Hedge fund peak?
They have thrived during the bear market, but are hedge funds the place to be in the future?
By Larry Dignan
Dec. 26, 2002
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Is it time to hedge on hedge funds?
Courtesy of solid performance in a dismal bear market, hedge funds have quietly become a glamour asset class that's increasingly going mainstream. Once limited to the extremely rich, hedge fund investments can be had for as little as $25,000 in some cases. But the "pedestrianization" of hedge funds has its pitfalls, and it's not clear whether they'll maintain their popularity in the long run.
To understand the current love affair with hedge funds, consider a few statistics. Historically, hedge funds do well in bear markets. In 1987, the year of a stock market crash, hedge funds returned 14.49 percent compared to an S&P 500 return of 5.24 percent. Part of that performance is attributed to the ability to short, or bet against, stocks.
According to Van Hedge Fund Advisors, hedge funds this year on average returned 0.4 percent year-to-date through Nov. 30. That stacks up well compared to a 17.2 percent loss for the S&P 500 index. Through October, U.S. hedge funds that sell stocks short did best, with a return of almost 32 percent.
Given those returns, it's no surprise that the number of hedge funds has surged over the past two years. Industry tracker Hedge Fund Research counts at least 5,135 hedge funds this year, from 4,454 in 2001 and 3,873 in 2000. According to HFR, hedge fund assets year-to-date are about $600 million, up from $536 million in 2001 and $487 million in 2000.
"The biggest reason hedge funds have outperformed the last two or three years is that they can be long and short stocks," said Bryan M. Place, a financial planner in Manlius, NY. "Hedge fund managers can use any style and asset class. That gives them a lot of flexibility."
Because hedge funds have so much investing flexibility, they hold out the hope of absolute returns regardless of the market conditions: investors can make money in both bull and bear markets. And by hedging, volatility and risk is low, hedge fund managers say. If it works out, all you need to do is hand a money manager a minimum ranging from $25,000 to $500,000 for a "fund of funds" or a basket of hedge funds, or $1 million or more for a single hedge fund, and pocket the returns.
"Our responsibility is to preserve capital and increase it without unnecessary risk," said William Landberg, Chairman of West End Financial Advisors, a boutique investment firm that manages hedge funds, including a fund of funds.
The 2003 outlook is generally upbeat for hedge funds, but it's unclear what will happen if the stock market rebounds. Hedge funds can lag in bull markets for primarily two reasons -- short selling doesn't work as well and fees dilute returns.
Meanwhile, some hedge fund investors may be disillusioned with returns. Overall, hedge funds are roughly flat in 2002. While that's impressive compared to year-to-date losses for the broader market indices, it's not much of a gain -- especially for institutions that used absolute return as a marketing motto.
"The pitch of absolute returns could come back to haunt the industry," said Jim Hedges, president and chief investment officer of LJH Global Investments. "Some dumbed it down to 'You'll always make money.' "
Indeed, November's market rebound could be a preview of 2003. According to Van Hedge Fund Advisors, both the S&P 500, up 5.9 percent, and Nasdaq, up 11.2 percent, beat hedge fund returns, which were up 3.2 percent net of fees.
Hedge fund managers acknowledge returns in some areas are disappointing, but still better relative to market benchmarks. Most managers said they are absolute return oriented, but say you can't totally ignore returns relative to other investments.
"I still think hedge funds should be an absolute return vehicle with results in the 10 to 15 to 20 percent range," said White. "But it's dangerous to just look at one year."
Regardless, 2003 is expected to be another good year for hedge funds relative to the market. The flexibility to play stocks both long and short should pay off, say analysts.
"Next year, hedge funds should outperform for the simple reason they can be short," said Place. "It's a stock picker's market and that should help hedge funds. After that, however, it could be a difficult place to be."
Democratization?
Hedge funds aren't for everyone.
