Institutional Investor's Alpha Magazine - June 2008 - (Page 10)

Milking Oil C onsumers strapped by high fuel prices got some good news in April: Demand was down, driving oil stockpiles higher. Overnight gas prices, however, shot up by 14 cents a gallon. The contradiction was repeated in early June — another decline in consumption, another jump at the pump. By mid-June crude oil prices had reached almost $140 per barrel on the New York Mercantile Exchange, as the national average for a gallon of gas topped $4.00, a $1.50 increase in two months. What gives? China’s unslakable thirst for energy and the falling dollar are among the usual suspects. But many critics blame rising prices in part on speculation by hedge funds. The U.S. Commodity Futures Trading Commission Professor Sacrilege rom the corridors of academia comes a paper surely considered blasphemous — or at least bad PR — by hedge fund managers: It raises questions about whether hedge funds are worth their fees. Written by Kenneth French, a finance professor at Dartmouth’s Tuck School of Business well known for his research on markets, the working paper, “The Cost of Active Investing,” suggests that passive investors — those who put money into index funds — do better over the long haul than active investors like hedge funds. Discussing the issue in an “I’m just asking” tone, he cites data from 1980 through 2006 that shows how a passive portfolio would have beat the valueweight average of all active and passive investors by 67 basis points a year. It’s been said before. What French brings to the table is an unusually hard look at hedge funds. He calculates that 0.13 percent of the entire value of U.S. equities in 2006 was eaten up by hedge fund management fees, up from 0.04 percent in 1996. Extending part of his study into 20 07, he finds single-manager hedge fund fees — especially when combined with fund-of-funds fees — “a stark illustration of the negativesum nature of active trading.” French says the value-weight average fee for U.S. equity-related hedge fund assets last year was 4.63 percent. F Tuck School’s Kenneth French shows record purchases of crude-oil contracts by hedge funds and other speculators (including a 50 percent increase in net long positions since the start of the year). At a Senate hearing in late May on price increases, David Kelly, chief market strategist for JPMorgan Funds, said, “I think it is very important to realize that the growth in world oil consumption is not that strong.” John Hofmeister, president of Shell Oil Co., went so far as to suggest that oil would be more fairly priced at somewhere between $35 and $90 a barrel. Big public pension funds and endowments, which have helped fuel the growth of the hedge fund industry, may also be contributing to the pain at the pump. Using the so-called swaps loophole, pension funds enter into agreements with investment banks that allow them to circumvent limits on the number of futures contracts purchased. Some fault the CFTC, responsible for regulating the commodities markets, for allowing such activity. In an effort to shore up its credibility, the CFTC responded in late May with a series of initiatives aimed at boosting transparency within the energy futures markets. U.S. Treasury Secretary Henry Paulson Jr. rejects the notion that speculators are to blame, saying that oil prices are “about supply and demand.” But in a May research note, Lehman Brothers economists argued that “non-supplydemand factors” contributed to the price increases. Blaming traders for higher energy prices is misguided, says John Damgard, president of the Futures Industry Association: “Anyone who knows how futures markets work will realize that prices at Nymex reﬂect in a very accurate way the balance between supply and demand.” Proposals that include greater reporting requirements, new layers of oversight and even limits on speculation could cause lasting damage to the efﬁciency and appeal — Dave Simons of the futures markets, he adds. The average fund-of-funds fee was 1.85 percent. As a result, investors in a fund of funds would have needed the underlying managers in which it invested to produce excess returns of 6.48 percent just to cover all their fees. French estimates that at the start of 2007, there was $458.6 billion in U.S. equity-related hedge funds, which he says had to take $29.7 billion in proﬁ ts from other U.S. equity investors for their fund-of-funds clients to break even. “With somebody like Jim Simons, every billion he takes out is a billion somebody had to put in,” notes French, referring to the founder of Renaissance Technologies Corp., whose Medallion Fund has delivered an annualized return of 40 percent since 1988. “My hope is that just by seeing the stark numbers, some investors will go, ‘Oh, okay, now I get it: It really is a negative-sum game.’” — Karl Cates Not Quite Out of the Woods I f the trade of the year in 2007 was to short the ABX, the subprime mortgage index, along with subprime lenders and subprime mortgages themselves, then the question hedge fund managers and their investors are now asking is: What happens next? And, more pressing, what’s the best way to proﬁt from the massive dislocation in the mortgage markets? “It is a trillion-dollar opportunity,” says Michael Hennessy, managing director of $1.2 billion Morgan Creek Capital Management, a Chapel Hill, North Carolina– based fund of hedge funds that caters to foundations and 10 • INSTITUTIONAL INVESTOR’S ALPHA • JUNE 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - June 2008

Investor's Alpha Magazine - June 2008 Contents Letter From the Editor Longs & Shorts Cover Story: Alpha Hall of Fame Bruce Kovner Michael Steinhardt Kenneth Griffin Louis Bacon Steven Cohen George Soros James Simons Seth Klarman Julian Robertson Jr. Jack Nash Leon Levy Paul Tudor Jones II Alfred Winslow Jones David Swensen Looking Ahead: Back to the Future Research Center: Europe Hedge Fund 50 Unhedged: Let the Sunshine In

Institutional Investor's Alpha Magazine - June 2008

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