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Hedge Fund Opportunities Shrinking


WASHINGTON - The very expansion of the hedge fund market is reducing its investing opportunities, and slowly forcing the most cunning hedge fund managers to look to the long term.

"The more hedge funds there are, the fewer investing opportunities there are," commented Frank A. Cappiello, in giving the keynote address at the National Association for Variable Annuities Regulatory Affairs and Compliance Conference here.

"The market has become so efficient that it is hard for all but very long-term investors to make money," continued Cappiello, a Washington-based financial analyst and chairman of Montgomery Brothers, Cappiello.

Hedge funds, Cappiello explained, exploit "seams in the market," or inefficiencies that yield short-term results. Even though hedge funds employ 20 different strategies, they are "all short-term oriented because the business is short-term."

Hedge fund investors expect, and scrutinize, quarterly results, in the absence of which they will pull out their money. This puts enormous pressure on hedge fund managers, Cappiello continued, to generate gains very quickly. However, with thousands of funds managing $1.1 trillion globally, these strategies produce fewer gains per transaction, so "profits depend on a lot of action."

In fact, portfolio turnover is definitely on the rise. In 2003, the average portfolio turned over 2.99 times, but in 2004, that figure rose to 3.35 times, according to the most recent survey from the Hennessee Hedge Fund Advisory Group in New York. Hennessee's annual hedge fund manager survey polled managers of 752 hedge funds, representing 155 management companies with $238 billion in assets under management.

This volume of transactions makes hedge funds, with a relatively modest 3% of global capitalization under management, a significant force of an asset class. And now, the growing challenges to the high-line returns typically associated with hedge funds raises questions of the market impact of hedge fund failures.

Past history confirms current fears, with the collapse of Long Term Capital Management, Greenwich, Conn., several years ago nearly a market-shaking economic catastrophe. However, "it is very doubtful that one hedge fund disaster could threaten the markets," Cappiello opined.

In the case of Long Term Capital, the fund was grossly overleveraged at 330%. While leveraging is the hallmark of hedge funds and a fundamental distinction from mutual funds, fund managers steer clear of that degree of leverage nowadays. The Hennessee survey revealed that, in 2004, the average hedge fund gross exposure was 148%, "bringing to question the notion that hedge funds are a highly leveraged asset class," the survey concluded.

Hedge funds fade away all the time without even a whimper of market impact, Cappiello said. Most die because of mispricing of holdings, over-leveraging, ego (by managers not admitting investing mistakes or misjudgment soon enough to correct) or outright fraud, he added.

"Hedge funds will become a less significant market force as opportunities for investing become more difficult to find," Cappiello concluded.

Regulators have turned their focus to hedge funds in the last few years. Even though hedge fund investing is limited to sophisticated investors with at least $1 million in investable assets, the Securities and Exchange Commission has expressed concern over hedge fund regulation because of increasing investment by pensions and charitable funds. Although funds-of-funds are the fastest-growing area of hedge fund investing, direct pension investment in hedge funds has increased 145% since January of 2000, according to the Hennessee survey. During that period, pension investments grew from $29 billion to $71 billion in 2004.

With more pooled money belonging to smaller investors involved in hedge funds, regulators want greater accountability, and now 30% of hedge funds are registered with the SEC, most voluntarily, he said.

Hennessee's survey discovered that hedge fund registration with some domestic agency, either the SEC, NASD or Commodity Futures Trading Commission in Washington, jumped 50% between 2003 and 2004. In 2004, fully 61% of hedge funds were registered.

Cappiello speculated that the changing of the guard at the SEC with the departure of Chairman William H. Donaldson is likely to turn down the heat on hedge funds. "Hedge fund regulation is moot - the new Commissioner will have much more on his plate," Cappiello concluded.

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