Amy ----The bubble that we really are headed for :
Hedge Funds Go the Way
Of the Sub-Zero Fridge
By ERIN SCHULTE
THE WALL STREET JOURNAL ONLINE
Like the Sub-Zeros and sports cars popping up in eat-in-kitchens and cul-de-sacs across suburban America, hedge funds -- once reserved for the Park Avenue elite -- are going somewhat down-market.
Both the Dow industrials and the Nasdaq fell to fresh lows Friday, and given the performance, investors are hunting for places to put their money where it won't evaporate. Hedge funds, on the surface, seem like a natural choice, given that they've outperformed the market for the last two years.
Some blame the market's recent gyrations -- primarily lower -- on hedge-fund trading, which tends to be extremely active. Hedge funds, growing more influential as investors take advantage of shrinking minimums, short stocks, move quickly in and out of position and act as much on hunches as fundamentals. Given the fragility of the stock market, down five weeks in a row, the rise of the hedge funds is adding more tinder to the fire.
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Investors who previously couldn't afford hedge funds and their hefty minimum investments -- often $1 million or more -- are getting in on the action through hedge funds of funds. These investments work like mutual funds, allowing investors to make smaller contributions and own parts of a greater array of funds than they could afford alone.
Though hedge-fund inflows have flattened out somewhat this year, critics say there could be too much money coming in too fast to a market niche that has a limited talent pool and less transparency than mutual funds.
"I think it's inevitable there will be more high-profile blowups, more scandals, more fraud," said Roy Weitz, founder of FundAlarm.com, which advises investors on mutual funds. "As the market gets more competitive, the hedge-fund managers are going to have to try more things to stand out."
Hedge funds use leveraging and sophisticated, sometimes risky, trading methods, like investing in the debt of troubled companies or making bets on announced mergers, aggressively betting on the spread between the offer price and the target company's share price. With hedge-fund assets leaping 38% last year to $563 billion, it's clear that investors are increasingly interested in the high-octane world of hedge-fund investing. What's less obvious is whether it's in their best interests.
"Hedge funds are being mass-marketed, and minimums have come down dramatically," Mr. Weitz said. "Individuals are going into these kinds of things without knowing what they're getting into."
Until recently, hedge funds were in the realm of possibility only for the top tier of investors. That changed in 1996 with a major overhaul of securities laws that opened up hedge funds to more investors. Increasingly, hedge funds are available to investors whose wallets are merely stuffed, not exploding.
Hedge funds that cater to less-wealthy investors register under the Investment Company Act, which offers certain protections to investors and requires the funds to give investors some peeks at the books, something regular hedge funds aren't required to do.
Investors can get in on hedge-fund action for much smaller minimum investments today through funds of funds. For example, the Oppenheimer Tremont Market Neutral Fund, a hedge fund of made up of a basket of other hedge funds, requires a minimum investment of $50,000. The investor's net worth must exceed $1.5 million.
"The interest in funds of funds is very strong," said Neil Wilson, managing director for Managing Director of Friedman, Billings, Ramsey Investment Management in Arlington, Va., which opened a fund of funds this year. The minimum investment is $1 million, as it's not registered.
"It allows you to get the diversity without having to put in the minimums for each of the individual funds. If it's properly constructed, it can also reduce the volatility."
Some say cultural trends have helped pique investors' interest in hedge funds.
"People are generally getting a taste for luxury goods and feel the garden-variety portfolio of mutual funds isn't a custom-enough product for them," Mr. Weitz said. "Things that were luxuries 20 years ago are mass produced -- it's sophistication without knowledge."
Like all luxury goods, funds of funds are expensive. On top of the big fees charged for the underlying hedge funds, the fund-of-funds manager typically takes a 1% fee plus about 10% of annual profits. Hedge funds charge a fee of 1%-to-2% of assets and generally take about 20% of annual profits.
Deutsche Bank is the latest to offer a new fund of funds, according to a June 11 SEC filing showing it would offer units of its DB Hedge Strategies Fund for a minimum of $50,000.
Because of the increased offerings to retail investors, SEC chairman Harvey Pitt last month announced that the SEC is beginning a formal fact-finding investigation of hedge funds to determine if their traditional hands-off approach is in the public interest.
According to New York's Hennessee Group, the number of hedge funds in the U.S. last year jumped to 5,500 -- an increase of nearly 15%.
And the growth is expected to continue, despite (or maybe because of) the bad market. A recent survey by Goldman Sachs showed that investors expect the industry to grow by another 26% this year.
Hedge funds snapped back quickly from their tarnished days in 1998 when the implosion of Long-Term Capital Management, its bets leveraged by massive debt, threatened to throw a wrench into the entire financial system.
The largely unregulated investment vehicles may seem an unusual choice for investors growing inherently distrustful of corporate opaqueness and shady stock deals, especially given hedge funds' heavy fees.
Hedge funds aren't constrained by the same rules as mutual funds, like reporting performance regularly and limiting leverage. Thus information on fund performance can be difficult to get.
Still, despite the shadowy world in which they operate, ultrawealthy investors, foundations and pension funds are still rushing to hedge funds.
Given the group's relative performance, it's not difficult to see why. Hedge funds grew by nearly 4% last year, compared with an 8.1% loss for mutual funds, according to New York's Hennessee Group, an advisor to hedge-fund investors. The S&P 500-stock index sank 13% during the same period.
Last year, Morgan Stanley Dean Witter's chief market strategist and long-term bear, Barton Biggs, raised concerns about the ability of the hedge-fund industry to absorb a lot more capital without sacrificing returns.
And Paul Roye, director of the SEC's Division of Investment Management, warned public-pension officials last year that the hedge-fund "craze" posed a potential threat to the retirement plans they oversee. "Clearly, the flow of billions of dollars into hedge funds creates opportunities for legitimate fund managers, but also for Ponzi-scheme operators and swindlers," he said.
Mr. Roye's comments notwithstanding, pension funds are showing more interest in hedge funds. The California Public Employees' Retirement System, the nation's largest pension fund, said it wants to build its hedge-fund investments in the upcoming year, increasing the funding by up to $1 billion, though that's still less than 1% of its assets.
A common criticism of hedge funds is that there's greater potential for fraud since their reporting requirements aren't as stringent as they are for mutual funds.
In the past two years more than 10 hedge funds have been accused of misrepresenting their returns or their investment strategies. Michael Berger, for example, pleaded guilty last November to concealing nearly $400 million in losses from investors in his Manhattan Investment Fund by making fake statements showing it was growing 12% annually.
Even more rampant than fears of fraud are fears of incompetence.
"The issue is not that we have a bubble that's going to implode, the issue is that with so much money flowing in, it may affect performance," says Charles Gradante, president and chief executive officer of New York's Hennessee Group. "If they take on too much money and can't generate enough good ideas, they start investing in mediocre ideas."
As investors line up to throw money at hedge funds, there's an increased demand for hedge-fund managers. Some fear that not only ideas getting scarce, but talent is running thin.
"Initially, it was the George Soroses and Julian Robertsons of the world," said Mr. Weitz. "But there's only so many people who are good at anything. The hedge-fund world is drawing more people into it to run the money and clearly, they can't all be stars."
Best Wishes
Bill |
