Viewed against the Standard & Poor's 500's showing, recent hedge-fund returns have been satisfactory -- but not stellar. The CSFB/Tremont index tracking broad hedge-fund performance is up about 13% in the past year, compared with 16.34% for the S&P. Hedge-fund pros insist, however, that their portfolios aim to capture much, if not all, of the upside in bull markets and, more important, protect against losses in bear markets. Also, the CSFB/Tremont index has a standard deviation that's about half that of the S&P 500's, implying lower volatility.

Thanks to those selling points, investors have bought into the hedge-fund story in a big way, worries about blowups aside. The $1.3 trillion industry received $44.5 billion in net new cash in the third quarter, according to Hedge Fund Research.

For the third consecutive year, Barron's has convened a roundtable to analyze the industry and its trends, from the rapid asset growth to a lack of volatility in the market to the recent implosion of hedge-fund Amaranth Advisors. This year's panelists are Peter Thiel, who runs Clarium Capital Management, a
$2.3 billion global macro hedge fund in San Francisco; John Bader, co-chairman and managing principal of Halcyon Asset Management, a New York-based multi-strategy firm with $5.7 billion under management; and Blaine Tomlinson, founder of Financial Risk Management, a London-based fund of funds with $12 billion in assets.

Barron's: Let's start with your take on the financial markets in 2006.

Thiel: Two thousand six was not a terribly eventful year in some ways, but the trend we saw was that markets started the year very far from equilibrium, and they ended the year even further from equilibrium. So you saw some volatility and credit spreads continue to decline. The housing bubble slowed and may be coming to an end, though it's certainly lasted longer than people would have thought possible. Equity markets continue to rally to even higher levels, so we think a lot of global distortions became even more extreme.

Barron's: What's your sense of the markets, John?

Bader: Both equity and credit strategies were profitable for us in '06, merger strategies in particular on the equity side. Activity has been strong, as private-equity funds have on the order of $1 trillion of buying power. We've seen bidding wars around the world, such as [gaming company] Aztar [ticker: AZT] in the U.S. Another area we've liked is cable stocks, which were trading at historically low multiples in the fourth quarter of last year.
On the credit side, we've made nice profits, notwithstanding a very defensive posture. We have not wanted to have high-yield exposure at this point in the cycle; typically, peak defaults have trailed peak issuance by about 3.7 years, and that would place peak defaults in the fourth quarter of '07. The places
we've made money have been more event-oriented plays -- for example, claims-resolution situations dependent upon litigation. Volatility strategies have not been especially profitable, and we think it's a very interesting time to be long volatility now.
Tomlinson: The best-performing liquid-asset class this year has been equities, and, not surprisingly, the best-performing hedge-fund strategies have been risk-seeking strategies in equities, especially emerging markets, and credit. Event-driven and friendly activism, which is reasonably prominent in Europe, has done really well for us. And generally our European equity strategies and credit strategies have done well. Also, convertible [bonds] have bounced back from the wash-out last year.

Barron's: Any parts of the market that didn't work out so well?

Tomlinson: The most disappointing strategy for us has been Japanese equity small-cap, which really hasn't paid off. Overall, though, there has been a lot of opportunity in equity and credit strategies. Relative-value strategies have generally found it harder, because they require more volume and more mean reversion.
Relative-value trades, at their most basic, involve pairing, say, a long position in a utility stock against another utility holding that's shorted.

Barron's: What about global macro funds?

Thiel: It's definitely been a challenging year for the macro funds, ourselves included. Part of the challenge has been that there are some of these imbalances that, in our view, have simply not broken.
For instance, the housing bubble has gotten significantly more extreme.
Obviously, risk premiums have come down. So the various strategies that were structurally long high-risk and short low-risk have all done very well. But many of these strategies are correlated. So whether people are long emerging-market stocks or long small-caps or long subprime credit, they've all been very, very highly correlated strategies, and we think that they are likely to be correlated quite the other way in 2007.
Tomlinson: I agree with quite a lot of that. One has to be very careful about correlations, because what you've seen is that strategies that have paid off have been risk-seeking strategies. And if there is some form of market shock, you're going to get a switch to risk aversion.

