Hedge funds spent 2003 living off their reputation for performance, even as that performance wilted. Investors, however, are unlikely to lose their taste for them in 2004.
The average hedge fund returned a bit more than half of what an
index fund netted this year. Despite that, investors in these exclusive, largely unregulated pools of capital set an annual inflow record before the third quarter was even over: $45.4 billion in new hedge fund investment, according to Tass Research. Investors put $16.3 billion into hedge funds in 2002 and $31 billion in 2001. Tass tracks about 4,000 funds in its database.
The jump in hedge fund investments in the first three quarters of this year will continue in 2004 and beyond, say hedge fund experts and investment advisers.
Hedge funds are not for everyone -- by design, only wealthy investors and institutions can invest in most of them. Those constituencies show no signs their ardor is fading. Many investment advisers also believe hedge funds will soon become more accessible to retail investors, which could mean large amounts of additional capital becomes available. It's far from certain they will, however. The
Securities and Exchange Commission
is widely expected to bolster its supervision of them next year, but whether that will make it easier to buy in is not yet clear.
Even at a time when these largely unregulated funds are under close government scrutiny, they remain the alternative investment of choice for institutions, and a wise option for diversifying portfolios for the wealthy and semiwealthy.
"This is very broad-based participation
in hedge funds, because many people don't trust the rally," says Bob Schulman, the co-chief executive of Tremont Capital Management, a Rye, N.Y., unit of OppenheimerFunds. Schulman says once-burned investors would prefer to let someone else run their money this time around.
"They do not want to get their equity exposures back up to 60%, 70% or 80% -- whatever they ran to in the bubble," he said.
The average hedge fund returned only about 13% by the end of November, compared to 22% on the S&P 500. So what is the appeal of these seemingly risky, hard-to-understand funds that call for minimum investments of $1 million?
Simply put, many hedge funds aren't that risky, and the huge jump in institutional money is forcing them to let some daylight in. Because institutions -- pension funds, endowments and charitable foundations -- have taken a beating in equities for the last three years, they want alternatives to conventional investment funds. Because institutions are generally cautious investors, hedge funds seeking those dollars have opened their books a bit wider, increased liquidity and become more responsive to investors' concerns.
A Goldman Sachs and Russell Investment Group survey published last month says U.S. institutions with more than $3 billion have 5% of their assets in hedge funds. That's expected to rise to 7.5% by 2005 -- about $17 billion.
The main beneficiaries are funds of hedge funds, where one manager parcels out investors' money to a number of different hedge funds. He takes an annual fee and a performance fee if the underlying funds reach a return, known as a hurdle rate. It's expensive, because the other funds also charge fees, but it spreads out the risk.
Funds of funds are also the biggest draw for investors at the other end of the hedge fund spectrum, the so-called mass affluent. These are people who have between $1 million and $5 million, and they need an investment option that preserves their capital.
"What investors are looking for with funds of funds is something that can generate absolute returns, rather than good relative returns," says Eliot Weissberg, a branch manager with The Investors Center in Avon, Conn.
For clients who meet the SEC's accredited investor criteria -- a net worth of $1 million and income of at least $200,000 a year -- Weissberg recommends a 5% to 15% allocation to a fund of hedge funds, particularly to supplement bonds. "Some people are saying, 'I'm wealthy, and I want to stay wealthy.' Fixed income can't perform on a 10-year forward-looking basis the way it did on a 10-year look-backward basis."
He says investors have to accept the limitations of an absolute return strategy, and embrace slow but steady results.
"They are seeing relatively boring but positive returns," Schulman says of hedge fund investors. "There are plenty of exciting managers, but if you look at diversified portfolios on aggregate, they're pretty boring and positive."
Whether the SEC sees hedge funds in the same light is still an issue.
The commission put hedge funds in the spotlight with extensive hearings in May, before mutual fund market-timing and late-trading scandals claimed much of the agency's time and resources. Concerned that investors weren't being advised of the risks of investing hedge funds, its staff produced a lengthy report this September, recommending fund managers register as investment advisers.
The proposals are short of the clampdown urged by hedge fund critics, but politics may take over and preclude major changes. The report also called for clear descriptions of risk hedge fund marketing materials, recommended a standard valuation format and urged more disclosure of managers' fees.
Reported disagreements between SEC Chairman William Donaldson and fellow Republican-appointed commissioners Paul Atkins and Cynthia Glassman may mean many staff proposals are pushed aside as the commissioners seek unity on other issues, including mutual fund governance.
Schulman, at Tremont, calls manager registration "a minor inconvenience" and predicts investor demand from the top and bottom of the market will fuel hedge fund growth. The stock market may be back, but investors are poorer and wiser, and looking at this rally more skeptically.
"Look at the anemic trading volumes. This is not a case of, 'OK, everybody back on the bandwagon.' People have short memories, but not that short."