Hedge Fund Darwinism With Don Putnam

The most successful big hedge funds are those that have brought new teams and added more strategies to their platform. "The Clinton Group started as a mortgage-backed securities shop, and now they have five different teams. All big hedge firms did that. Even Tiger at some point had seven or eight teams of people doing different things," Putnam notes.

So can funds of funds survive? Perhaps, if they're able to diversify into a multi-strategy format with only one layer of fees. Guggenheim offers another model. Its $2.8 billion alternative division is a hybrid between a fund of funds and a bank's proprietary desk.

Founded by proprietary desk traders who once oversaw trading themselves, the firm outsources trading to hedge funds but manages the risk internally. It can do so by setting up so-called "managed accounts" with each hedge fund; this basically means that the money remains in house and that Guggenheim can deliver transparency and statements to its clients. "It's a brilliant transaction," says Putnam, who worked on the initial phase of the deal.

Another surviving method is to join banks -- a reverse brain-drain in which talent heads back to the Street.

Firms may sell themselves to either a bank or the public. Chances are that the IPO option will prevail, as it allows a firm to preserve its team and strategy, though that's not necessarily true when the buyer is a bank. A successful example, Putnam says, is the U.K.-based hedge fund RAB Capital, which went public a couple of years ago.

Another survival technique is to pick and choose between a retail model and an institutional model. "It will be hard to serve two masters in the platform," Putnam says. That is because institutions tend to prefer quantitative strategies and lower fees and will accept more moderate returns, provided that the risk-adjusted performance is right. High-net-worth investors tend to trust traders, not computers, and they are ready to pay more for higher returns.

Interestingly, high-net-worth hedge funds flourish in Europe, where the private banking tradition has been established for decades.

"High-net-worth investors may have to move their money overseas because there may be more choices and better performance there," Putnam says.

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