I conducted an interview with Steven Drobny, President of Drobny Global Advisors and author of Inside The House of Money. The discussion pertains to the hedge fund industry, including implications of an M&A boom in hedge funds, hedge funds as asset managers, the industry's marketing gimmicks, risk/reward trade-offs, regulations and correlations to the market, investment banks taking positions in China, emerging markets and more.
Steven Drobny is the engine behind Drobny Global Advisors. Steven has pushed the firm to new business areas, countries and client bases. If you want to know who's who or what's what in global macro, ask Steven. To learn more about global macro hedge funds, read his book Inside the House of Money.
Before partnering with his namesake in 2000 [his name was already on the door!], Steven worked for Deutsche Bank in various roles, most recently in the Hedge Fund Group in London. While at DB, Steven also worked in the derivatives and trading groups in London, Zürich and Singapore. Prior to Deutsche, Steve was with AIG Trading in their Metals and Energy Trading Groups.
Steven Drobny holds a Masters degree from the London School of Economics and a Bachelors degree from Bucknell University.
YA: Steven, thank you for joining us. A recent trend in the industry has been "Hedge Funds as Asset Management Complexes"[Note: DE Shaw's push into traditional asset management. Fortress and MAN Group already are asset management complexes]. If you're running a $5 billion fund, a 2% management fee brings in $100 million without any hassles. Say you're up another 10%, so that's another $100 million. Managers are disincentived to make money. What do you think needs to be done?
SD: Nothing. The marketplace will define where investments are made and the fees charged for asset management. Investors are allowed to choose what they want and if they don’t like something they can vote with their feet. Remember, by definition, investors in hedge funds are required to be qualified investors. We are not talking about unsuspecting retail investors getting cold calls from their local stock broker. If performance does not stack up over time, there will likely be adjustments.
YA: In 2006, the hedge funds as a group have underperformed mutual funds and market indexes. With over 9K hedge funds seeking to generate alpha, a majority of which utilize the common strategies such as convertible arbitrage and long/short equity, don't you think the market is getting a little too overcrowded?
SD: No, I don’t. Again, investors that choose to invest with hedge funds are making a conscious decision. As long as that decision is educated, the marketplace should dictate the flow of capital. Whether the number is 900 or 9,000 or 90,000, the marketplace will ultimately decide.
The same thing applies to the different hedge fund strategies. Investors will choose based on performance. In the global macro space, hedge fund managers are at an advantage because of the breadth of their mandate. They are permitted to trade any asset class around the world.
As far as this year, hedge funds as a group are under-performing mutual funds and market indexes. And, this is a market environment in which you would expect that to occur because volatility across markets has collapsed. Long risk assets has been the trade of the year. So investor portfolios, which are overwhelmingly long assets, have done well.
Hedge funds are meant to occupy a slice of a portfolio because they are traditionally uncorrelated and provide downside protection in volatile markets. The key is producing consistent positive absolute returns uncorrelated with other markets, and if hedge funds can do that, there will be a place for them in investor’s portfolios.
YA: Where do you see the hedge fund industry going?
SD: The industry is going to be constantly evolving. Every six months the industry looks different from the prior six months. The hedge fund business is here to stay because it provides needed portfolio diversification and because it is very attractive from an employment standpoint due to it’s attractive compensation structure.
As long as that doesn’t change, hedge funds will continue to attract the smartest, most talented money managers, and at the end of the day investors are going to want access to that talent. So there always will be a hedge fund business, whether it grows, stabilizes, contracts or even converts into a total asset management business, remains to be seen.
The best comparison is with professional sports. If you are the best basketball player in the world, are you going to play in Italy? No. You’re going to play in the NBA for the highest bidder.
YA: When Alfred Jones started his hedge fund back in 1940, his purpose was to generate alpha by a long/short strategy, with returns uncorrelated to the markets. In the 80s and 90s, hedge funds did just that. Of late, HF returns seem increasingly correlated to the broad market indexes. Why do you think so?
SD: It really depends on which market indices and which hedge fund strategies you are comparing. There are certainly managers and strategies that will look as if they are correlated to the broader equity markets at certain points. The key is whether they are correlated over time. Again, if managers or strategies fail to deliver, investors will adjust their portfolios.
YA: China has seen a large inflow of capital, especially into the financial sector. The major banks, such as Citigroup, BoA and Goldman, have all taken sizeable stakes in the Chinese financial sector. In other words, the herd seems to be too bullish. What do you make of this trend?
SD: It is dangerous to assume the herd is always wrong. The truth is that the inflows into China are being limited by government restrictions. Perhaps the inflows would be much larger if the restrictions were limited.
