Investors Are Flocking to Hedge Funds - 06/24/01

    The stock market plunge of the last year has spread pain across much of Wall Street. But for one corner of the investment world, times have never been better.
    Hedge funds, those shadowy investment vehicles catering to the wealthy, are surging in number and popularity.
    Assets of the lightly regulated investment pools have almost doubled to more than $400 billion in the last three years.
    And their greatest growth may lie ahead. Experts predict the industry may expand to many times its current size in coming years as rich individuals are followed into the funds by a wave of institutional investors.
    The attraction for those who can afford the price of admission: Hedge-fund managers pitch themselves as fast-moving, go-anywhere investors whose goal is to profit regardless of the markets' backdrop.
    That has become a big drawing card for investors whose faith in a buy-and-hold strategy has been badly shaken by the stock market's dive.
    What's more, hedge funds generally made good on their promise last year. The average fund posted a 7.6% gain, compared with the 10% drop in the blue-chip Standard & Poor's 500 index, according to Hennessee Group, an investment advisory firm in New York.
    With most U.S. stock indexes still in the red this year, hedge funds' appeal has only increased. The Hennessee index was up 2.9% through May.
    "Many investors are champing at the bit. They want to throw money in as fast as possible," said Michael Ocrant, editor in chief of MAR/Hedge, a New York-based information and data company.
    But as the industry mushrooms, so do concerns that the funds' growing clout may bode ill for investors and for financial markets.
    Individuals and institutions hasty to jump into the game may overlook the high risks in some of the industry's more exotic flavors of funds, experts say.
    It was less than three years ago that the industry--and global markets--were rocked by the fiery meltdown of Long-Term Capital Management, a hedge fund whose huge bond-market bets went awry.
    Even for lower-risk hedge funds, returns could prove to be disappointing because so many new funds are piloted by inexperienced managers, some industry analysts warn.
    "Occasionally, I see managers [where] I'm amazed anybody gives them a dime," said Bill Knight, managing director at Pacific Alternative Asset Management Co. in Irvine, which invests in hedge funds on behalf of clients.
    Hedge funds have been a part of the Wall Street landscape since the 1960s, but it wasn't until the 1990s that they began to proliferate, in part thanks to the renown of such legendary managers as George Soros.
    Officially, hedge funds are investment vehicles that pool the assets of clients, similar to how mutual funds blend investors' money. Though some newer hedge funds require minimum investments of $100,000 or less, most demand much more than that to get in.
    While mutual funds are designed to be transparent to the public--and to financial regulators--hedge-fund managers long have had an almost maniacal attitude about secrecy. Most shy away from press interviews, for example.
    The penchant for privacy stems in part from the funds' often fast-paced trading: Because success may depend on a nimble response to shifting market trends, hedge funds seek to shield their moves from rivals that might try to beat them to the punch.
    Also, hedge funds are prohibited from advertising, so managers fear that dispensing too much information may cross securities regulators.
    Because they're private partnerships catering to well-heeled investors, hedge funds generally are free from government oversight. As long as investors meet net worth and other qualifications, regulators take a largely hands-off approach.
    The lack of regulation has furthered a daredevil image of the hedge-fund business that fund experts say is inaccurate. Some funds, in fact, are designed specifically to generate modest returns while protecting against major losses.
    Still, the freedom that hedge-fund managers enjoy in their investing has paid off in the last year. For example, many have profited from selling stocks "short," a bet that share prices will fall in value.
    Mutual funds, by contrast, are largely constrained from shorting and have been stuck doing little more than waiting for the market to rebound.
    The prospect that the heady bull market of the 1990s is giving way to a long period of doldrums for stocks has caused more investors to turn to hedge funds with at least a portion of their capital.
    At the same time, some of Wall Street's most talented people are opening hedge funds--causing a brain drain from the mutual fund industry, which at $7 trillion in assets so far dwarfs the hedge fund business.
    One of Fidelity Investments' top mutual fund managers of the last two years, David Felman, this month left the firm's Mid-Cap Stock fund to join new hedge fund Andor Capital Management.
    Even by the Wall Street's inflated standards, money managers can make far more money running hedge funds than mutual funds.
    Hedge funds typically charge an annual management fee of about 1% of assets, compared with about 1.5% at mutual funds. But there's a kicker for hedge-fund managers: They usually keep 20% of any profits they generate.
    The result is that hedge-fund managers' pay can far outdistance the $436,500 median salary of stock mutual fund managers, and the salaries of pension fund managers.
    The two men running Harvard University's endowment said this month they were leaving to form their own hedge fund even though one of them made $7.3 million last year while the other earned $8.7 million.
