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Funds and ETF's
Hedge fund madness

Hedge fund madness

By Kevin O'Leary
Globe Investor Magazine Online, Nov. 14, 2008

Kevin O'Leary is the chairman of Gencap Funds LP, the manager of the O'Leary Global Equity Fund (OGE.UN-TSX).

I had dinner last night at Grille 23 in Boston. The fillet on the bone there is to die for and their collection of eclectic American Cabernets may be the largest on earth. If you like drinking Cabs you must go there before you die.

Grille 23 is also ground zero for the hedge fund industry. There is over a trillion dollars invested in Boston-based hedge funds and on any night some of the world's most famous hedge fund managers can be found dining there.

These days it pays for me to hold court at the Grille for the market intelligence I receive. At the O'Leary Global Equity Income Fund we are long-only, deep-value, yield-oriented investors. I need to know what sectors the hedge fund guys are selling and make sure we stay out of their way until they are finished liquidating. What has been happening in the hedge fund industry over the last 90 days has been absolutely brutal and may be responsible for much of the remarkable volatility we are seeing in the world's stock and commodity indexes. Hedge fund operators are also having a profound effect on the world's debt markets.

Let me explain why. Seven years ago if you were a lowly mutual fund manager working at Putnam or Fidelity a new world was awaiting you promising untold riches. Using your "street cred" as a former money manager you announced your departure to launch a new hedge fund. In the early 2000s hedge funds were hot and with a fee structure of 2 per cent of assets under management and 20 per cent of any capital gains attained, the money you could make was a whole lot better than the salary from being a mutual fund "grunt."

It was easy to raise a quick $250-million (U.S.) and set up an office in the back streets of Boston's picturesque downtown. Next step, get levered up. By calling Lehman, Goldman or HSBC bank you could borrow up to 10 times or more on the $250-million you raised in Japanese yen at 1 per cent or less.

Now you are swinging a big stick with the equivalent of $2.5-billion of buying power and you place your bets on a basket of high-yield bonds or equities in markets like New Zealand, Australia and Europe.

With these trades on it was time to go golfing and let the money pour in from fees and your lucrative cut of the capital gains. The magic of leverage provided returns that had never been seen before in the money management industry. This was the storied "carry trade," a word that brings terror into the hearts of investors worldwide these days.

It was hard to resist and I have to admit that for a while I had personal investments with over 11 different hedge managers. I always made sure I had their cell and home phone numbers so if I didn't get the 3.5-per-cent-a-month return I was expecting I could call them up and yell at them. Those were wonderful times.

If it sounds to good to be true it usually is and about 18 months ago the whole multi-trillion- dollar hedge fund industry began to unravel. Here is what happened.

When the first cracks appeared in the subprime U.S. housing market the big banks that had lent all that money to hedge fund operators had to start shrinking their balance sheets. They started by calling in their loans from hedge funds, which in turn had to start unwinding their highly levered equity, commodity and bond positions in a hurry. As the debt crisis accelerated the hedge selling increased geometrically and valuations of the stocks and bonds they owned got crushed. It was like yelling fire in a packed theatre; utter chaos ensued. But wait, it gets worse.

There are thousands of hedge funds managed by 30-something-year-olds who have never experienced anything like this. They were simply not working during any of the last really nasty bear markets. I saw many of them last night at the Grille looking like Mac trucks had run them over.

Their losses are huge and now they are facing massive redemptions from their investors that they cannot fulfill so they are throwing up what are called "gates" on their funds. You know you have been "gated" when your hedge fund manager tells you it will take two years to return some or any of your capital because all of the unit holders want their money back at the same time.

Is the hedge fund selling over? Not by a long shot. I have dumped all my hedge managers save one that did an excellent job for me in the Indian market because he operates there. Many of the managers I spent time with last night are going out of business. After all who is going to give new money to a manager who has "gated" his fund.

The destiny of any fund that is suffering massive redemptions is to die a slow and painful death. The same could be said for the whole hedge fund industry. If anything, now is the time to go long the stocks that the hedge industry has pounded into the ground making their services even more redundant. Even worse the U.S. government has announced they want to examine the industry under a microscope with an eye to regulating it. Time to get out until the dust settles and you find out what the new rules are going to be.

The collapse of valuation on so many hedge funds also exposed a dirty secret about the industry. Supposedly the reason you paid such high fees for hedge fund managers is that they had a special talent to "hedge" when necessary. In other words short stocks to protect your capital in a declining market.

So what happened? The market declined but instead of making money many hedge managers actually lost more on a percentage basis than the markets declined. That is because they were not really short-they were just really levered. It would have been better to have called them Ledge Funds. I howled with laughter the first time I heard Gene McBurney, one of the founders of GMP, use this term and I immediately stole it, making it my own.

I have been going to Grille 23 for so many years now that I have made friends with many of the waiters. Last night we reminisced about the old days when it was commonplace for a hedge fund manager to take out his investors and order three bottles of 1982 Latour - 1982 Latour is so good that legend has it that is impossible to get a hangover from drinking too much. I'm proud to say that I have tested this theory many times at the expense of a hedge fund guy.

Last night we drank a bottle of $85 industrial waste. My how times have changed.

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