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Hedge Funds Inc.

Hedge funds and their managers are known as high rollers. But some experts worry the funds are growing too corporate and too cautious

Hedge funds have developed a reputation as the highest of high rollers. Huge risk and huge returns have gone hand in hand. Pioneer George Soros makes $1 billion for his Quantum Fund in a single day by making a massive bet against the British pound. Long-Term Capital and Amaranth Advisors collapse when highly leveraged bets go bad, leading to billions in losses. Members of Congress are even fretting that they need to tighten up oversight of the funds, for fear of smaller investors losing their shirts.

Now, however, finance experts are raising a very different kind of concern. They worry that hedge funds, as they grow and mature, are becoming too institutional, too bureaucratic, and too risk-averse. The fear is that the returns at many hedge funds are going to go from astronomical to average. "You have to take risks to produce market-beating returns. That's what we pay people to do," says Robert Discolo, head of hedge fund strategy at AIG Global Investment Group (AIG). "But a lot of managers are notching it down. I'm not happy about it."

He's not the only one. Russell Read, chief investment officer of the $225 billion California Public Employees' Retirement System, said at a recent conference that hedge funds taking on average risk are "inherently unsatisfying." There's evidence to support this point. In 2006, hedge funds overall actually lagged the Standard & Poor's 500-stock index, with the average hedge fund returning 12.9% to investors, while the S&P index rose about 13.5%. (see BusinessWeek.com, 5/14/07, "Hedge Fund Fees: The Pressure Builds").

Behavior Modification

Why the newfound caution? One important reason may be the changing nature of hedge fund investors. In the early days, hedge funds were backed by wealthy individuals and institutional investors like AIG that wanted them to swing for the fences. In recent years, however, pension funds have become much more important in the hedge fund industry, and their appetite for risk tends to be much lower.

Pension funds have been plowing money into hedge funds and other alternative assets because they want to diversify beyond the typical stocks and bonds. Yet while wealthy individuals are often looking for the highest returns possible, pension funds are more conservative. They want enough cash to meet their pension obligations, but they generally don't want the risk associated with chasing blowout returns. "We have been known to sell funds that have been knocking it out of the park because we thought they were taking too much risk," says Neil Petroff, senior vice-president of tactical asset allocation and alternative investments at the Ontario Teachers' Pension Plan. So big are pension funds like OTPP, which manages $92.5 billion, that hedge funds modify their behavior to suit them.

That's an issue for investors like AIG's Discolo. The 17-year veteran gains a broad perspective on the market by handling a fund of funds that invests money in hedge funds run by other managers. Even though there are now 8,000 to 9,000 hedge funds, he says it's tough to find exceptional performers. "They are managing the assets in order to keep the assets and not taking enough risk to create market-beating returns," he says.

Fishing for Big Fish

The phenomenon isn't unique to hedge funds, of course. The mutual fund industry became more institutional years ago. A similar transformation is now under way at private equity firms. They're building larger management teams, with human resources, public relations, and legal staff—all things that were once unheard of.

"We are seeing an institutionalization of private equity firms," says Gregg Slager, a partner with consultant Ernst & Young Transaction Advisory Services. "This is a natural evolution to a professionally managed asset class."

Private equity returns look like they're headed lower, too. As the firms have raised billions of dollars, they have had to turn to large-cap deals where it's harder to find a bargain-basement deal. Big companies, which have the resources to hire bankers and other expensive advisors, are more difficult to buy on the cheap. "As private equity firms go after bigger companies, they probably would admit that their returns are a bit lower, 20% rather than 25%," says Monte Brem, CEO of Leucadia Capital Partners, a private equity firm that was launched this year in La Jolla, Calif. "It's a function of the amount of capital being deployed."

The amounts are getting huge. On May 20, a private equity group at Goldman Sachs (GS) and TPG Capital agreed to pay $27.5 billion for wireless operator Alltel (AT) (see BusinessWeek.com, 5/21/07, "Private Equity Dials Up Alltel"). The deal comes a week after Cerberus Capital Management said it would buy the Chrysler operation from DaimlerChrysler (DCX) for $7.4 billion, plus the assumption of $18 billion in liabilities (see BusinessWeek.com, 5/14/07, "Cerberus Nabs Chrysler").

Outsized Returns

The changing approach of alternative asset managers is likely to have an impact on returns, but experts don't agree on exactly what that will be. Discolo fears that returns will drop as a result. But Charles Rossotti, a senior advisor at the Carlyle Group and a director at Merrill Lynch (MER), expects a different kind of fallout. "The conventional wisdom says that as more money flows into the sector, it will drive returns down," he says. "I think that has yet to be shown to be true. I think that what's really happening is that the disparity between the performance of the top quartile and the bottom quartile of alternative investments is getting wider than it is in other industries."

Perhaps. But one thing is clear: Hedge fund managers and others in alternative assets are making rational decisions about what is best for them. The concern for Discolo and others is that hedge fund managers have decided they don't need to take on big risks to get their own personal, outsized returns. "I think that so much money is coming in that hedge funds are getting wealthy from the management fees," he says.

See BusinessWeek.com's slide show for a roundup of the top-performing U.S. hedge funds.

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