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Hedge funds are risky—and sometimes highly lucrative. A growing number of Penn alumni find that combination irresistible.

By Aaron Short | Illustration by Franklin Hammond

“I think one has to be fairly honest about a lot of lucky things that have happened,” Cliff Asness EAS’88 W’88 is saying. “I think too many people who are successful love to attribute it all to their own skill or decisions or acumen. And some of that is true—but a lot of that isn’t.”

Asness is sitting in his sunlit corner office, with a view of the Greenwich, Connecticut harbor and the Long Island Sound in the distance. His modesty is both disarming and somewhat unusual in the hedge-fund business. Even more unusual is the fact that he has allowed a writer to visit him at his hedge fund, AQR Capital, and ask a wide range of questions about investing strategies and his role in the finance industry—and that there are no lawyers present.

Asness speaks in rapid staccato, with the energy and enthusiasm of a young graduate student whose thesis could break new ground in his field. And, in fact, he was a graduate student in finance not long ago, designing quantitative models and testing new theories on investing in speculative markets. That he and the dozens of other Penn alumni who developed their own investment firms in the past 20 years have become successful financial managers is not necessarily surprising. That they did it by bucking the established investment banks and large-asset management firms—and are in the process of turning the financial world on its side—borders on the astounding.

Hedge funds represent a relatively pure, unregulated form of high-risk capitalism. Whether they will continue to stay unregulated, and continue to offer a lucrative way of navigating the treacherous shoals of the market, is unknown.

In 2005, according to, a record number of new hedge funds were created—2,073, compared with 1,435 created in 2004—but another 848 were liquidated, also a record. Today there are approximately 8,500 hedge funds in existence, with combined assets of more than $1 trillion, up from $400 billion five years ago. From 1987 through 2004, hedge funds returned an average of 14.94 percent a year once fees were deducted, according to The Hennessee Group, which tracks industry funds. The Standard & Poor’s 500 funds, by comparison, returned 11.88 percent. But in 2004 hedge funds compared less favorably, returning 8.3 percent compared with 10.87 percent for the S&P 500.

On June 22, The Wall Street Journal ran a piece titled “Hedge Funds Hit Rough Weather But Stay Course,” which noted that, amid the “market tumult of the past two months, a handful of hedge funds have shut down,” including the Ospraie Point Fund, Saranac Capital Management, and a significant part of KBC Alternative Investment Management. (The most spectacular shutdown came in 1998, when Long-Term Capital Management all but collapsed, dumping securities around the world and wreaking havoc on international financial markets.) But, the Journal added, “even as markets have become tougher to navigate, problems among hedge funds remain fairly well contained.” And as long as they offer a way for investors to make significant money, they will survive.

A hedge fund is a small pool of capital that a money manager uses to buy stocks, sell stocks, or perform other activities that a more traditional firm with a larger amount of assets—say, a mutual fund—would not be able to. Hedge funds have been around since 1949, when Alfred Winslow Jones, a financial journalist, started a fund whose investment approach involved “hedging” long stock positions by selling short other stocks to protect against market risk. (Selling short means selling a stock which the seller does not own and believes the price will continue to decline; he or she may borrow the stock from a broker and sell it, then buy it back at a lower price. One buys long with the expectation that the stock will rise in value.) Unlike mutual funds and other investment firms, hedge funds are essentially unregulated by the government, and because of their relatively small amounts of capital, managers can move funds more quickly in and out of certain areas, with (usually) less effect on the market. They can also pursue a market-neutral strategy—identifying cheap stocks that may be on their way upward or stocks whose growth is stalling and declining, and investing equally in both.

Using such a strategy, a hedge-fund manager could start 10 funds, half of which would go long, the other half going short. The market would determine which position would make money in a given year, and at the end of that year, the five funds that lost money would likely be closed. In the meantime, a “lot of money [would get] transferred from investor to manager,” points out Dr. Marshall Blume, the Howard Butcher III Professor of Financial Management and professor of finance, in Knowledge@Wharton, the bi-weekly electronic newsletter. “There’s a lot of incentive to do that.” Furthermore, by closing funds that perform poorly, those managers help create hedge-fund indexes that suggest overly robust returns, notes Knowledge@Wharton, “like figuring a class’s performance by ignoring the fact that half the students dropped out.”

Hedge funds also have extremely high barriers to entry, welcoming only the most sophisticated—and well-heeled—investor. A net worth of $1 million or an annual income of $200,000 for an individual (or $300,000 with a spouse) is generally the minimum, and most investors are worth far more than that. Additionally, hedge funds consist of a small pool of investors, usually less than a hundred, and their advertising is done through word of mouth or reputation.

