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Tarred by Market-Timing Brush, Hedge Funds Quit the Business

Will Swarts

Hedge funds that used to rack up hefty profits trading mutual funds are running scared, even if they haven't done anything wrong.

Investigations in New York and Massachusetts turned up the heat on market-timing hedge funds, and some of them are getting out of the mutual fund kitchen altogether. The ripple effect from New York State Attorney General Elliot Spitzer's investigation into late-trading arrangements between mutual fund companies and hedge funds has affected businesses from Manhattan to Malta, shuttering funds and zipping lips as the controversy unspools.

"A lot of them may be feeling very paranoid," said Dermot Butler, chairman of Custom House Group, a Dublin company that does hedge fund administration and other support work for funds and managers.

The term "market timing" still covers the legal practice of rapidly trading in and out of financial instruments, but has been conflated to automatically mean "market cheating," a development fund managers contacted for this story decried.

With the exception of a $40 million settlement with Canary Capital Partners and an investigation of Veras Capital Partners, criminal prosecutors are currently concentrating more on mutual fund executives than hedge fund managers.

But hedge funds, including Tidewater Capital, Peconic Capital Fund, Diamant Asset Management, Diamant Master Fund, Lighthouse Multi-Strategy Fund and Veras are mentioned in a Securities and Exchange Commission subpoena of brokerage A. Brean Murray issued last week, according to reports. Spitzer has also subpoenaed the $3.5 billion Trout Trading Fund, run by Bermuda-based Trout Trading Management Company, now renamed Tewksbury Capital Management; the $80 million Haidar Capital Management; and Samaritan Asset Management.

Ritchie Capital Management, Cambridge, Mass.-based Chronos Asset Management and two london firms, Pentagon Capital Management and Headstart Advisers, are mentioned in Massachusetts Secretary of the Commonwealth William Galvin's civil complaint, which came out at the same time as the SEC's charges of civil fraud by seven Prudential Securities employees.

That's made folks in the already secretive hedge fund world as talkative as Harpo Marx, and few are laughing, either.

Several funds have closed their doors, industry sources said, including one manager who sent $500 million back to investors.

Some of this activity may be a hedge against legal entanglements in the future, and some may be the simple desire of market-timing hedge fund managers to lead quiet, wealthy lives.

Robert Reis, whose Houston-area firm DLR Advisers once traded mutual funds and now uses Rydex funds, said investors have withdrawn all but $40 million of the $500 million they managed 18 months ago. It is now considering using stock baskets such as I shares, QQQs and Spiders.

"It's cost us a lot of business," he said of the investigations. "We lost clients because at one time, we traded mutual funds. The only reason we used them was because the execution was cheap."

He said the firm, a registered investment adviser and commodity pool operator, was audited by the SEC in May 2002, and then received a subpoena requesting documents last month.

William Beckers, a Santa Barbara hedge fund manager who runs the SBIC Timer Fund, a fund of hedge funds, said half the 16 managers he invests with withdrawn from his fund, and some have closed their doors. He said one manager returned a total of $500 million to investors within the last 30 days. He says some funds are no longer trading U.S. mutual funds, and that others quit trading in and out of variable annuity funds, which are set up by insurance companies and managed by mutual fund companies.

"That business is over," he says.

Meha Arebi, of Cougar Asset Management on the Mediterranean island nation of Malta, said the firm shut down its market-timing Isis Fund, rolling over investors' $26 million into a global macro strategy.

"When the scandal came out, we decided that the strategy could cause problems," she said.

In Europe, it is.

In London, which has the second-largest concentration of hedge funds behind New York, the market-timing scandal spawned a few inquiries and a fair bit of nervous silence.

"I know a nubmer of people in Europe who will not deal in American funds," Butler said. "They are terrified of litigation and the class-action mentality."

Headstart Advisers, the $760 million London firm named as a Prudential trading partner in the Massachusetts complaint, didn't return repeated calls for comment. Headstart's funds investing in the U.S. market were down 18% for 2002 and its global funds were up 2.9% in 2002 and are up 7% for the year to date, according figures from U.K. consultancy Allenbridge, which researches hedge funds.

Allenbridge, which also advises investors on unit trusts, the U.K. term for mutual funds, surveyed U.K. mutual funds to see which allow market timers to trade their funds.

Most said they had no agreements with hedge funds, though one or two said they'd had agreements in the past and scrapped them, according to Jacob Schmidt, Allenbridge's director of hedge fund research. "It seems that no one is now involved -- I can't believe that."

"This is not a hedge fund problem -- this is an industry problem, a mutual fund company problem," he said. "I think the hedge fund community that is involved in this is perhaps not even 1% of all hedge funds. I don't think the major players are hedge funds, but the mutual funds who allowed it."