Assets in Larry Simon’s hedge fund unit at Bank of New York nearly doubled in 2001, even though the equity markets sank and many mutual funds had performance losses of at least 10%.
Mr. Simon credits the explosion in value of the 16 proprietary funds in his Ivy Asset Management unit to the talented portfolio managers he has been able to attract. Since December 2000, Ivy has gone from $2.9 billion of assets to $5.4 billion, an 86% increase. Mr. Simon said that growth was the result of strong portfolio management and investment inflows. Industrywide, hedge fund returns averaged 4.4% last year; Ivy’s returns were 18%.
“Skilled managers have demonstrated the ability to navigate difficult markets,” Mr. Simon said. “This is all about having the skill to make your way through.”
Hedge fund companies, he said, are drawing the best young talent from established mutual fund firms, making the products attractive to wealthy and institutional investors during market volatility.
Meanwhile the hedge fund business itself is maturing and becoming more conservative, he said, and this is making it the business more appealing to banks.
“I think banks are looking to develop a menu of products, so clearly this will fit in a certain mindset for a certain clientele,” Mr. Simon said. “Hedge funds fit as an anchor on a ‘barbell’ approach to asset allocation.”
Institutions are scrambling to offer hedge funds, talented managers are scrambling to run them, and institutional and high-net-worth investors are scrambling to buy them.
But what makes these funds hot amid inclement business conditions?
“We are sitting at the end of a 10-year bull market,” said John Pileggi, a New York alternative investment analyst who had been in charge of ING’s hedge funds. “There is just more of a focus on these products now that you can’t find 36% returns on an index fund.” The world of hedge funds, he said “is the interesting place to be.”
Hedge funds had $408 billion of assets under management at the end of 2000, according to research by Deutsche Bank. Now they have $792 billion. They are similar to mutual funds in that both create pools of stocks in which individuals and institutions can invest. But unlike mutual funds, hedge funds can sell stocks short and borrow money to boost returns.
Also, since the Securities and Exchange Commission does not regulate them, hedge funds are not required to disclose the trades they make, the positions they hold, or the losses they suffer. They are generally aimed at investors with a minimum of $1 million to commit, who are considered sophisticated enough to handle the lack of disclosure.
“Hedge funds are not unlike mutual funds of 20 years ago,” Mr. Pileggi said. “They are slipping in under the radar. They can’t be advertised. They can’t promote returns. If you have information on them, it is hard to decipher and tell who is real and who is not.”
In the past 10 years the number of hedge funds has grown from 600 to 6,000, and good money managers have been leaving mutual fund companies for hedge funds to gain an independence that has become harder to find at the large mutual firms.
Bill Helms, an executive vice president at LJH Global Investments, an alternative-investment consulting firm in Naples, Fla., said: “Basically, hedge funds take advantage of the volatility in the market. They are best positioned in times like these.”
The CSFB/Tremont Hedge Fund Index, which tracks the performance of 370 portfolios, was up 3.2% from Jan. 1 through Nov. 30 of last year. In the same period, the Standard & Poor’s 500 was down 13.7% and the Dow Jones Industrial Average was down 21.7%.
Roland Lorenzo, the president and chief operating officer of the CSFB/Tremont Index, said, “The consistent returns provided by hedge funds this year have saved diversified portfolios from double-digit losses.”
Mr. Helms said hedge funds are blossoming as both bank and nonbank fund families flounder. “Institutions are under pressure to perform,” he said. “Investors are accustomed to the returns they were getting during the bull market, and they want more of that.”
Mr. Helms said this is leading many managers and companies, including banks, to open their own hedge funds. The barrier to opening and running hedge funds is not high, he said, and institutions see them as “profitable and certain for high returns.”
In 2001, more banking companies rushed to join the hedge fund fray. Goldman Sachs Group Inc. started its first hedge fund of funds in May. Goldman, which had managed $4 billion of hedge funds before coming out with the new product, said the fund seeks annual net returns of 10% to 12% over three to five years.
Wells Fargo & Co. created its first hedge funds in August, when it started six. In December a new Wells alternative asset management unit launched two additional funds.
Northern Trust Corp. started one product in March and two more in June. When the Chicago banking company introduced the funds, it aimed to have $300 million to $400 million of assets under management by yearend. It amassed $650 million.
Companies such as Wachovia Corp. and State Street Global Advisors’ SSARISAdvisors LLC also built up their hedge fund rosters in 2001.
Sam Weiser, the chairman of the Managed Funds Association, said the companies that have had the most success with hedge funds, such as Bank of New York Co. and Citigroup Inc., have bought strong hedge fund companies. The banking companies that succeed, he predicts, will be those that both sell and invest in hedge funds.