    Hedge-fund managers justify their pay by noting that they make money only when clients do: Typically, a fund that loses money one year must get back to even before the manager earns a dime.
    "There's certainly something to be said for hedge-fund managers only being paid if their investors make money," said David Dali, co-head of OneWorld Investments, a Boston-based firm that started an emerging-markets hedge fund in late 1999.
    Yet some observers fear it simply has become too easy to set up a hedge fund and attract large sums from return-hungry investors who may not understand the risks.
    Fewer than half of today's 4,800 hedge funds existed six years ago, Hennessee Group estimates.
    Even some hedge-fund managers are surprised that they're getting backing.
    "Quite frankly, I shouldn't be able to start one up," said one manager with just four years on Wall Street.
    In some cases, hedge-fund managers run little more than glorified mutual funds but charge hedge-fund fees, critics say.
    "In the late '90s, there were kids who had barely learned to shave who started hedge funds as a way to charge exorbitant fees to people who should have known better," said Alan Beimfohr, a principal at Knightsbridge Asset Management in Newport Beach, which runs a small hedge fund.
    Though many experts dismiss the possibility, one concern is that the explosive growth of hedge funds raises the risk of a market disaster triggered by unexpected losses at one or more funds.
    "It's like everything else in the market. It won't happen again until it does," said Ocrant of MAR/Hedge. "Before Long-Term Capital Management happened, everyone said it couldn't happen."
    Indeed, hedge funds entered the public consciousness with the 1998 collapse of Long-Term Capital Management.
    Headed by trading legend John Meriwether, LTCM was run by a constellation of Wall Street stars. But a series of ill-fated bond-market bets, which were exacerbated by the use of enormous leverage, crippled the fund in September 1998 and threatened a domino effect of losses at investment firms to which LTCM owed money.
    Fearing the potential for global market fallout, the Federal Reserve Bank of New York engineered a $3.6-billion bailout of LTCM by major investment banks.
    In the wake of LTCM, there were calls for greater regulatory scrutiny of hedge funds. But the effort was stymied when a bill proposing greater financial disclosure by large hedge funds died in Congress.
    The only notable change since LTCM, experts say, is that regulators now keep a tighter watch on bank lending practices to hedge funds--an effort to prevent the massive leverage that doomed LTCM.
    The hedge-fund industry today paints LTCM as an anomaly. Although the use of borrowed money can boost hedge funds' financial clout well beyond the $400-billion asset base, many funds say they use little or no leverage.
    In fact, as the name implies, many funds say their goal is to hedge their clients' bets, limiting the risk of significant losses.
    "The majority of hedge funds in existence today are not involved in the types and amount of risk that Long-Term Capital was involved in," said Ignacio Sosa, co-head of OneWorld Investments, a Boston-based hedge-fund firm.
    In contrast to the so-called macro funds of the past, which made huge bets on trends such as currency movements and interest rates, many hedge funds are far more tightly focused.
    Many hedge funds also are becoming more open about their activities because the composition of their investors is changing.
    Traditionally used by the wealthy and by endowments, hedge funds now are seeing rising cash inflows from pension funds and other institutional investors. The newcomers demand more detailed information and pay close attention to the risks that fund managers take, experts say.
    But the majority of dollars invested in hedge funds in 2000 still came from wealthy individuals, according to Hennessee Group.
    Wealthy investors are parceling greater amounts to hedge funds in part because mutual funds and individual stocks no longer carry the same bragging rights, experts say.
    "Particularly for individual investors, there's a certain cachet to being in a certain hedge fund," said Bruce Ruehl, chief investment officer at Tremont Advisers, a Rye, N.Y. investment consulting firm. "There's definitely a lot of cocktail-party benefit."
    Yet, despite strong returns for many hedge-fund categories in 2000, the industry had its share of bombs. Of the more than 500 funds that Hennessee Group tracks closely, 15 lost more than 40% last year, including three that shed more than 60%.
    Even the savviest hedge-fund managers have been tripped up by erratic markets in recent years.
    Julian Robertson, head of Tiger Management, exited the business last year after his resistance to technology stocks badly dulled the performance of his funds.
    Conversely, the Quantum funds run by George Soros, who gained fame in 1992 by making $1 billion betting against the British pound, were hit hard last year by staying too long in tech shares.
    The Securities and Exchange Commission has brought charges against a handful of funds in recent years for fraud, often alleging that managers siphoned off investor assets to buy homes and cars.
    But the greater threat to investors, experts say, is in the same wide strategy leeway and lack of regulatory constrictions that make hedge funds so attractive in the first place: Can novice managers adequately control the risks they're taking, particularly if they're trying to rebound from a period of losses?
    "The temptation is to do things you didn't intend to do when you started out," said hedge-fund manager Beimfohr. "You're under incredible pressure to perform and you think, 'Gee, I'll just do this one crazy trade. I think it'll work out. No one will ever know.' "

