Trimming Hedge Funds

The industry is booming now, but new rules, subpar performance, and copycat mutual funds with cheaper fees may spark a shakeout

By Amey Stone

Hedge-fund managers are the toast of Wall Street, wined and dined by brokerages eager for their trading business and courted by big investors clamoring to place some money with a hot hand. Assets are pouring into these high-minimum, often high-risk investment vehicles intended for sophisticated investors, and the number of new funds is growing.

Assets of hedge funds have doubled from less than $500 billion in 2000 to almost $1 trillion today. In 2004 alone, the number of managers increased from 7,000 to 8,050, according to Hennessee Group, an adviser to hedge-fund investors. The launch of a billion-dollar hedge fund, once a rarity, is now a weekly event.

SOWING SEEDS OF DEMISE.

  Yet even as the boom continues, signs of its eventual cooling are clear. Factors such as new regulations, weaker returns, increased competition, and rising interest rates are combining to make hedge funds less profitable for both portfolio managers and investors. At the same time, mainstream mutual funds are adopting some of the same risk-reduction strategies popularized by hedge funds, making them viable alternatives to the pricey, exclusive investment vehicles.

The result of all this will be a saner, tamer hedge-fund world in a few years. But it could get ugly along the way. "History suggests that any time money pours into a particular vehicle, that sows the seeds of its own demise," says Michael Panzner, head trader for Rabo Securities and author of The New Laws of the Stock Market Jungle. "At the very least, there will be a slowdown. At the worst, a big shakeout."

Regulation is the most obvious reason a more subdued hedge-fund world is on the horizon. New rules passed by the Securities & Exchange Commission in 2004 require hedge funds to register as investment advisers by February, 2006. Funds are already setting up compliance departments and preparing for possible audits by Security & Exchange Commission examiners. "That's just going to take time and money to put into place, and that's a distraction," says William Tueting, a partner in the Chicago office of law firm Chapman & Cutler.

BACK TO BASICS?

  In the longer term, Tueting fears new oversight will discourage hedge-fund managers from employing the kind of sophisticated trading and risk-taking strategies that have generated high returns and provided financial markets with liquidity in the past. He expects regulation to continue ratcheting up in the future.

The more serious -- and perhaps surprising -- reason for the tempering of the hedge-fund universe, however, is closer at hand. On average, hedge funds have underperformed both the stock market and the mutual-fund world for the past two years.

The Hennessee Hedge Fund Index gained 8.3% in 2004, compared to nearly 11% for the Standard & Poor's 500-stock index, including dividends. In 2003, the S&P delivered 28.5%, while hedge funds returned 19.7%, according to Hennessee. Investors who flocked to hedge funds for their market-beating potential during the bear market from 2000 to 2003 may now return to more conventional investment options.

"ALL-YOU-CAN-EAT BUFFET."

  What happened to the hot hands of hedge-fund managers? The vagaries of the capital markets explain their cooling. When the economy is improving and stocks are rising, good-old buy-and-hold investing often works better than the kind of computer-generated, derivative-laden, complex trades performed by many hedge funds. Many portfolios that sell stocks short were trounced in the fourth quarter of last year, as the post-election rally took investors by surprise. The plethora of hedge funds trying to take advantage of the same sort of short-term arbitrage opportunities is also making it harder to profit from strategies that worked well in the past.

The narrowing spread between short-term and long-term interest rates is a big culprit. "Hedge funds have had a great play borrowing short-term and buying high-yield," says Margie Patel, manager of the Pioneer High Yield Bond Fund (TAHYX ).

But where an easy eight-percentage-point return could once be reaped from that trade -- and more if the managers magnified the bet using leverage -- now there's just a two-point spread between Treasuries and junk bonds. "There's not enough risk-free arbitration for all of us to have an all-you-can-eat buffet," says Patel. By Amey Stone

RISK-ADJUSTED EDGE.

  With the Federal Reserve expected to hike short-term interest rates further, the spread is likely to narrow more this year. That also means increasing expenses for hedge funds, which often seek to magnify their returns by borrowing money to invest. "Cheap money has been a big lubricant for financial markets in general and hedge funds in particular," says Panzner. "When you take that away, it raises the prospect of an adjustment."

These trends mean hedge-fund investors, who often are already paying big fees for ho-hum results, may end up getting even less bang for their buck. Hedge-fund managers get paid a percentage of profits generated by the portfolio, which can go as high as 5%. Mutual funds, on the other hand, charge an annual expense ratio (averaging around 1.2% for large, actively-managed stock funds) whether they make money or not.

Schwab Hedged Equity Fund (SWHEX ) is one stock fund that uses hedging strategies to try to outperform the S&P 500 with lower volatility. Its expense ratio is 2%, and it returned 17.4% in 2004.

The most sophisticated investors may not mind if their managers don't beat the stock market, as long as the fund generates much less volatility, says Peter Rajsingh, senior vice-president at Global Partners Group, a financial-services firm that manages and markets hedge funds. "Hedge funds generally outperform on a risk-adjusted basis," he asserts. Plus, with skill at selecting managers, it's possible to identify funds that will outperform their peers, he says.

"INCOMPETENCE AND DISHONESTY."

  Indeed, the demand for such low-risk, well-managed portfolios for pension funds and other institutional investors may continue expanding, even without the souped-up returns. Catering to that market is yet another reason a more restrained hedge-fund world is on the horizon. As they market themselves more to state pension funds and other institutions, "they have to tone down their style and bureaucratize a little," says Panzner.

That doesn't mean there won't be some ugliness after the boom subsides. Many small hedge funds will simply close up shop, a winnowing process that has always been in effect as unsuccessful funds prove unable to attract assets.

But Jim Rogers, an author and hedge-fund pioneer who founded the Quantum Fund with George Soros, believes a more severe shakeout is coming as too many inexperienced managers enter the field. "There will be more problems because of incompetence and dishonesty, just as there have been in every gold rush in history all over the world," he said in an e-mail interview.

"BLURRING OF THE LINES."

  Some hedge-fund shops will no doubt venture further out on the risk spectrum in search of returns. Already, a few are branching into new trading strategies because the old ones aren't working so well, notes Patel. Diversifying beyond the strategies that worked for them in the first place is a warning sign for hedge funds -- just as it is for any company, she says. Patel doesn't think there will necessarily be a blow-up, but she expects many small hedge funds will disappear, while others will migrate to mainstream stock-picking.

For Global Partners Group's Rajsingh, these trends are simply "the evolution and maturation" of the industry. Rather than hedge funds being tamed, he expects mutual funds to become more like hedge funds. Panzner agrees, anticipating "a blurring of the lines" as mainstream money managers adopt some of the risk-management tools pioneered by the hedge funds.

Ultimately, the taming of hedge funds will be positive for financial markets. Nonetheless, when the gold rush ends, possibly sometime this year, it won't be without some pain.

Stone is a senior writer for BusinessWeek Online in New York

Edited by Patricia O'Connell

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