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Managed funds star sees chances for DIY hedge managers

By Michael Coote

Friday 13th August 2004

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Bill Gross, founder and head of Pacific Investment Management Company (Pimco), is never one to mince his words and his regular Investment Outlook column is keenly awaited and often a source of great hilarity.

For both style and substance, his columns are worth reading at www.pimcofunds.com. In the managed funds world, Gross is a star.

Pimco is based in Newport Beach, California. Set up in 1971, it is now one of the world's top fixed-income managers, with about $US392 billion under management. According to the website, "Pimco's total return approach to bond investing was pioneered by Bill Gross over 25 years ago and focuses on income and capital appreciation, rather than just income alone, while trying to manage overall risk. This approach is still the backbone of Pimco's portfolios."

When the pioneering and successful Gross writes something in his columns, people tend to pay attention.

The latest column has a go at hedge fund managers. It has been something of an open season on hedge funds as more publicity has been attracted to their rapid growth in funds under management over the past few years (see chart). The Economist, for example, has been crabby about hedge funds for quite some time.

The big break for hedge funds was the 2000-03 equities bear market that saw a massive shakeup of the conventional wisdom that owning shares was the best long-term option for capital appreciation. While sharemarkets tanked, hedge fund managers made money for their investors primarily because they were able to short-sell assets, either directly by borrowing shares, selling them, buying them back at a lower price, returning them to the lender and pocketing the difference, or through derivatives that synthesized the procedure.

Investors were attracted by the returns hedge funds were making. At the same time, many equity funds management personnel laid off in the bear market set up shop as hedge fund managers. The result has been an explosion in the number of hedge funds to about 7000 today, managing about a trillion US dollars in assets. Hedge funds have become important customers of Wall Street, supplying about $US10 billion or 7% of total annual trading commission revenue.

Hedge funds are highly variable creatures in how and what assets they trade, and the category undergoing greatest expansion is that of "long/short equity," or share trading that entails either buying low and selling high (long) or selling high and buying low (short).

Gross' beef with hedge funds traverses the usual accusation of high fees charged but he hits on a point that is getting more attention. Big influxes of new managers and money into the industry are starting to crowd out at least some trading opportunities. To magnify tighter trading margins, some hedge fund managers are resorting to greater use of leverage, either by investing borrowed money or using derivatives. Gross paints a tears-before-bedtime scenario if interest rate shifts clobber hedge funds reliant on high ratios of cheap borrowed funds in relation to equity.

"America's and, therefore increasingly, the world's economy is unstably founded on a base of cheap money used as leverage to support certain asset prices of dubious value," he writes. "If and when the cost of those funds moves sharply higher for any reason ­ a dollar crisis, inflation, foreign central bank sales of Treasuries, increasing budget deficits, to name a few ­ then the flaws of a levered economy will be quickly exposed."

It is certainly of relevance to investors and their advisers to establish to what extent the returns of any given hedge fund are dependent on using debt over equity.

Derivatives may not be such a problem, provided their market is very liquid and thus that their trading prices do not gap too much in the event of an interest rate shock.

Gross derides hedge fund managers for doing what investors can do for themselves by combining debt with equity and short selling through derivatives. Yet his comment raises the intriguing idea that in fact investors could DIY as their own hedge fund managers and we will probably see more of this trend. As a simple example, an investor could become a long/short equity trader by buying some stocks he thought cheap with borrowed money, and at the same time short-selling the market through a futures contract or option. Presto! He is a hedge fund manager.

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