The key is to ask “why are all of these institutions dedicating the time and energy into this market?” Then evaluate whether the opportunity is worth the attention. It seems to be a reflection of a booming, growing emerging market that has attracted capital for the long term.
YA: As hedge fund returns have come down over the years, their appetite for risk has rapidly increased. Your partner, Andres Drobny (no relation), once said that "to make money and have value you have to have risk/reward parameters dominating what you do in markets."
With the recent debacles such as Amaranth and Archeus Capital [the most famous ones], do you think hedge funds are erring from the risk/reward scenarios, caused by narrowing of spreads [due to an overcrowded industry] and/or chartering in unseen territory?
SD: First of all- the one thing the press gets wrong, is that Amaranth or Archeus are symptomatic of the HF industry. As you mentioned earlier there are about 9K hedge funds. We are talking about two funds.
Out of 9K hedge funds, there are going to be some good ones and some bad. The same applies to mutual funds and private equity funds. The key for investors is choosing the talented managers that have a good risk/reward framework and aren’t taking excessive leverage or risk in illiquid markets. At the end of the day, the onus is on the investors to choose and decide which hedge funds are the best out there.
Right now, we’re going through a pretty significant period of low volatility, low interest rates, and tight market spreads. There have been periods of time like this in the past and it typically unwinds back to a more volatile, riskier markets. The question is when and how do we get there and what the path looks like.
YA: In your book, Inside The House of Money, you interviewed some of the best traders in the world. Could you tell us one characteristic they all shared?
SD: Humility. The popular image of big successful traders pounding their chest and always being right is really the guy that ends up out of the market after a couple of years when a secular or cyclical trend reverses. The best traders that have longevity, who have been through multiple market cycles and have consistently made money are very humble. They know that they are not smarter than the markets and to be in this game for the long term one has to be flexible.
YA: M&A activity has been steadily increasing in double-digits since 2002. It seems that 2006 will be the record year, beating the $3.327 trillion in global volume and $1.525 trillion in U.S. volume posted in 2000. With so much buying power, do you foresee another hedge fund strategy, dedicated to say such as LBO and/or PE financing, on the horizon other than event driven strategies?
SD: Perhaps. There will always be innovation in financial markets. Hedge funds are part of that process. Whether there is a different title to the strategy, who knows. Hedge fund strategy titles are mainly for marketing purposes. At the end of the day, what a hedge fund is supposed to do is make money in any market environment, regardless of their strategy.
That is what global macro is all about and has always been about. In terms of slicing and dicing the hedge fund business into smaller, more finite, specific strategies, this has typically been a good way to raise money, especially in a world full of liquidity. If liquidity contracts, things may be very different.
YA: Lately there has been a lot of chatter about regulating the hedge fund industry. What are your views on regulating the industry- stricter oversight by the SEC and/or a self-regulating body?
SD: The most successful hedge funds are running their business in such a way that is over and above what any regulatory government body would require. If regulation keeps out some of the frauds and scams, then that’s a good thing for the industry. Generally, regulation tends to increase costs with questionable benefit.
But, if regulation can be proven to boost investor confidence, then I am all for it. Again, the key is allowing investors to make educated decisions about their investments. Let the market work. If investors are not comfortable with the way their manager runs the firm, then they should not allocate the capital, regardless of what any government body does.
YA: In May, when the US markets were hit by a correction, most emerging markets followed it downwards and when the US markets regained their footing in August so did EM. I have a hard time imagining EM markets up if US markets are down 10% or so. What are your views on emerging markets?
SD: EM presents tremendous opportunities just as any new market presents great opportunities. In terms of the US being down 10% and EM being up, it depends. I don’t think you can classify EM as one thing. China is very different from Russia, which is very different from India, which is very different from Brazil, so it depends on which market, what the different economies are doing, and the prospects.
For example: If the US market is down 10% but the US currency is down 50%, perhaps EM will be up, especially if you’re a US based investor. A large part of it depends on what your home currency is.
YA: Drobny Global Advisors is known for its unorthodox style of research advisory and investment conferences [providing actual trade-able ideas in a casual atmosphere with the audience concentrated among what’s considered “very smart money”]. You recently wrapped up a conference in Iceland. Could you tell us a little about what was discussed?
SD: Sure. The overall mood was mixed so the overall general feeling I took away from it was that we are at a major inflection point. Often at turning points, confusion reigns until the new trend is established.
YA: Steven, thank you very much for taking time out for this interview. Best of luck with DGA and look forward to the second edition of Inside The House of Money.
SD: Thank you and good luck to you too.
Steven Drobny’s book- Inside The House of Money, offers a rare insight into the minds of the world’s best hedge fund traders and how they profit in the global financial markets. Click here to learn more and buy Inside the House of Money.