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    Staff writer Walter Hamilton can be reached at
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    Hedge Fund Boom
    Hedge funds, which can invest across the broadest spectrum of financial markets, have exploded in number since the early 1990s as more wealthy investors and institutions have sought to diversify their bets.
    Total number of hedge funds, January of each year
    January 2001: 4,800
    Source: Hennessee Group

    A Sampling of Fund Strategies and Returns
    Hedge funds can follow a wide variety of investment strategies. Here are some of the more popular:
    Macro: Among the riskiest of all investing styles, macro funds make bold bets on broad market trends, such as currency-price shifts. Long favored by star managers such as George Soros, the strategy has been less profitable in recent years and has fallen out of favor with younger fund managers.
    Short selling: These funds aim to profit specifically from falling share prices. Short selling involves borrowing shares of a company and selling them, hoping to replace them later with stock bought at a cheaper price.
    Market neutral: This strategy entails buying stocks of some companies for potential gains--a "long" bet--while selling short the shares of other companies the manager believes are overvalued. The goal is to produce steady returns with relatively low overall risk.
    Convertible arbitrage: These funds make a two-sided bet. They buy a company's convertible bonds (which are convertible into stock at a set price) while selling short its stock, in an attempt to profit from temporary market pricing inefficiencies. Convertible-arb funds rely on heavy leverage to magnify returns because they tend to earn only tiny profit on each trade.
    Merger arbitrage: Funds using this strategy buy the stocks of companies that are takeover targets, while selling short the shares of the acquiring companies. The goal is to profit from the fluctuating difference between the target's market price and the price the acquirer eventually pays. A profitable strategy in the past, it has been less so lately because of the falloff in merger activity in the weak economy.

    Average Returns by Fund Strategy
    Here are average returns for key types of hedge funds in 2000 and the annual average for the period 1990-2000, net of fees charged. Many funds earned less in the 1990s than the return generated by simply buying and holding the Standard & Poor's 500 index stocks. But that changed in 2000 as stocks tanked.
    Source: Hennessee Group

    Hedge Fund Assets Each Year
    In billions of dollars; figures are for January of each year
    2001: $408 billion

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    Who Hedged in 2000
    Sources of money invested in hedge funds in 2000, by investor category:
    Individuals: 55%
    Funds of funds: 16%
    Corporations: 14%
    Pension funds: 8%
    Endowments/foundations: 7%
    Source: Hennessee Group          _x000D_