The only things that hedge funds have in common are their legal structure for investing, and the lucrative fees they charge their clients. Unlike mutual funds, which can only collect management fees based on the size of the assets regardless of how well the fund performs, hedge funds charge asset fees and performance fees. While hedge funds generally keep asset fees low, at about two percent, they set performance fees as high as 20 percent (a fee structure known as “two and 20”).

Transparency is not part of the hedge-fund picture. Whereas mutual funds must publish holdings reports that show full disclosure of their funds every six months, hedge funds have no such requirements. Only their investors who are accredited and meet minimum standards know how well a hedge fund is performing.

This past June, a year and a half after the Securities and Exchange Commission (SEC) ruled that hedge-fund advisors must report a few basic details (the name of their funds, their location, and the assets they manage) and open their books to routine inspection, a federal appeals court overturned the rule. The court’s decision “abruptly halts, for now, the SEC’s attempt to regulate the murky world of hedge funds,” The Wall Street Journal noted. But, it added: “Observers say it’s unlikely the SEC would close the door completely on some form of hedge-fund regulation, given the growing size of the industry and the use of such funds by less sophisticated investors, such as pension funds.”

Hedge funds did not really take off until the 1980s, when such legends as Michael Steinhardt W’60, George Soros, Julian Robertson, and Michael Milken WG’70 epitomized the extreme risk-taking nature of investing in hedge funds. Steinhardt actually formed his Steinhardt Partners in 1967 and went on to earn billions—then, following some losses in the market, abruptly closed his fund in 1995 to devote his time and fortune to his Jewish Life Network/Steinhardt Foundation. He chronicled some of his financial feats in his 2001 autobiography, No Bull: My Life In and Out of the Markets[“Briefly Noted,” Jan/Feb 2002].

In the mid-to-late 1990s a new generation of money managers emerged, inspired by Steinhardt’s success in the financial markets but determined to invest on their own terms. Asness and Daniel Och W’82—who left larger investment houses like Goldman Sachs and Morgan Stanley to start their own funds, AQR Capital and Och-Ziff Capital, respectively—are among the Penn alumni who have played prominent roles in the success of this new wave of hedge funds. (So have certain educational institutions, including Yale University, which sought out these firms early in their development and put significant percentages of their endowments in the hands of superstar investors.)

While Och politely declined to be interviewed for this Gazettearticle, several other managers agreed to talk, though they often had legal counsel present during interview sessions or requested to review quotes before the article came to print.

Their backgrounds are as diverse as their investment strategies. While most studied finance, computer science, or accounting as undergraduates (taking courses in portfolio management and speculative markets), and about half received MBAs, they entered the industry from a broad range of professional backgrounds. Most hedge-fund managers who left larger banks to start their own firms cited the potential increase in salary and the desire to be their own boss as their primary reasons for leaving.

Asness, for example, entered Penn’s Jerome Fisher Program in Management & Technology in the early 1980s. He originally focused on computer engineering and mathematics, and expected to go to law school.

“I was exposed to computer engineering, discrete math, computational math, speculative markets, options, futures, derivatives, and portfolio theory at Penn,” he recalls. “Back in the ’80s, my dad and I thought that combination of the finance and engineering programs was perfect for the future.”

Having particularly enjoyed the theoretical side of finance, Asness enrolled in a Ph.D. program in economics at the University of Chicago, picking up an MBA there on the side. His studies at Penn and Chicago helped him develop his own theories on efficiencies in the market and quantitative models for investing. While working on his thesis, he joined Goldman Sachs’ asset-management group, applying quantitative techniques to a much broader set of decisions, and soon began investing in world bond markets and even currencies. Yet it wasn’t long before he became restless.

“Goldman was a huge place,” he points out. “I had a tremendous desire to be my own boss; focus on research, writing, and trading; and be more entrepreneurial. I used to work on writing papers on models, and now I get to write on policy.”

After Barry Friedson EAS’90 GEAS’90 graduated from Penn with a B.A. and master’s in computer-science engineering, he went to work for the aerospace industry. He credits his finance classes at Wharton with (belatedly) inspiring him to go back to graduate business school at NYU and earn his MBA after he observed the aerospace industry go into decline. Having studied emerging markets at NYU, he worked as a data provider at Lawrence Capital, a standard mutual company, and is now vice president for hedge-fund technology with Deutsche Asset Management in New York.

“I left to work at a hedge fund because I wanted to get exposed to many strategies: stressed debt, long/short selling, and arbitrage,” Friedson recalls. “It was definitely an opportunity to learn more.”

