A New Life for Hedge Funds

The hedge-fund industry is at the same critical juncture as the mutual fund industry in the early 1980s. With hedge-fund assets expected to swell to $1.7 trillion by 2010, the spotlight is shifting to marketing. Have investors forgotten about the LTCM fiasco of 1998?

Just when investors thought it was safe to go back into hedge funds, a cousin of the controversial investment option has reinvented itself into a new market player: a sort of mutual hedge fund for the sophisticated investor.

Insiders say the new idea, dubbed Family of Hedge Funds (FHF) after the long-established Family of Mutual Funds (FMF), may revolutionize the hedge fund industry
n the next decade. In a FHF, smaller "niche" hedge funds specializing in different sectors are sold under one large umbrella.

Rama Rao, the manager of the Bohemia, N.Y.-based hedge fund, RR Technology and Growth Fund, argues that the polarization of the market's large players -each touting assets of more than a billion - and "niche" funds - each with assets under $100 million - makes the industry ripe for change. "The net result of these two extreme groups is that a void exists," he observes. "There are no real market leaders with national or global and efficient customer operations support for the average sophisticated user. The FHF brings together a variety of different hedge funds under a single unified organization.

Indeed, more than 80 percent of US hedge funds sport assets of less than $100 million, and more than half of this smaller group have assets of less than $20 million, according to Rao. However, the top 15 percent of the largest hedge funds control 80 percent of the total assets under management.

Larry Alintoff, Co-President of the New York-based Gotham Investment Fund, says he recently turned down an FHF offer for his niche hedge fund, which specializes in commodities and futures trading and has a capitalization slightly more than $4 million.

But he'll never say "never." Indeed, Alintoff envisions a system where investors could approach a FHF group with six to eight hedge funds ranging from market-neutral to global-macro sectors, a kind of one-stop shopping site for the hedge fund investor. Rao believes a key advantage to an FHF would be its ability to reduce lockup periods for Investors' capital - now often as high as one year - due to its larger liquidity pool.

Despite the brief backlash after the $4 billion bailout of Long-term Capital Management (LTCM) last year, fund sponsors and investors are returning to hedge funds in droves. Today, US hedge funds hold between an estimated $200 billion and $300 billion, and are growing at an annual rate of 20 percent. However, Rao says only 1 percent of institutional investors' funds are invested in hedge funds, and less than 2 percent of assets of high net worth individuals. However, that's just a small fraction of the US equity market. The total capitalization of stocks listed on the New York Stock Exchange is more than $15.2 trillion alone.

But Rao is betting that investors' appetite for hedge funds will soon grow much larger. With an estimated $10 trillion worth of inheritance passing between generations in the next 50 years, he predicts the market for traditional investments will become too saturated, to the point where "the innovative mutual fund managers will see their returns fade as their styles are copied and the inevitable regression to the mean takes hold. " That means more money being diverted to hedge funds: In the next 10 years, be predicts the industry will grow to $1.7 trillion in assets.

What continues to attract investors to hedge funds? Their stellar performance. During the 1990s, hedge funds garnered an average 37 percent return, says Rao, outperforming both the S&P 500 and the US Pension Fund Index. And hedge funds deliver high returns, even if the marker goes south.

Originally, a hedge fund - a term coined in 1949 - was defined as an investment whose strategy included both long and short positions in the stock of companies of the same sector. But today, the term covers a broader spectrum of investment methods, from using arbitrage and low-risk, market-neutral policies to using higher-risk leverage strategies. As with most investments, there's a correlation between risk and return. Theoretically, the higher the risk, the higher the return, if the investor understands what he's doing.

However, since many hedge fund managers are entrepreneurs who have fled trading desks, they tend to be the kind of "lone wolves"who aren't willing to sell the same funds they're managing, observes Hunt Taylor, Senior Vice President of the Rye, N.Y-based Tremont Advisers, a hedge-fund research company.

Taylor predicts hedge funds soon will be marketed like mutual funds, separating the managing and marketing functions. Perhaps the best model for the hedge-fund industry is the music industry, with the hedge-fund manager in the creative role as artist, he observes. "They will sign up with an agency and the agency will go out and try to get them deals," he says. "They'll get distribution through major labels: the Merrill Lynch's and so forth.

The marketing of hedge funds is a very immature industry right now that is going to go through some serious evolution. You may see families of contract marketers before you're done."

The memory of the LTCM bailout remains a painful one, however. Though the fiasco prompted calls for greater regulation, it also drew this admission from Federal Reserve Bank of New York President William J. McDonough: "I do not believe that it would be easy to develop a workable approach to the direct oversight of hedge funds.

The reality is that imposing direct regulation on hedge-fund entities that are chartered in the major industrialized countries would likely result in the movement of all operations to sites offshore. Our approach to improving the financial system's interactions with [highly leveraged institutions] is to focus quickly and aggressively on the decisions by banks that could create excessive leverage or imprudent credit exposure."

Taylor agrees overzealous lenders were to blame for the LTCM problem: Indeed at the end of 1997, LTCM was leveraged at a 28:1 rate. "To isolate hedge funds as a scapegoat doesn't fix the problem," says Taylor. "What did happen is that you heightened awareness of the amount of leverage that is floating around in one area of the system.You basically looked at the lenders and said that you've got be careful. The history of banks is that they have been overly committed to sector after sector, often with dire consequences.

" Regulations governing managed products, such as mutual funds, generally don't cover hedge funds, which often are organized as private limited partnerships to benefit from maximum flexibility. They usually target a limited number of investors, often fewer than 99, which allows them to avoid registration and public disclosure requirements.

Rao believes that the hedge fund industry is at the same kind of critical juncture faced by the mutual fund industry in the early 1980s. But as nightmares of the LTGM bailout fade and investments in hedge funds continue to soar, Rao is finding himself asking other questions, such as: "Who will play the role of the Fidelity [Investments] of hedge funds?"