Barron's: Let's look ahead.

Bader: No. 1, we believe that M&A activity is very much going to continue until credit dries up. As I've noted, peak credit defaults trail peak issuance by about 3.7 years, which would have credit defaults peaking at the end of next year. However, I suspect that liquidity in the marketplace will postpone that
day of reckoning, although it's difficult to say.

Barron's: John, you've indicated that as a way to hedge against potential credit and geopolitical risks, you are "long" volatility. What's a very basic example of how to play that trade?

Bader: Maybe the simplest way to get long volatility is to buy options on the VIX index, although there are typically more efficient ways to do that.

Barron's: Where are your credit investments?

Bader: Our credit book largely consists of floating-rate, secured bank debt. We also believe some of the biggest opportunities are going to be within the M&A space.

Barron's: There's been a lot of discussion about how low volatility has been in recent years, and how that's made it tough for some hedge-fund strategies. What's your read on the volatility situation?

Thiel: Generally speaking, if you have low volatility, it's safe to take on lots of leverage. If you have high volatility, you can't put on nearly as much leverage, and you're forced to de-lever. As the world has gotten smoother the last two years, the markets have become very uneventful. That has encouraged people to put on more and more leverage in all sorts of markets, whether it's going long equities or buying houses. Owning a house is a leveraged bet on low volatility, because you will be fine as long as house prices don't go down.

Barron's: What are some of the other scenarios should volatility increase?

Thiel: You would expect equity markets to sell off. You would expect spreads to widen on all sorts of subprime markets. I would expect the dollar to get dramatically stronger, especially against the euro, the pound and emerging-market currencies.

Barron's: What other factors do you see impacting volatility?

Thiel: Our view is that volatility has been suppressed across all global markets as a result of the flow of petrodollars into the world economy. Basically, there was a $1 trillion dollar tax increase on oil, and while that's bad for consumers, it's actually been very good for financial markets because the money has basically been this regressive tax that's been reinvested in financial markets: gold, real estate, tech stocks, emerging markets and equities.

Barron's: John, what's your view of the credit cycle, which does appear to be
getting a little long in the tooth?

Bader: Right now, there is a relatively low default rate, but it's definitely heading up. The question is how quickly it's going to happen. Is it going to happen in '07? Is it going to happen in '08? Will it go beyond '08? That's a function of liquidity and market psychology. In the high-yield market, underlying fundamentals are sometimes much less important to changing market psychology than the blowup of a big deal. In 1989, it was United Airlines, and the credit spreads blew out dramatically. The underlying fundamentals were weak before that, and bad deals were getting done, but it needed that big bust to kill market psychology. I'm not certain how quickly we will see that bust, but you're clearly on the upswing in terms of default rates and, hence, my reason for wanting to be long volatility as a hedge to reduce the risk associated with the equity and credit positions we have.

Barron's: So you are betting, in terms of the credit cycle going bust, that there's a 50% chance of that happening next year, and it increases with time?

Bader: That's correct. My gut tells me I don't want to be unhedged. It also tells me we are not talking about an '07 event for credit spreads to really blow out, because of the liquidity created by these structured products, such as adjustable-rate mortgages. The day of reckoning probably gets postponed beyond 2007, but I wouldn't stake my life on it and I am going to be very hedged. The second and third quarters were very strong for hedge-fund flows. How well is the industry digesting all of this money?

Tomlinson: Clearly, there has been an issue and a continuing issue that some of the managers who have done well are taking too much money and their returns are going to come down, there is no
question about it. And it is a real problem for expectations and for clients; that's the nature of the beast.
But looking at strategies and the current market environment, you've got many pools of capital competing for different opportunities. In equities, for example, what hedge funds do and what long-only managers do are often quite different. They are often fishing in different ponds. Certainly their risk objectives are very, very different.

Barron's: So, save for certain pockets of the market, you see plenty of room for this new money to work. What about you, John?