Friedson directs the building and development of the quantitative model and the trading application for his firm’s funds. He has built a number of portfolio optimizers (computer programs designed to select the best portfolio for a client in terms of risk and reward), which the managers use to make their investment decisions.

“We do both single manager in-house funds and funds of funds,” Friedson explains. (Funds of funds allow individuals to pool their investments over a larger group of money managers, which means they can enter the hedge-funds game with a lower level of income and wealth than those who invest in other funds.)

When Robert Bliss W’82 came to Wharton in the late 1970s to learn about finance, there were no courses in alternative investing. After a stint at Merrill Lynch, he worked for his family business in chemical manufacturing for 10 years. After his family sold the company in 1996, Bliss, who had accumulated some capital from the sale, pondered his next move.

“My feeling was to allocate a large amount into hedge funds and learn about the quantitative strategies needed to beat the market,” he explains. Bliss soon developed a technical, model-driven strategy; tested it with his own money, then with his friends’ and investors’ money; and finally, after developing a successful track record in the industry, brought in outside investors. At his firm, Windmill Capital in New York, hedge-fund managers invest in a wide range of funds.

Other alumni who got involved in hedge funds two decades ago are now spending more of their time in management roles. Alan Winters WG’84 joined Kingdon Capital in 1986. More recently, as chief operating officer, he has been more involved with the management and oversight of the firm.

Kingdon Capital invests in the technology, health-care, and consumer industries, in particular. “We find out how good the company’s products are, what their business model is, and we pay attention to valuation and the technical details of the firm,” he says. “We see ourselves as a fundamentally based investment shop, where we might use quantitative tools from time to time.”

Howard I. Fischer W’81 was one of several managers who had a lawyer present, and often was not able to comment on specifics regarding his firm’s structure and fields of investment. Intense and somewhat guarded, he was mostly amenable to making broader comments on the nature of the private fund industry.

Fischer arrived at Wharton in the fall of 1977 to learn about trading in the markets; he majored in finance and accounting. After graduation, he worked for a large brokerage firm for 12 years, then saw an opportunity to start his own small hedge fund in Stamford, Connecticut. He has been with it since 1993.

For Fischer, a typical day consists of leading meetings with an administration team to run the business side of the fund—including investor relations, actively managing the trading portfolio, and making trading decisions. “I spend a lot of my time actively trading and directly interacting with the people involved in executing ideas and coming up with trading decisions,” he explains.

Hedge-fund investment strategies vary as widely as the backgrounds of the managers cultivating them. Asness’ office in Connecticut has dozens of computers and a gigantic server that is constantly running calculations of quantitative models in search of undervalued and stalled growth stocks.

“At AQR Capital, we apply quantitative and statistical models, gigantic reams of computer code and algorithms, to apply financial theory to try to make money,” says Asness. “It is one of the cleanest examples of the M & T [Management & Technology] type program—where, without computer or mathematical skills, we would be like everyone else. We would be guys who know about stocks trying to pick stocks, but we’re not. We’re modelers. We are applying more of a scientific method to the finance side. The models are still evolving and growing, and we revise them every day.”

Asness guides the research process and is involved with every research decision—developing and revising the computer models, and giving ideas to younger managers, who use the models to test them. He also oversees the models to make sure that they are providing an accurate reflection of the broader changes in the market. He has published widely in journals, including the Journal of Portfolio Management, on topics addressing policy issues on the overvalue of various markets, the necessity of expensing options, the future of hedge funds, and their relationship with other areas of the market.

“There’s a huge trend toward investing in hedge funds in the past decade,” he says, “but it’s an ebb and flow like anything else.”

Other managers who studied at Wharton approached investing with a more qualitative model. Barry Coffman W’81, whose Boston-based Boldwater Capital fund focuses mostly on high-yield bond markets, spends his day looking for mispricings or misevaluations within a company. When he finds one, he either trades on an attractive return or short-sells it. The fact that he is working for his own company gives Coffman far more options to buy and sell securities.

“You have a greater role in influencing performance of that equity,” Coffman says. “The entrepreneurial spirit exists. There is greater control, as you have the freedom to invest how you want in a way that you want it to be done.”

Jacob Doft W’91 founded his own investment firm, Highline Capital Management, in 1995. “I did not want to be an investment banker or a consultant, advising people how to invest money,” he says firmly. “I wanted to be a principal, where I would invest my own money and others’. I started my firm because I loved investing in the market—and this was the most interesting, original way to do it.”

Doft’s firm does long/short U.S. equities, mostly focusing on companies going through important transformational changes. They conduct their research by visiting and talking to companies on the phone, and brainstorming ideas in staff meetings.

“We have more of a qualitative approach for investing in good businesses—that is, companies that are improving themselves,” he explains.

