Should investors send their dragons back to their lairs?

Thu Feb 2, 2012

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The ability of hedge fund dragons to vaporise this year may leave institutional investors sceptical of the long term power of the magic of the dragons


By Susan Barreto

Welcome to the Year of the Dragon. In the Chinese zodiac, dragons, the highest-ranking animal in the Chinese animal hierarchy, are considered so lucky that a baby boom is coming to China in 2012. Dragons symbolise character traits such as dominance and ambition and they prefer to live by their own rules. If left to their own devices, they are usually successful.

Dragons are driven, unafraid of challenges and willing to take risks. These are traits that many want in themselves as well as in those that they trust with their money. So institutional investors may want some dragons in their portfolio? Or do they?

According Chinese zodiac experts, these traits are a double-edged sword as 'dragons' may often feel exhausted and unfulfilled after excelling with their (over) drive. Given 2011's lacklustre returns, it seems that the hedge fund dragons might be running on empty.

And it is this very uncharacteristic, un-dragon-like, exhaustion that may have led to the high risk behaviour during the on-going financial crisis. Diamondback Capital, for example, recently agreed to pay more than $9 million to settle insider trading charges with the Securities and Exchange Commission over trading in shares of Dell Inc. and Nvidia Corp. in 2008 and 2009. Also caught up in the insider trading investigation is Level Global Investors, which closed its doors in 2011.

But like mythical creatures, some dragons such as Boyer Allan, FrontPoint and most recently Arrowhawk, seem to have disappeared in a puff of their own smoke as they return money to their investors. The ability of hedge funds to vapourise this year may leave institutional investors sceptical of the long term power of the magic of the dragons.

According to InvestHedge reports, the New York State Common Retirement Fund, Indiana Public Employees and Ohio School Employees' Retirement all had both Diamondback and Level Global. While New Jersey Division of Investment and Texas Teachers just had Level Global and New Mexico PERA, Missouri State Employees' Retirement System and Philadelphia Board of Pensions and Retirement each have Diamondback in their direct portfolios.

The long term effects of these fire-breathing dragons will take some time to measure. Hedge funds are expected to have a boost at the University of Cincinnati, but it too is also thought to have Diamondback in its portfolio. All as a new CIO settles into the endowment's investment office.

FrontPoint's closing affected the Maryland State Retirement System, which was completely divested by the close of 2011. But the timing to hire tamer dragons is perfect as the pension fund brings on board Albourne as its new consultant (see page 6). Meanwhile, Kentucky Retirement System (see page 6) will discuss this month whether or not to replace Arrowhawk, which is closing down following problems in reaching its asset raising goals.

In a year that saw $17 billion of inflows into hedge funds from the institutional investor community (see page 14), it seems that the rules of the game have yet to be perfected. For instance, why is it that due diligence by consultants and investment staffers didn't prevent these scenarios from arising?

Unlike traditional asset managers that are placed on watch lists and often dropped due to a loss of staff or significant performance problems, hedge funds do not seem to be subject to the same rules by the institutional community. When asked about Eton Park's recent personnel turnover and performance problems, one public pension fund CIO seemed to be unaware of what had been happening at the firm.

It seems that many overstretched CIOs are happy to get annual updates, while in the fast-moving hedge fund world most funds of funds know quarterly updates are a must, especially when lock ups can mean money can take up to three years to be released. The problem is that institutions allocating directly on their own are given little warning and perhaps too much drama when their holdings need to be liquidated against their will.

ISSN: 2151-1845 / CDC10004H