Bader: Money flooding in simply means that strategies get commoditized faster.
But let me be very clear: Every good investment strategy I have ever seen gets commoditized sooner or later. What we have tried to do is identify and monitor strategies and understand when they are creating alpha and to exit strategies when they aren't working.

Barron's: How do you go about managing investors' return expectations?

Tomlinson: What funds need to do is customize portfolios to achieve specific return objectives. If a client says he wants cash plus 5%, you can structure a portfolio that gets pretty close to that in terms of expected returns. If a client is looking for a smarter way of taking equity exposures in Europe through
long/short managers and they want an alpha, or excess return above the market, of about 5% to European equities, that's what we do.

Barron's: What's your sense of the blurring of the lines between hedge funds and private- equity funds?

Bader: You are certainly seeing more of it. We are longtime investors in private debt and private equity. We have been very, very mindful of liquidity issues. In certain instances there can be -- and there doesn't have to be -- a mismatch between the horizons that some of these private-equity investments require and the relatively shorter lockups that a lot of hedge funds have. I don't think this is a problem for great multitudes of hedge funds. But for some, it certainly is an issue.

Barron's: What is the biggest danger that you see as hedge funds and private-equity funds become similar investment vehicles?

Thiel: There is obviously something very strange about enormous amounts of money that has gone into private equity. Is this justified or not? It comes back to the volatility. What does a private-equity investor do? They buy a company. They pay themselves a very large dividend where they take all the company's cash. Then they borrow money from a bank, and they leverage things up even more.

If you have a low-volatility world where nothing happens, that investment strategy works and you will make money. The bet that people are making who are going into private equity is there is going to be no meaningful bump in the road and that the low volatility will continue.
Bader: I'm not sure that's true, because a lot of people are looking at it the other way around and positioning themselves for the bump in the road. The other thing to note is the reason hedge funds are looking at this area -- particularly as institutional money flows in -- is that you typically get paid a premium for illiquidity. You have many investors, typically offshore, who really want as much liquidity as possibly in hedge funds. And then many of the U.S. institutions recognize the premium you often get paid for illiquidity and they actually sometimes like less-liquid strategies. You really have to look at it on a case-by-case basis.

Barron's: One of the biggest headlines of the year involved Amaranth Advisors, a hedge fund that lost about $6 billion last summer on bad energy trades. What's your sense of what happened there and how it's impacted the industry?

Tomlinson: When the fund's NAV [net asset value] lost 25%, the creditors were in there and basically looking after their own interest. The other issue for me was the fact that it was against the interest of the equity investors. There were two groups, reportedly two groups -- over-the-weekend-type negotiations --
they wanted to survive and probably there wasn't time for equity interests to be represented in there. But clearly in that situation, equity interests weren't represented and some of the prime brokers basically looked after themselves rather than the interest of the hedge-fund manager or in the interest of equity investors.

Barron's: What about Amaranth as an event within the hedge-fund industry?

Bader: It was a big event. There is no question it made some institutions nervous. But hedge funds are sometimes misunderstood. There are some hedge funds that try to be very defensive and have low volatility, and others that want to bet the ranch. A hedge fund is just a vehicle. There are mutual-fund managers who try to bet the ranch. There are mutual-fund managers who try to be defensive. There is no
great secret that Amaranth was making a massively leveraged directional bet on commodities. Tomlinson: They had moved away from a multi-strategy system.
Bader: They had other strategies, but they had a massive, aggressive bet on commodities and I think that was fairly well recognized. But this has made investors focus more on risk controls and "tail risk."

Barron's: Which means?

Bader: Disaster scenarios. When we look at the risk of our portfolios, we look at the potential shock and drawdown, or negative returns. What happens if you have an '87 Crash? What happens if credit spreads blow out to 2002 levels? The return relative to what happens in the tail-risk context is a very important point. A lot of investors in the hedge funds are more focused on the return relative to the monthly volatility. There is a danger in that -- that's important too -- but the danger is, I can devise lots of strategies where
you make money every single month with very low volatility until disaster happens.

