Alternative investing is all the rage, as I noted in my last column. As an individual investor, you might feel that the dealings of hedge funds, private equity and venture capital don't apply to your portfolio. Yet, when there is such a sea change taking place in the investment landscape, it is important to try to understand why it is happening and whether it makes sense, because the ripple effects can reach you.
Hedge fund is an all-encompassing term that includes a variety of privately run investment vehicles. There are hedge funds that trade only in a niche, such as distressed bonds, or multi-strategy funds that trade in all kinds of markets.
The inner workings of a large multistrategy hedge fund became much more visible when Citadel Investment Group recently filed a prospectus for a $2 billion bond offering. Citadel, which has about $13 billion of investor funds, disclosed that it paid a mind-boggling $5.5 billion in interest, fees and trading costs in 2005.
How can that be? Well, Citadel is leveraged 12-1/2 times, to control $166 billion of assets. Thus, the interest costs on that massive borrowing account for a large portion of those fees. The fund also claims to trade up to 3 percent of the daily New York Stock Exchange and NASDAQ volume.
These statistics, as well as the feast of fees generated by large hedge funds, certainly explains why Wall Street firms, which lend the money and transact trades for hedge funds, are eager to facilitate more of their business.
Citadel is considered one of the upperechelon hedge funds, with returns in excess of 20 percent annually over the past eight years. And there is also no question that many of these top funds are run by bright people-legend has it that Citadel's founder, Ken Griffin, started out trading convertible bonds from his dorm room at Harvard.
Brian Hunter, who was Amaranth Advisors' star trader, has a master's degree in mathematics. Amaranth was a multi-strategy hedge fund, trading all sorts of investments, such as stocks, convertible bonds, distressed debt and European loans.
During 2005, Hunter placed large, leveraged bets in the natural gas market. He made the fund $1 billion by wagering that natural gas prices would rise in the wake of hurricanes Katrina and Rita. For his trading prowess, Hunter was paid $75 million.
Only eight months later, in August 2006, natural gas prices did not behave according to Hunter's "models," causing Amaranth to implode, losing $6.5 billion in a matter of weeks. Amaranth had to shut down, but of course its managers were not required to return any of their past earnings-thus exposing one of the absurdities in the way performance fees are structured in most alternative investment vehicles.
What is amazing is that Hunter's services are in hot demand. It is rumored that many hedge funds are interested in hiring him.
It all makes one wonder if the investors in these funds really understand what is being done with their investment dollars.
It's perhaps telling that a principal at the bond manager PIMCO passed on the Citadel offering saying, "This sale shows that the credit markets are pushing limits. When you don't like the business, and you can't get your hands around it, no spread is enough."
Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or firstname.lastname@example.org.