoning for the hedge fund business.
"It is what I would call the investment du jour," he says. "I'm always suspicious of the investment du jour, whatever that might be."
Riepe says the 2000s have so far provided a fortuitous environment for the short-selling strategies favored by hedge fund managers, many of whom boast that they can make money in any market. Not since the Great Depression has there been a better time to short stocks, he says.
Short selling, when an investor tries to profit by betting that a stock's price will decline, became common after the bottom fell out of tech stocks in 2000. Many hedge funds still regularly short stocks.
Investors burned by the late 1990s tech bubble have been only too willing to attempt to make their money back by running into the arms of hedge fund managers, Riepe says. "Hedge funds are kind of the seductive option out there," he says.
Hedge fund assets have doubled since 2002 and there are now 8,000 such investment vehicles, according to Riepe. About $1.2 trillion of the $1.5 trillion in total worldwide hedge fund assets are held in the United States. Mutual funds have $9.2 trillion.
Short-term focus
But hedge funds only thrive when markets are volatile. Their short-term focus requires frequent trading of stocks and other financial instruments. That has made hedge funds even more popular with Wall Street brokerage houses than with the investing public.
One Wall Street trader recently told T. Rowe Price managers that their prudent stewardship of about $150 billion in equities generates lower commission profits for his firm than a $2 billion hedge fund for which he also executes buy and sell orders, says Riepe.
Hedge fund managers move in and out of stocks at lightning speed. Within the past two years, more of them are also pressuring corporate managers to sacrifice long-term performance and sell off assets for quick gains, even when the lagging unit may be suffering only a temporary setback.
The mutual fund industry is not without alleged sin. New York Attorney General Eliot Spitzer uncovered a potential market-timing scandal.
Still, Riepe maintains the rapid trading and myopic vision of hedge fund managers harms small, patient investors like those who place their money with T. Rowe Price. Plus, beleaguered chief executives get confused. "Who is my shareholder?" Riepe says CEOs might ask themselves.
With the financial might that billions of institutional dollars have bestowed on hedge fund managers, CEOs too often side with the rapid traders. Riepe questions whether hedge fund stakes in American corporations truly represent an ownership interest. "They're basically speculators to whom we are giving rights of ownership," he argues.
Riepe is willing to give the devil his due. "That's not to say there aren't some very, very good and smart and effective hedge fund managers out there," he says. "But I'm hard-pressed to think there are 8,000. And if they won't tell me how they do it and they haven't been doing it for more than six months, then I'm going to be a little bit nervous about that."
The U.S. Securities and Exchange Commission began requiring more hedge funds to register as investment advisers in February. "That was the right thing to do," says Riepe. "But it was more of a political solution."
Some hedge fund managers dodged the registration requirement by increasing their "lockup" periods, the number of years before investors are allowed to withdraw their money. Riepe says the SEC lacks the staff to regulate even the limited number of hedge funds that did register.
One audience member at the presentation later asked Riepe if there was a way for investors to position themselves to profit from a blowup in the hedge fund business.
"The big blow will be a few more of these frauds because it's been so easy to raise money," Riepe says. Despite more bad publicity, however, Riepe sees the demise of faddish hedge funds to be a slow process.
Lockup periods of three to five years at many hedge funds will preclude a sudden huge outflow of cash, he says.
The average life of a hedge fund lasts fewer than five years, according to Riepe. Some are so highly leveraged that they collapse, like Long-Term Capital Management. Others are closing down because of copycats. "There's too much money pursuing too few strategies," he says.
Riepe has a few words of caution for small investors who buy stocks to hold for the long haul: Steer clear of public companies where hedge funds hold a significant stake.
James S. Riepe
Position: Retiring this month from the board of T. Rowe Price Group Inc., where he has been vice chairman since 1997.
Age: 62
Compensation: Excluding stock options, a bonus of $3.3 million augmented his $350,000 base salary in 2005. In retirement, he will earn $183,334 in consulting fees from T. Rowe Price in 2006. Starting next year, his fee will be $100,000 a year.
Education: Bachelor and master's degrees in business administration from the University of Pennsylvania's Wharton School. He currently chairs the Ivy League university's board of trustees.
Industry posts: He has served two terms chairing the board of governors of the Investment Company Institute, a trade group for the mutual fund industry. He also has sat on the board of the National Association of Securities Dealers.
Why did he come to Tampa? A local Wharton alumni group co-hosted his April 5 visit. A Penn football teammate during the early 1960s, William R. Paul, a Tampa partner with the law firm of Ruden McCloskey Smith Schuster & Russell PA, helped persuade Riepe to travel from Baltimore.
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