Will Hedge Funds Be Overrun by All the Traffic?

The industry is straining to keep returns high amid record inflows of cash

Hedge fund managers are the comeback kids of Wall Street. Only two years after the widely publicized meltdowns of former star managers Julian H. Robertson Jr. and George Soros, investors are once again clamoring to sink their cash into this investment vehicle for the wealthy.

The $500 billion hedge fund industry is seeing the largest inflows of cash in its history: Preliminary results show the funds attracted $86 billion in new capital in 2001, double the total inflow of the previous year, and the cash continues to pour in. Freeman & Co., a financial-services consultant in New York, forecasts demand will grow 25% a year for the next five years, pushing total fund assets over the $1 trillion mark by 2006.

The quiet deluge of new cash sends up red flags for both investors and the financial markets. Record-setting inflows are chasing too few funds, straining the performance of a limited pool of talented managers. And since many of the best managers' funds are already closed to new investors, the spillover is up for grabs. Less experienced startup shops, whose managers migrated from mutual funds and trading desks are filling the void. Many of these newcomers, lured by hefty fees of up to 20% of profits, aren't well-versed in short-selling or the use of leverage. "They largely learn by trial and error, albeit with other people's money," says Philip N. Duff, the former chief operating officer for Robertson's Tiger Management and founder of investment managers FrontPoint Partners LLC in Greenwich, Conn.

Prohibited by law from advertising its wares, the industry has labored mostly in secrecy. These managers, who can invest in just about anything, don't have to report their funds' holdings even to investors, and they can keep their often huge losses secret from fund-tracking firms. But fear of more accounting time bombs a la Enron Corp. is raising credibility concerns. New York hedge fund manager Kenneth Lipper's recent 40% write-down of his portfolio creates suspicion that others have pumped up returns by failing to accurately price their securities. "Hedge funds are much less likely to be a `trust me' investment," says B. Scott Reid, managing director for Auda Advisor Associates LLC in New York, a hedge fund adviser to mutual-fund giant Franklin Resources.

All these risks are borne, for the most part, by affluent investors. Individuals own more than 80% of the hedge fund assets, with the balance held by a growing number of institutional investors. Pension funds, endowments, and foundations are driving the lion's share of the growth: The pension-fund industry's share of hedge funds increased 76% a year from 1996 to 2001, reports financial-services consultants Casey, Quirk & Acito LLC in Darien, Conn. What's new is that hedge funds, which until recently required $1 million in net worth and huge initial investments, are increasingly targeting mainstream investors. Brokerage firms, banks, and mutual-fund companies are piling into this niche. Among those making debuts this year are the Montgomery Partners' Absolute Return and Oppenheimer Tremont Market Neutral funds, both of which have $25,000 minimums (BW--Jan. 21).

So far, hedge funds have beaten the major market indices during the bear market, though they barely edged out Treasuries. The average U.S. hedge fund earned 5.6% last year, not including fees, while the Dow Jones industrial average, the Standard & Poor's 500-stock index, and the Nasdaq Composite had returns of -7.0%, -13.0%, and -21.0%, respectively, according to Nashville-based Van Hedge Fund Advisors International Inc.

But some of the most lucrative investing strategies of late appear to be maxing out. As opportunities dry up, managers are under pressure to take on additional risk by leveraging more or drifting away from their stated style.

Take "long-short" equity funds--one of the largest, and oldest, categories of hedge funds. Such funds buy stocks of companies believed to be undervalued while shorting the shares of others that the manager believes are overpriced. These funds collectively posted the worst returns last year, in a market where they should have shone: Long-short equity hedge funds fell 3.7% in 2001, according to the CSFB Tremont Hedge Fund Index. "It's a bit of a lost art. The money is flowing to people not able to handle the market," says David R. Webb, a hedge fund manager for Cleveland's Shaker Investments. After weak performance and the loss of two managers, American Express Co. was forced to liquidate a long-short fund, the Advisory U.S. Equity Fund I, which gave AmEx its start in hedge funds in 1996.

Not all strategies are tanking. Distressed-security portfolios that invest in the debt and equity of companies near bankruptcy are expected to boom in coming years. But chasing the hottest fund categories can be hazardous, as is borne out by the performance of funds that invest in acquisitions. As mergers dried up, so did business: The risk-arbitrage sector gained 5.1% last year after returns of 17% and 19.9% the two previous years.

The most popular strategy last year--convertible arbitrage, up 14.6% in 2001--may also be dead in the water. Such funds buy bonds that are convertible into a company's stock and hedge against a decline in the stock by selling it short. Hedge funds now own a majority of the record $102 billion of new convertible securities issued last year. One risk to investors is that the bonds might fall in value because of credit concerns. That proved to be Lipper's undoing. Moreover, these funds may borrow heavily to magnify returns, increasing the potential for trouble.

If the performance woes and lack of transparency persist, institutional investor interest could wane. Managers are asking tough questions, says senior consultant David Holmes of Louisville's Mercer Manager Advisory Services. "There are new questions about how they work, how they add value, and what are the real risks," he says. Unable to see behind the curtain, investors may not know what a manager is up to until it's too late. "That sort of thing is death to pension plan managers," says FrontPoint's Duff. "It puts their job at risk, and that's worse than losing money."

In the past, such scrutiny did not prevent pension funds from pouring cash into Robertson's Tiger funds or Long-Term Capital Management in the months before they collapsed. Still, more transparency should ultimately help investors. "Hedge fund managers are going to have to make some changes if they want to keep the `educated' money," says Barry H. Colvin, president of Tremont Advisers Inc. in New York. Already, rating agencies such as Standard & Poor's (which, like BusinessWeek, is owned by The McGraw-Hill Companies) are developing systems to measure hedge fund performance, quality of management, and risk.

Right now, investors remain upbeat because the alternatives look worse. "The stock market looks crappy, the bond market is choppy, and investors are wondering where to put their money," says Timothy J. Rudderow, president of Princeton (N.J.)-based Mount Lucas Management Corp., which created and runs a hedge fund index. "Mutual-fund companies and investment banks look out over the same 10 years and ask, `Where am I going to earn my fees?"'

Good question. Here's a better one: "How are they going to make money for their investors?" Hedge funds--lucrative as they are for those who run them--may not be the answer.

By Mara Der Hovanesian in New York

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