Hedge Funds: Let the Bad Times Roll

Many who bet on a down market are thriving these days

How well did hedge funds do in the latest quarter? That all depends on what you think their job is. Traditionally, hedge funds are supposed to produce positive returns, after fees, even in the toughest of circumstances. Only about 60% managed to do that in the teeth of a vicious first-quarter bear market, according to Greg Newton, president of MAR/Hedge, a newsletter that tracks hedge-fund investments. On the other hand, fully 86% beat the Standard & Poor's 500-stock index, which fell 12.1%. As far as Newton is concerned, that's pretty good: "The comment I keep making to anyone who will listen is that, generally speaking, in market conditions like the one we had in the first quarter, a substantial majority of hedge funds are going to outperform benchmarks."

Hedge funds are lightly regulated investment partnerships that are open only to wealthy investors, with a typical minimum investment of $500,000 and a wide range of investment strategies, including short-selling. Fund managers get most of their money by taking a 20% cut of the profits. Not surprisingly, funds that make bets on stocks falling--so-called "net short" funds--were the quarter's hottest performers, with the median fund in the category up 13.4%, after fees, according to MAR/Hedge, whose database was recently acquired by Zurich Capital Markets Inc. Last year as well, short funds did best, posting 18% returns.

On the flip side, with the Nasdaq Composite Index down 25% for the quarter, hedge funds specializing in technology investing performed the worst. For instance, Essex High Technology Fund, which had returns of 122% in 1998 and nearly 400% in 1999, lost 61% in 2000 and another 30% in the first quarter, according to MAR/Hedge.

So did tech-heavy hedge funds fail because they didn't have positive returns? Not according to many observers. After all, most did better than Essex. The median tech hedge fund was down 11%. "Spectacular performance is always relative. In this context, 11% losses compared with 25% losses for Nasdaq is a reasonably spectacular performance," says Newton. Some did even better. Pequot Technology Fund, a member of Pequot Capital Management's multibillion-dollar hedge-fund family managed by Dan Benton, actually earned 11%.

Circumstances had a lot to do with which funds did well. The market was cruel to the "closet longs," which purported to be hedged against a down market but weren't. In contrast, it was a good quarter for funds specializing in convertible arbitrage, which buy convertible bonds of companies while selling short the company's stock as a hedge. With the Federal Reserve pushing down interest rates at the same time stocks fell, these funds made money both on their long positions in bonds and their short positions in stocks. Highbridge Capital Corp., a top convertible arb player with $3.5 billion under management, had 5% returns in the quarter.

SUPERTANKERS. Many large funds struggled in the first quarter, proving that bigger may not be better. One of the biggest losers was Zweig-DiMenna, a long-short U.S. equity fund with more than $5 billion in assets. It was down 19% for the quarter, compared with losses of 5% last year. A Zweig-DiMenna spokesperson says the fund is counting on rate cuts to boost the market and push it into the black. Another giant, Maverick Fund, with $4.7 billion in assets, was down 1% for the quarter, compared with 28% returns last year. Big funds can't sell their huge holdings quickly when they see the market moving against them. "There really is a difference managing large funds. It's like trying to steer a supertanker vs. a nice nimble boat," says Nicola Meaden, CEO of Tremont TASS Europe Ltd., a research and advisory firm.

Still, most hedge-fund managers are feeling pretty good about themselves lately, after a string of years in the late '90s when they met their goal of producing steady gains but were faulted for falling short of the roaring S&P 500. "We've always said the real test for hedge funds is in bear markets," says Elizabeth R. Hilpman, partner of Barlow Partners in New York, which invests in several hedge funds. "So far, they've passed that test with flying colors." Too bad only the rich can play.

By Debra Sparks in New York

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