Barron's: What's an example of that?

Bader: If I go out every month and I short puts on the S&P 500 10% out of the money, unless the S&P 500 goes down 10%, I am going to make money on this. I will pocket that money every month like clockwork, and it will have low volatility, most likely. That is, until S&P does go down 10%, in which case I
will probably be carried out. Now that's an example of a put-selling strategy masquerading as an alpha engine. The Amaranth blowup will force people to understand what the tail risk associated with some of these strategies is. Many people have their heads in the sand.
Tomlinson: I agree with that. I'd like to see standardized risk-reporting by strategy type or by instrument. Some hedge-fund managers have pretty sophisticated risk reports, but it really varies a hell of a lot. Another takeaway from Amaranth -- and this deals with multi-strategy managers -- is that successful traders increase their power and influence in these funds. That's a potential structural issue for multi-strategy funds. Nevertheless, the best hedge funds really do have independent risk controls. The best hedge funds really do have independent valuations. The best hedge funds are run by real businesses, and the fact is that, like in any real business, you can get some kind of flaws. But I wouldn't say that's a structural issue across the entire industry.

Barron's: There's been a lot of criticism that Amaranth, as a multi-strategy hedge fund, lost its way and put on too much leverage.

Bader: It's important to recognize there are a lot of hedge funds that don't use a lot of leverage. There are others that use massive amounts of leverage. Everybody connects the dots. In asking your question, one of the things you are doing is connecting the dots between Amaranth and multistrategy. I frankly never thought of Amaranth as a multi-strategy fund. This was a fund that had morphed into making a massive leveraged directional bet on energy. Most investors recognized that, but wanted to make the bet. In the trenches of the hedge-fund world, it wasn't any great secret that Amaranth had a massive directional bet on energy, which by the way everybody knew also had made them a huge amount of money, until it didn't.
Barron's: Shifting gears to funds of funds versus multi-strategy hedge funds. What are the pros and cons of each?

Bader: There is a place for both. For smaller institutions and individuals who can't do the work of identifying, doing due diligence and monitoring managers or cannot commit minimums that certain managers require, funds of funds that generate alpha are well worth the fees. But with many funds having longer lockups today, there is a greater challenge for the fund-of-funds manager, in as much as he is less nimble. Also, that fund-of-funds manager may have to understand that the writing is on the wall two years ahead of time for many strategies. The multi-strategy fund manager has the benefit of being able to look out the window to see if it's raining. If it's raining, he can decide whether to take an umbrella. He doesn't have to forecast two years ahead of time that it's raining.

Barron's: But what makes it harder for a multistrategy manager to be effective?

Bader: The disadvantage is that he or she doesn't have the whole world to choose strategies from that the fund-of- funds manager has. For the multi-strategy manager, the issue is recruiting the talent, and the question is whether they can dynamically switch between strategies. But longer term, because of the nimbleness multi-strategy funds have, many institutions will choose multi-strategy hedge funds rather than funds of funds. Both models are valid and both will continue to prosper.
Tomlinson: I agree with a lot of the sentiments, not all of the statements. There is a role for single-manager funds and multi-strategy funds. But there are more than 6,000 hedge funds. Looking forward, at least 50% will be outside of the U.S. Also, as John points out, there will be more niche strategies. Funds of funds are in a much, much better position to not only cover the world in terms of existing strategies, but also in terms of developing strategies. As hedge funds develop new, innovative strategies, due diligence is a huge issue and not a trivial problem, even if it's a very experienced analyst. I'm talking about somebody who understands markets and who has traded, himself. You are making judgments on people and processes that can take two, three, sometimes four years for them to get really good at it. Due diligence and monitoring is not about box ticking.

Barron's: But what about the extra layer of fees that funds of funds charge?

Tomlinson: This causes a concern. But it comes back to: Where is the industry going? Your ability to be able to stretch a product to certain clients' needs is huge -- a customized portfolio, for example. So there is that flexibility with funds of funds and the ability to find innovative and niche strategies.

Thanks, gentlemen.