Pequot's Wien Sees No Hedge Fund Bubble

By Emma Trincal, Senior Financial Correspondent | Tuesday, April 10, 2007


NEW YORK (HedgeWorld.com)—There is no hedge fund bubble. At least, that's the opinion of Byron Wien, chief investment strategist at Pequot Capital Management Inc., the $7 billion hedge fund run by Art Samberg. Mr. Wien, the former senior investment strategist at Morgan Stanley who spent two decades at the bank before joining Mr. Samberg, is a well regarded veteran strategist whose opinion matters on the Street. His move to Pequot took place only a few months after John Mack deserted a position at Pequot to become Morgan Stanley's chief executive Previous HedgeWorld Story.
In an April commentary letter for investors titled "There is No Hedge Fund Bubble"—a copy of which was obtained by HedgeWorld—Mr. Wien noted that "everyone is preoccupied with bubbles," pointing to the crisis in subprime loans and the frantic private equity activity. The concern regarding hedge funds centers on the rapid growth as measured by number of firms and assets under management. Yet, Mr. Wien wrote that he remains bullish on the sector.

"My view and perhaps I am talking my own book here, is that hedge funds represent an evolutionary step in money management," wrote Mr. Wien. "They are here to stay, and the funds under management are likely to grow larger over time."

While hedge funds are becoming more institutionalized, their value to investors is tied to talent. As a result hedge funds will keep on luring well-paid star traders, analysts and portfolio managers from the buy-side, Mr. Wien wrote.

Since they get paid hefty fees, hedge fund professionals have an impact on their local environments. In a digression on hedge fund money, Mr. Wien pointed to hedge funds' "profound influence on the market for contemporary and impressionist art, as well as the real estate markets in New York, Connecticut, Florida, California and various ski areas."

While it's certainly good news for real estate brokers and trendy galleries in New York's Chelsea neighborhood, what is the impact of this new wealth on investors?

Mr. Wien in his note hinted at some of the vulnerabilities of hedge funds whose wealth remains tied to the markets, even though the cliché is that they always make money, even when they lose money for their clients. One of those vulnerabilities is, ironically, the existence of bull markets, which make hedge fund performance lag equity benchmarks. "Short selling has always proven problematic in a bull market," wrote Mr. Wien.

During the strong stock market recovery of 2003, for instance, the Standard & Poor's 500 stock index delivered close to 30% annualized returns while hedge funds earned only half that due to their short positions. Hedge funds continued to underperform in 2004 before outperforming the markets again in 2005.

While managers' fees can balloon, they can also burst with sudden redemptions. "A long-only manager could suffer a down year and survive, but a hedge fund with a high water mark would risk not only losing clients, but valuable investment staff if performance were negative," Mr. Wien wrote in his commentary. One way to counter that for some hedge funds has been to offer longer lock-ups with lower performance fees, Mr. Wien wrote. Another way has been for managers to reduce portfolio volatility in order to keep their institutional clients.

Hedge funds may not always outperform the benchmarks, but when markets are down they do well. Perhaps this is why institutional money continues to flow into hedge funds. Mr. Wien stressed that hedge funds tend to deliver performance with less risk. From January 2002 to September 2006, managers generally earned better returns with a lower standard deviation than their long-only counterparts, he wrote.

"As I look ahead it seems clear that hedge funds will continue to grow in importance," wrote Mr. Wien in his conclusion.

It's an upbeat picture, and it has some ramifications. One of them is the relationship between hedge fund investing and the robust performance of small-cap and midcap stocks. The typical long/short hedge fund has about 67% of its assets in small-cap and midcap stocks, Mr. Wien wrote, citing a study by Morgan Stanley. As long as hedge funds continue to heavily invest in those stocks, their performance will remain strong.

Another ramification: As entrepreneurial founders will need to take their business to the next level and raise capital to reach institutional stature, Mr. Wien wrote that he expects more firms to go public.

In conclusion, Mr. Wien wrote that he does not see an end to the hedge fund boom.

Mr. Wien, who joined Pequot in 2005 Previous HedgeWorld Story, did not return a call seeking comment.