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Hedge Funds Taking Steadier Approach

NEW YORK - Call it growing pains. As much as hedge funds have impacted the investment community in recent years, the increased interest in, and significant inflows to, hedge funds from institutional investors have changed the way the $1.1 trillion industry operates.

"It's an entirely different game than it was 10 years ago," said Robert Schultz, who heads alternative fund services in the Americas for HSBC in New York.

These changes have resulted in new strategies, new products and even new regulations, according to panelists at The National Investment Company Service Association's Hedge Funds Conference held here recently.

Once a small community of a few hundred funds targeting high-net-worth individuals with unconventional investment ideas, the hedge fund industry has grown exponentially in the past two decades. In fact, between the late 1980s and 2003, the industry swelled from $40 billion under management to $650 billion, according to HegdeCo Networks, an industry information clearinghouse and consulting company based in West Palm Beach, Fla. Today, there are more than 8,000 funds, about 5,000 of which are registered, with $1.1 trillion under management. Analysts do not expect the growth to slow, either.

Much of that surge comes from institutional investors, such as endowments and pension funds, which are plunking down sizeable amounts of money in hopes of gaining alpha, any alpha, in a climate where most other investments are delivering single-digit returns.

Unlike yesterday's hedge fund investors, who sought supersized returns, these investors simply want reliable growth. "Pensions and endowments are not opportunistic investors," said Paul N. Roth, a partner at Schulte Roth & Zabel, a New York-based law firm with a large hedge fund practice. "They don't care about outsized returns."

This shift in philosophy has impacted the way the industry operates.

"The old hedge fund manager was the guy who grabbed the bat, stepped up to the plate, and swung as hard as he could to hit the home run," Roth said.

Today's managers, playing to institutional investors' interests, are swinging for a base hit, which may mean tempered strategies and perhaps fewer risks. Hedge funds are keen to attract this business, since most institutional investors have more money to invest than individuals, and the funds that win this business will grow the fastest, Roth said. That means small hedge fund boutiques will face more competition.

"Morgan Stanley, Goldman Sachs, Bear Stearns, we all [offer hedge funds]," said Barry J. Cohen, senior managing director of alternative investments at Bear Stearns of New York. "But if you look at the websites, you barely know they're there," he said.

That's because the increased popularity of hedge funds has also attracted the attention of regulators and spawned strict rules about the marketing and sales of registered funds.

"Regulators are very, very concerned with the trend toward retailization," Roth said.

Since February, hedge funds, formerly lightly regulated, have been required to register as investment advisors with the Securities and Exchange Commission and provide some basic data. Firms that meet certain hurdles, such as those with less than $100 million in assets under management, are exempt.

Cohen estimates that about 85% of all operating hedge funds have registered with the SEC, collectively representing more than 5,000 funds and almost 1,200 advisors.

Last week, during a speech in Minneapolis, SEC Chairman Christopher Cox announced that Federal regulators plan to comb through the recently submitted registration data. The analysis may lead to new rules for the industry, Cox said.

Another result of the rapid growth of hedge funds is a proliferation of products. Cohen predicted a continued rollout of registered hedge fund products. As a result, both the cost and the time required for approval should shrink as the SEC becomes more efficient at handling hedge funds, he said.

The biggest trend among new hedge fund products has been hedge funds-of-funds, which are hedge funds that allow investors to buy into a pool of other hedge funds. In part, these products themselves are a result of a growing practice among hedge fund managers to do business with one another, Cohen said. Previously, hedge fund managers were notorious for protecting their investment strategies.

Hedge funds-of-funds are also growing in popularity due to an increased demand for transparency, especially from institutional investors, speakers said. That means that investors will know not only what other hedge funds their fund has chosen, but the holdings of those underlying funds, as well.

"Open architecture would have been unthinkable 10 years ago," Cohen said. "Now it's common."

Funds-of-funds also typically can absorb a large amount of money, and allocate it through a diverse network of underlying funds, which addresses the challenge many fund managers face when they attract institutional investors who have large amounts to invest.