Don't Fence In Hedge Funds

With a wide range of investing styles, they need room to roam

By Steven Rattner

As a partner in an investment firm whose repertoire includes hedge funds, I'm faintly amused by the skirmishing over risk, regulation, and even the suitability of these vehicles. So much commotion over words -- "hedge fund" -- that by themselves denote not an investment strategy but a compensation structure.

That certainly wasn't the case in 1949 when Alfred Winslow Jones formed the first hedge fund with the then novel concept of balancing his long stock positions by selling short other stocks to protect, or hedge, against market risk. From that well-defined antecedent, "hedge funds" have become a melting pot of fee-thirsty money managers.

Today's hedge funds travel the galaxy of asset classes, from bonds to stocks to commodities to real estate and beyond. Some try to make money by exploiting small differences in security values at (theoretically, anyway) little risk. Others swing for the fences with huge directional bets and minimal, if any, hedging. Trading strategies can be similarly varied. Some managers shuffle their holdings on each new juicy fragment of information, while others practice Warren Buffett-like long-term investing. A current flavor in hedge-fund land is the "long only" fund: no shorting at all, but still hefty fees.

In fact, successful hedge funds consistently reflect only two not unrelated features: high fees and strong performance. As justification for the fees, managers often stress the skill needed to minimize risk by operating on both sides of the market. But most investors evaluate the high fees differently -- by the results. Smart investors focus on picking the best managers and swallowing the fees when they think they will net out ahead. Indeed, some of the most successful hedge funds, such as Renaissance Technologies Corp. and SAC, pocket up to 50% of the profits and still deliver breathtaking net returns.

What frightens investors and regulators alike is the wide disparity of performance, prudence, and even honesty that pervades hedge funds. In the traditional asset management world, performance also varies. But these fee-based managers generally limit each fund to a single defined universe (such as U.S. large-cap stocks), constructing workmanlike portfolios that, not surprisingly, yield workmanlike results, often just tracking the market averages. Meanwhile, heavy regulation protects against fraud.

In the Wild West of hedge funds, the latitude given to managers -- free to wander the investment globe looking for opportunities, free to leverage, and mostly free of supervision -- has led some experts, such as Yale University investment chief David Swensen, to warn off individuals. But too much caution can be as painful as too little. The import of much publicized frauds (Bayou) and meltdowns (Wood River or Long Term Capital Management) shrinks when measured against 8,000 hedge funds shepherding $1 trillion-plus in capital.

Most important, even averaging in poor performers, hedge funds historically have delivered, particularly in down markets. To be sure, the flood of money and people into hedge funds have made outsize returns harder to come by -- the typical hedge fund returned 5.9% for the first 11 months of 2005, compared with 4.9% for the Standard & Poor's 500-stock index. Those aren't the double-digit returns of yore, but it's still outperformance, and it may well continue for a simple reason: High fees (and high compensation) still draw the best and the brightest to hedge funds.

Investing in hedge funds need not be an exercise in fear. With maturity has come greater visibility into overall investment approach, use of leverage, portfolio concentration, risk control, and the like. The government has moved to require registration of many hedge funds (harmless, but of dubious benefit in netting the occasional bad actor). A more useful requirement would be greater standardization of how performance and risk levels are reported. But mandating portfolio transparency -- another idea floating in the regulatory ether -- would needlessly endanger performance.

Direct hedge fund investing should continue to be limited to institutions and only the wealthiest (and presumably most knowledgeable) individuals. Others can invest in publicly registered "funds of funds," which provide more diversification, more disclosure, and a sophisticated intermediary to evaluate underlying funds. For investors and regulators, the secret to understanding hedge funds is to first accept the irrelevance of the term "hedge fund."

Steven Rattner is managing principal of private investment firm Quadrangle Group and former deputy chairman of Lazard.

Before it's here, it's on the Bloomberg Terminal.