Banks and hedge funds

Should banks buy hedge funds to take advantage of the booming returns posted by these funds?


Hedge funds are private investment partnerships that cater largely to institutions and wealthy people and invest in a range of instruments, from stocks and bonds to oil futures and derivatives. They have found many new fans in recent years among pension plans, charities, school endowments, and individual investors, with funds under management doubling to about $870 billion (almost 1 trillion) from four years ago and a number of funds rising to about 5,900 funds today from 2,500 a decade ago. TASS, a research firm, reckons that funds under management will balloon to $2.4 trillion by 2008.

Hedge funds require an initial investment of at least $250,000, and the investor needs to have $1million to $1.5 million of net worth. Hedge funds have recorded annual gains of 10.7% since 1994, according to CSFB/Tremont, which tracks about 400 hedge funds. That tops the annual gains of 10.4% for the S&P 500. And hedge fund returns often move in a different direction from the overall market.

Until a year or two ago, most hedge funds charged an annual frees of 1% of their assets under management, to cover the expenses of running a fund, and took 20% of the gains each year as an “incentive” free. But the bite from the fee has been rising.

At the same time many invest in hedge funds through intermediaries, such as fund of funds or salespeople, who add their own layer of fees. Fund of funds appeal to mainstream investors by putting together a series of hedge-fund managers in one diversified portfolio.

The rising fees come as the new money coming into the business is surging. The percentage of institutions investing in hedge funds increased to 23% last year from 12% in 2000. As all of this money floods in, some hedge-fund managers are finding it harder to locate ripe opportunities.

Currently, hedge funds are unregulated by the SEC. But the Commission is considering a new rule that would require advisers to larger hedge funds to register with the SEX and provide additional information to investors.

In late September, J.P. Morgan Fleming, one of the world’s biggest asset managers, spent $1.3 billion for a majority stake in Highbridge Capital, a fund with $7 billion in assets. Lehman Brothers is apparently in the talks to acquire GLG Partners, an even bigger fund. Whisper abound that more deals are in the works.

However, even with it’s dream team, Highbridge could have a tough time repeating its past performance (12-yr track record of strong returns). In the current year, hedge fund returns have been falling. According to CSFB/Tremont’s index of hedge fund returns, investors earned 2.6% in the eight months to August, against 15.4% in the same period last year. Reasons to blame:

* Tough markets and economic situation
* Enormous amount of cash flooding into hedge funds. There are only a limited number of things the funds can do to make money, mostly different types of arbitrage, when investors play on the mispricing of two similar financial instruments. For a fund, growing bigger means taking bigger positions and risk driving down returns.

There are only a limited number of strategies. Most hedge funds are “market neutral”. That is, they do not bet on a market going up or down but on the perceived mispricing of one security compared with another, or one market compared with another; or they strip down complex securities into their component parts and take advantage of mispricing in this way.

Funds that specialise in convertible arbitrage, for example, used to buy the convertible bonds, strip out the bond part and sell the cheap option that was left. But with so many investors now scouring the globe for mispricing, such opportunities have disappeared in many markets. In convertible arbitrage, the option is no longer cheap, and funds are now mostly forced to take a view on the creditworthiness of the borrower instead; or to play in markets in which they have no special expertise; or to leverage up their bets still further with borrowed money.

The amount of money sloshing into hedge funds also seems to have brought down returns. While moving lots of money into and out of currencies is cheap, because the markets are so liquid, the same does not apply to, say, shares in smaller companies, or corporate bonds, or emerging markets. It is for this reason that many of the more venerable funds have closed to new entrants.

Largest firms: Tudor Investment Corp. of Greenwich Conn,. Highbridge Capital Management of New York and D.E. Shaw & Co. of New York; charge 2% to 4% of assets as annual fee.