Place believes hedge funds can be dangerous for unsophisticated investors that cobble together the minimum requirement and bet the portfolio on a black box approach to investing, especially when some funds lock investors in for a year before they can sell. Place said no more than 10 percent of an investor's liquid assets should go to hedge funds.
"Hedge funds are good for the proper investor that can make them 5 percent to 10 percent of a portfolio," said Place. "But the mainstreaming of hedge funds is bad when you consider the more obscure investor."
What's not to like? For some financial planners like Place, plenty.
Critics of hedge funds argue a heavy fee structure -- roughly 1 percent of assets and 10 percent to 20 percent of the profits -- diminish returns over time.
And then there's the position of hedge funds in a portfolio and liquidity issues. Selling a hedge fund isn't as easy as dumping a mutual fund.
Disclosure is also an issue. Hedge funds are secretive by nature as they try to protect their strategies. The most extreme case resulted in the 1998 collapse of highly-touted firm Long Term Capital Management, which lost billions with investments based on fancy math executed behind closed doors before the government orchestrated a $3.5 billion bailout. And that was a company with Nobel Prize winners on its staff, proving that even the smartest financial wizards can stumble badly if no one is watching.
The Securities and Exchange Commission doesn't regulate hedge funds, but is examining the industry.
Mainstream dangers
Hedge fund insiders note that the mainstreaming of the industry could pose problems, but agree that alternative investments will become more widespread. For instance, many universities have invested roughly 20 percent of their assets in them, Landberg said. Pension funds are also hedge fund investors.
"The market will ultimately split between institutional-type funds and funds for high-net worth individuals," said Robert D. White, III, managing director at Investor Select Advisors.
Indeed, the two end points of the hedge fund industry are vastly different.
Wealthy investors can have their capital locked up for at least a year and be comfortable. After a year, these individuals can only exit the fund on a monthly and quarterly basis. The logic to the lock-up is clear, as money managers that may be short stocks don't want "hot money" that could rattle the portfolio.
The $25,000 types may be more skittish, resulting in covered short positions because of redemptions. "The $25,000 investor is very different from the $500,000 investor locked in for a year," said White.
As a result, a portion of the hedge fund industry, led by institutions and funds of funds, eventually will follow SEC regulations and offer lower minimums catered to individual investors. These firms will eventually become a subset of the mutual fund industry and offer returns tracking closer to the market. "Funds of funds will most likely look like mutual funds," Landberg said.
Meanwhile, rich individuals will continue to go with a black box approach allowing hedge fund managers to target absolute, less risky returns. "A lot of smaller managers don't want to jump through the institutional hoops, and there's still a lot of high net worth individuals out there," White said.
A two-tiered hedge fund industry does have a certain appeal to everyone involved. It would cater -- and potentially protect -- individual investors while still targeting the hedge fund industry's traditional market.
Until that split comes, however, there will be growing pains. Money managers note that the influx of hedge funds has diluted the original mission somewhat.
"You can't talk hedge funds generically because there are some that don't truly hedge," said Wilbur Ross, chairman of WL Ross & Co., a private equity firm. "That's part of the reason that performance is skewed among the hedge funds -- a lot of them don't hedge."
Ross said some hedge funds are glorified aggressive growth funds with a heavy fee structure. Big bets on a particular sector with lots of volatility may deliver returns, but don't adhere to the traditional approach of limiting risk, said Ross.
Hedge fund managers are split on style shifts in the industry. To Ross, frequent style shifts hurt performance. Others, such as White say shifting strategies aren't necessarily bad.
"Most people are good in certain areas and if you see sudden style shifts they're cowboys," said Landberg. "I am very suspicious of that. If a fund says 'we can do anything and we will,' we need to know that up front."
The hedge fund industry will also have to deal with regulation at some point. The SEC is bound to regulate the industry as small investors become involved, say hedge fund managers.
The industry is providing more disclosure as it works with institutional investors that are demanding more investment transparency, Hedges said. Nevertheless, Hedges and many of his peers expect the SEC to become involved at some point: "We're still an immature industry."
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