NYCO Hedge Fund Portfolio

Vega's David Mullins bullish on hedge funds

Feb-15-2005 - Stalling performance in US stocks and bonds will create opportunities for hedge funds, said Vega Group's chief economist and former Federal Reserve Board vice chairman David Mullins in his keynote address at MARHedge's 10th Annual European Conference on Hedge Fund Investments.

The conference, which runs through Wednesday in Geneva, will also feature a keynote address by Peter Bennett, senior investment partner at Gottex Fund Management Ltd.

Mullins, whose 30 years in financial services includes the co-founding of Long-Term Capital Management and a professorship at the Harvard Graduate School of Business Administration, sought to explain the growing interest of institutional investors in the hedge fund sector.

Looking at bond returns for the last 40 years, Mullins drew attention to the "dramatic swings" caused by increasing inflation in the 1960s and 1970s followed by decreasing inflation through the 1980s, and particularly the Alan Greenspan-managed 1990s.

Rates have been "squeezed down about as far as they can go," he said, and with short rates almost certain to go up, perhaps by 1% this year, the five-year annualized return on US Treasuries will be pegged at about 3.8%. "If you want more than 4%, you won't see it in bonds," said Mullins.

On the other hand, "The bull is back in stocks, led by NASDAQ. Can 5,000 be far away," he asked, "and does this mean it's time to get back on the stocks bandwagon?"

Mullins's view: probably not. The lion's share of the S&P 500 Index's 17% growth of the past two decades has been P/E growth, and P/E ratios are historically high, driven by productivity growth and low interest rates.

"Where can we go from here?" he asked. "It's hard to see. Stocks can only go higher if interest rates come down or productivity increases - and neither of those scenarios is likely."

Mullins doesn't hold out much hope for a shot in the arm from US policy. Making President Bush's tax cuts permanent may be possible, he conceded, but containing the budget deficit will remain difficult as long as the War on Terror continues, and pay-as-you-go reforms are "small proposals and not, to me, very impressive."

Headline-grabbing reforms planned for the US Social Security System could release a "staggering" flow of assets into the stock market, Mullins said, providing "a similar impetus to that which drove the stock market gains of the 1990s, and give another decade or so of good returns." But that depends on Congress, and Mullins doubts that Bush "is really politically good enough to get it through."

He cited an adage in Washington: "When all is said and done, more will have been said than done." Utimately, Mullins puts projected annualized stock market returns at around 6-9%.

Against this bearish view of traditional asset classes, Mullins observed that institutional investors were increasingly accepting that the only alternative is alternatives - particularly hedge funds. "Private equity and venture capital are highly correlated, because essentially they involve buying businesses," he said.

By contrast, he claimed that market neutral strategies offer a beta of 0.25 to both stocks and bonds, and even global macro exhibits a beta of just 0.45 to the S&P and 0.15 to the Lehman Aggregate Bond Index.

It's no surprise, he said, that high-net-worth individuals, endowments and foundations have led the way in allocating large percentages of their portfolios to hedge funds. "Here's the big story, though: Pension funds have finally focused intently on hedge funds."

With $50 trillion of assets under management in institutions, should current allocations of 1% be increased just to 3%, "that would double the size of the hedge fund industry," Mullins observed. "That's going to be interesting."

What's the best way to allocate those assets? "Most people think that you make money in hedge funds by selecting a great manager," said Mullins. "But that's not necessary, and besides, it's becoming increasingly difficult to pick winners, whereas in the past the wind was at our backs."

It also does not take into account the importance of asset allocation in highly cyclical strategies. "If you take just 5% from the bottom three of the seven alternatives I've listed - venture capital, mezzanine, buyout, equity long/short, event-driven, convertible arbitrage, fixed income arbitrage - and reallocate that to the top three, that will add 420 basis points to your annual return."

That is not to say that manager selection is unimportant. In fact, Mullins argued, it is demonstrably more important in hedge funds than in equity mutual, US buyout or US venture capital funds. "If you could only pick the middle of the second quartile of [hedge fund] managers as opposed to the average, that in itself would add 550 basis points per year to your return."

For Mullins, the best way for institutions to get exposure is not through the traditional fund-of-funds route, which he sees as adding diversification but not value. He takes the long view: "Why not simply build a portfolio of the large, best-known brand names that have survived the shocks? Institutions aren't really looking for huge returns; they want durable returns."

Mullins did not understate the problems presented by the hedge fund market. It's a fragmented and sometimes opaque industry, often with severe liquidity constraints, and multidimensional risk factors that require highly specialized skills and knowledge.

He pointed to "clouds on the horizon" such as the effects potential asset inflows may have on performance, and tightening spreads.

But ultimately he was bullish on the development of the opportunity set for hedge funds and their growing investor base, and confident that the basic structures and methodologies of the asset class will continue to ensure low correlation to stocks and bonds as the industry expands.