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The Hedge Fund Report: Who's Minding the Store?

Funds of funds see outflows amid concern about due diligence.

The flow of money into hedge funds slowed to $9.4 billion in the third quarter, down from $10.9 billion in the second quarter and $16.9 billion in the year-ago period, Hedge Fund Research reports.

Considering the industry's breakneck growth, a cooling off is probably a good thing. What's not so good is that during the same quarter, funds of funds saw outflows of more than $1.2 billion, compared with inflows of $3.5 billion in the second quarter and $6.2 billion a year ago.

Joshua Rosenberg, president of HFR, attributes those results to hedge funds' poor performance. But reports of shoddy due diligence around a couple of high-profile blowups probably didn't help. Funds of funds are pools of funds managed by people whose job is to select the best managers and to eliminate the bad apples or poor performers. When such managers fail to do their job, they can have trouble holding on to customers. That may be what has happened here, with investors getting more and more skittish in the face of scandals such as those that ripped Bayout Capital and Wood River.

Funds of funds also saw their legitimacy fiercely criticized last week. David Swenson, the chief investor officer for Yale and one of the most sophisticated hedge fund investors there is, slammed the industry in a

New York Times

op-ed piece. Swenson argued against the existence of financial intermediaries on whom less-informed investors rely, and urged the tightening of the rules governing who is allowed to invest in hedge funds.

"As it is often the case with financial excesses, what began as a resonable opportunity for sophisticated investors has become a killing ground for naive trend-followers, with scandals and frauds prompting predictable calls for increased regulation," Swenson wrote. "But if Congress and the

Securities and Exchange Commission

really want to protect individual investors, they should prohibit unsophisticateed players from participating in hedge funds."

Greener Pastures

The U.S. equity market continues to spook many investors, including hedge funds. In a research piece, Merrill Lynch analyst Cam Hui says that hedge funds have been reducing exposure to U.S. equities, even as the industry's ratio of long to short bets held steady. In other words, hedge funds have apparently been shorting their U.S. stocks while buying equities overseas. "Managers are seeking different markets with better returns outside of the U.S. and in many cases they are reducing or selling their exposure to the U.S.," said Richard Bookbinder, founder of New York-based fund of funds Bookbinder Capital Management.

Tighter Grip

It has become a trend now. Hedge funds looking for better performance are starting to resemble their private equity cousins: They are illiquid and lock money for years, not quarters. "Those illiquid funds have become more pervasive, even with small managers," says Dave Smith, founder of the Santa Monica, Calif.-based fund of funds and hedge fund Coast Asset Management. "Ninety-percent of the time, the fund offering substandard liquidity is in reality trading sufficiently liquid securities. It's complete

hogwash," he says.

Some of these newer and illiquid funds impose "gates." A 15% gate means that the investor gets 15% of his money per quarter. So an investor who pulled out the maximum would need seven quarters to get all his money back. "Those gates are for crappy managers who want to ensure that they have the management fees that they don't deserve," Smith says. But there is another reason behind the trend. Hedgies with lockups exceeding two years will be exempt from registration with the SEC. That seems like a good enough reason to lock people in.

Hiring, Buying

A few months after the press reported that the giant European hedge fund GLG Partners' convertible strategy was going through tough times, the London-based firm is bringing on board Steve Roth, co-head of worldwide convertible arbitrage and capital structure arbitrage at Deutsche Bank. He'll work alongside GLG partner Philippe Jabre on the firm's convertible and market-neutral funds.

Kirk Kerkorian boosted his stake in

General Motors

(GM) - Get Free Report

to 9.9% or 56 million shares, last week. According to a regulatory filing, the financier plans on pledging those stocks as collateral to secure a loan of at least $200 million from Bank of America. Kerkorian bought the shares through his investment company Tracinda Corp., named after his daughters Tracy and Linda.