Is the Hedge-Fund Party Over?

As hungry institutional investors pile in, it's getting harder to produce fat returns

By Amy Borrus

It took Peter Gilbert, chief investment officer of Pennsylvania's State Employees' Retirement System, two years to persuade his board to test the hedge-fund waters. When the pension fund did take the plunge in 1999, few other institutions were in the big private capital pools, dominated overwhelmingly by wealthy individuals and families.

But, recalls Gilbert, "we had become disillusioned with traditional money managers' ability to outperform the benchmark over long periods."


  It turned out to be a smart move: Hedge funds, which now account for 20% of the Pennsylvania pension plan's assets, have generated an extra $500 million for the $26 billion state fund. Last year's hedge-fund investments yielded returns of 15.6%, vs. 10.9% for the Standard & Poor's 500-stock index.

Today the Pennsylvania fund is no maverick. Lured by the prospect of similar sweet returns, pension systems and other institutions are barreling into hedge funds.

U.S. institutions boosted hedge funds assets by about 50% last year, to more than $100 billion -- on their way to $300 billion by 2008, according to investment-management consultants Casey, Quirk & Associates LLC.


  But for many institutions, the plunge into hedge funds feels more and more like a blind leap of faith. In a private poll of 45 top-level institutions in May, 59% said they anticipate a major hedge-fund blowup within two years, and 97% felt that future returns on hedge strategies will not match past performance.

More than a third (35%) said they "more or less backed into having a hedging strategy," and 44% didn't think their boards were capable of meeting their fiduciary duty to monitor hedge investments. And yet 43% expected to boost their hedge-fund holdings to more than 20% of assets within five years, a big jump over the 23% who are at that level now.

Those schizophrenic attitudes reflect the immense pressure on institutions -- particularly underfunded pension plans -- to hit return targets in lackluster markets, says David J. Rothkopf, chairman of the National Strategic Investment Dialogue, who directed the poll.


  "If the pack is moving into hedge funds, no one wants to be an outlier and risk falling behind," he says. The survey, conducted at a two-day conference sponsored by Arlington (Va.) investment adviser Strategic Investment Group, sought anonymous feedback from 45 money managers who oversee collective assets of $350 billion.

Participants included top pension, endowment, and foundation officials from General Motors (GM ), Lockheed Martin (LMT ), Harvard University, and the Ford Foundation.

Managers have good reason to feel jittery. Hedge-fund returns averaged a paltry 1.06% in the first half of 2005, according to Hennessee Group LLC, a New York investment research firm, and some big hedge funds are even piling up losses.


  With stock and bond market returns expected to remain modest, and talented money managers flocking in droves to hedge funds, many institutions see hedge strategies as their best shot at fattening returns and limiting risk.

"There's certainly a degree of wariness about hedge funds, but there's still an appetite because there are no yields out there," says Robert C. Watson, founding partner at Lyster Watson & Co., which advises individuals and institutions on hedge-fund investing.

While some institutional investors are hoping to score the George Soros-type returns of hedge-fund history, most insist they're not counting on outsize profits.


  Instead they're following "absolute return" and other strategies that aim for modestly better-than-market returns with less volatility, often using funds of hedge funds for diversification.

But no strategy can survive the trampling of a herd. "The more capital flows in, the more returns tend to go down," says W. Allen Reed, CEO of GM Asset Management, who oversees $90 billion in pension assets for General Motors. "The question is at what point do they go down to a level that, net of expenses, they're no better than investing in cash? Most of us don't believe we're at that point yet." GM, an early mover into hedge funds, has $2 billion in assets in its own "absolute return strategies" fund of funds.


  But others think the flood of new money already is shaving down returns. "The party's over," declares Joseph Aaron of investment firm Wood, Hat & Silver LLC, which has been pulling out of hedge funds.

"Regression to the mean is stronger than the pull of gravity. We're looking at a sustained period of mediocre performance," Aaron says.

Institutional investors are counting on skillful fund managers to beat the odds. But with more managers crowding in, institutions are more likely to end up paying fat hedge-fund fees for skimpy returns that barely beat the market. What's worse, they won't be able to say they didn't see it coming.

Borrus is a correspondent in BusinessWeek's Washington bureau

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