“It will be interesting to see if banks invest alongside their investors,” he said. “I mean, if [a bank] raises $2 billion to $3 billion, will they invest 10%? If the bank shows a significant amount of exposure, they will make their clients comfortable and, in turn, draw more investors.”
Mr. Pileggi said every small hedge fund manager wants to be the next Ivy Asset Management — and wants to believe that, having started a hedge fund company, he or she will be able to sell to the highest bidder.
These managers “want to build a hedge fund business that they can sell to a large institution,” Mr. Pileggi said. “They want to be the eyes and ears for a large bank into alternative investments,”. “But they have to be cautious. There is a lot of smoke and very little fire.”
Mr. Pileggi said that for a bank to succeed as a hedge fund provider, it must find the best young managers to run the funds. “Banks cannot just reallocate their talent,” he said. “Hedge funds require a specific set of skills.”
Many young, skilled mutual fund managers have left established fund companies in the past 18 months to start their own hedge fund firms. But starting a hedge fund can be difficult, and some job search consultants said they are seeing “a growing tentativeness” from portfolio managers to go it alone.
“There is a fear factor. Managers want to return to the safety of a larger organization where there is less risk,” said Jane Marcus, an executive vice president at Heidrick & Struggles, a New York financial executive search firm. “There is a real hesitation to go to a small start-up.”
Ms. Marcus said that in the mid- to late 1990s, large fund companies “lost a generation of talent” to boutique firms that sold hedge funds and other alternative investment products.
“Small boutiques is where the opportunities were. It was where the big money was,” she said. “Now people want to return to safety. People are taking a conservative approach to their next career move.”
Ms. Marcus said that though opportunities exist in hedge funds, managers want to explore them within a larger organization.
Mr. Weiser said the larger financial companies are expanding their alternative capabilities as managers clamor for the products and as more institutional investors seek to invest in them. The Fifth Annual Global Report on Institutional Alternative Investing, released in December by Goldman Sachs and Frank Russell Co., said institutional investors are increasingly turning to alternative investments to boost their returns. In 2003, it predicted, 8.1% of institutional portfolios will be invested in hedge funds, up from 7.5% last year.
The survey indicated that pension funds have 25% of their assets in hedge funds. Josh Weinreich, the global head of alternative investments for the New York unit of Germany’s Deutsche Bank AG, said there are not enough hedge funds to properly diversify the average pension fund.
“For the large pension funds, putting $50 million in a hedge fund is not meaningful enough to have an effect on their overall asset allocation,” Mr. Weinreich said. “Hedge funds are selling faster than they can be built up.”
In May, Deutsche Asset Management started a program of investing $500 million with multiple hedge fund managers using various strategies. Pension funds could also invest in this pool. Now $4 billion of assets that the firm manages is invested in hedge funds — $1 billion in individual funds and $3 billion in funds of funds.
Mr. Weinreich said pension funds currently account for 25% of all investments in hedge funds, compared with 4% in 1990. But pension funds are still an untapped market, and a major reason is lack of hedge fund capacity, he said, adding that institutional and high-net-worth investors should have 6% to 16% of their assets in hedge funds.
Mr. Pileggi said a balanced and diversified portfolio that includes hedge funds is the best bet. “There is a plethora of choices in the fund world, and a single fund cannot achieve everything in every environment,” he said.
Mr. Weiser said the hedge fund market is slowly growing saturated. He said he was at his son’s hockey game a few weeks ago and heard people next to him in the bleachers discussing the funds. “It is usually when everyone starts talking about these things that they are a bit overheated,” he said.
As the bigger players enter the market with enormous distribution and marketing capabilities, Mr. Weiser said, hedge funds will suffer.
“All of this aggressive activity in the hedge fund market only confuses the investors,” he said. “In the world of alternative investing, you are buying the manager. In traditional mutual funds, you want to go to the most reputable firm, because you are buying the market and the stability of a firm. But in alternative investments, you are buying a manager and his skills with managing the product and predicting the market.”
Mr. Weiser said an oversaturated market would “distract” investors from the best players.
“This market is not an automatic,” he said. “I ran a hedge fund for three years, and we were traded out of business. I see a lot of guys who see the corporate downsizing and believe that now is the time for them to jump to hedge funds. The waters will be rough.”
Ivy’s Mr. Simon noted that not every hedge fund did well in 2001. In fact, many who invested in hedge funds that use a “long” strategy lost significantly.
“The business itself is maturing and evolving steadily,” he said. “Investors and institutions are still looking for the best managers, and there will be pitfalls along the way. Investors are learning that it is hard to produce 10% to 12% returns year in and year out.”
But he said hedge funds are an important part of a balanced portfolio. “With a lot of finesse, a lot of patience, and a lot of diversification, hedge funds will win out. Investing is never a certainty, but these products, if managed correctly, will continue to be a good bet.”