“I have been involved in investing for 20 years, and it always surprised me that more institutions did not get involved in hedge funds earlier,” Howard Fischer says. “Hedge funds provide an opportunity for people to invest in more talented managers, in areas of the marketplace that were not typically accessible to the mutual-fund manager.” Given that the hedge-fund industry keeps attracting the best and brightest financial managers working in the market today, Fischer observes: “I would be surprised if that trend does not continue.”

While much has been written about the long-term viability of hedge funds in the mainstream and business media over the past five years, most of the managers interviewed agree that hedge funds are here to stay. Several expressed concerns that there could be some decline in the performance levels of some hedge funds compared with the past several quarters.

“In the past year hedge funds are not outperforming the market,” says Robert Bliss, “but in the past five years, hedge funds were vastly outperforming the market, and the funds accumulated during those years provided those protections during the downward market turn.”

Several months before the federal appeals court ruled against the SEC’s attempt to regulate hedge funds, Cliff Asness thought it likely that either the states or the SEC would impose regulations, mainly because of the risks that investors have faced recently. Which is not to say that he is enthusiastic about the idea.

“When it comes to regulating hedge funds, I prefer a solution with less direct regulation but increased tests for who can invest,” he says. “I think rich people and knowledgeable institutions should be able to make their own decisions, but we need to protect mom-and-pop investors. I don’t want retail investors. They tend to leave quickly when investments head south. One thing about wealthy people though, they tend to chase trends more than institutional investors, and that can get them in trouble.”

Neil Kuttner WG’78, chief operating officer of Cross Shore Capital Management, a small New York-area fund, noted that hedge-fund investors of all financial strata who do not know about hedge strategies or how much a particular hedge fund utilizes leverage can be engaging in risky behavior. Investors, no matter how wealthy, must do their due diligence and research to ensure that the fund they invest in is not engaging in irresponsible behavior.

A similar outlook is offered by Dr. Chris Geczy C’90, assistant professor of finance at the Wharton School.

“Yes, hedge funds and private funds are here to stay,” agrees Geczy, “but a massive blow-up could diminish investing. Endowments and state pensions will continue to allocate their money into larger hedge funds, enabling their asset size to grow. We will see an increase in the number of large funds, but the number of hedge funds overall may not increase.”

According to Geczy, this is due to the high regulatory and other fixed costs which will likely increase as the SEC and states continue to try to regulate hedge funds. Some members of Congress and a number of state attorneys general are taking a closer look into which branches of the government would be most suitable for the regulation of hedge funds.

Such regulation would make it more difficult for smaller hedge funds and those looking to start their own funds to survive in the industry without having a minimum threshold of tens of millions of dollars. “By and large, there has not been a fee compression,” Geczy explains. “Investors with the best track records may maintain their level of performance fees or even begin increasing them, but there could be increased stratification in the level of fees between large players and small funds.”

Asked about the broadening influence of hedge funds on the finance industry and investing public, Geczy responds: “It is possible that middle-class investors could gain more private-fund exposure, though the SEC worries about the ability of average investors to evaluate risk correctly. We may see more hedging mutual funds—that is, mutual funds that use strategies similar to those of hedge funds in order to get greater returns.”

The demand for hedge-fund positions among Wharton undergraduates and MBAs is extremely high. Geczy’s Wharton classes on hedge funds, which he taught with retired hedge-fund manager Leon M. Metzger W’77, are consistently oversubscribed, and hedge-fund firms have been actively recruiting on campus through the traditional career-services channels.

All of this could certainly change. There is much talk among those in the business community of a hedge-funds bubble, and even experts like Asness believe that there could be diminished returns over the next decade. An increase in the number of hedge funds has led to more competition for spotting those market inefficiencies; as a result, succeeding at the same level as even five years ago has become significantly harder. Money managers are split into two camps over whether performance fees will drop precipitously in the future, though it remains likely that the most successful investors will continue to charge high performance fees. No one knows how the states will eventually choose to regulate the industry. In Connecticut, several high-profile fraud investigations have brought unwanted attention to individual firms, as well as promises from Connecticut Attorney General Richard Blumenthal to make necessary changes in the coming months.

Despite the uncertainty, most of the hedge-fund managers remained optimistic that hedge funds will remain a permanent way of investing in the future and will become as traditional as the mutual funds, investment banks, and private equity firms throughout the country.

As Alan Winters puts it: “The key for hedge funds to survive is for them to continue to outperform the market after all the fees are paid. If you don’t outperform, you have no reason for being in existence.”

Aaron Short C’03 is a freelance writer who works and lives in New York.

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