Fund firms rethinking hedge fund strategy

Amid heightened scrutiny from regulators, concerns over conflicts of interest and an unpredictable stock market, mutual fund companies are rethinking their plans to rush into hedge funds.

A few years ago, when interest in mutual funds began to falter, fund companies turned to hedge funds as a way to hold on to rich investors and stem the defection of top money managers.

Industry heavyweights such as Boston-based rivals Fidelity Investments and MFS Investment Management quietly tinkered with hedge fund strategies internally.

Others, such as Franklin Resources Inc. in San Mateo, Calif., OppenheimerFunds Inc. in New York and The Phoenix Cos. Inc. in Hartford, Conn., jumped into the business by acquiring or teaming up with hedge fund specialists.

Today, some of those same companies are backing away from those strategies – at least for now, say industry observers.

MFS, for example, pulled the plug on its hedge fund experiment 11 months ago over concerns that selling such funds would send the wrong message to its mutual fund shareholders.

And last month, Fidelity, the nation’s No. 1 fund company, announced it had spun off an in-house investment firm that relied on computers to mimic some of the strategies used by hedge fund managers. The firm, Geode Capital Management LLC, managed money for Fidelity’s richest employees.

“Fidelity’s announcement basically says `game over,”‘ says Jim Lowell, editor of Fidelity Investor, an independent newsletter based in Needham, Mass. “If you ignore what Fidelity’s actions are telling you, I think you’ll have many sleepless nights due to the potential consequences of continuing to pursue the hedge fund folly.”

Indeed, the moves come as regulators are deciding whether to clamp down on the $665 billion hedge fund industry more closely amid growing concern about whether fund companies that are also selling hedge funds can skirt conflicts of interest.

They also come as stock mutual funds are outperforming hedge funds for the first time in more than four years. It’s unclear whether some fund firms are exiting the hedge fund business for good or merely backing off until all the dust settles.

Fidelity is believed to be tinkering with a market-neutral hedge fund that would invest in companies in the United States, Japan and Europe. The fund would be based on ideas from Fidelity’s deep pool of analysts, according to market sources.

Fidelity, meanwhile, is tight-lipped on its plans. “We aren’t going to speculate on what we may or may not do in the future,” says spokesman Vin Loporchio.

performance issues

Meanwhile, the prospect of regulators’ baring their teeth has certainly dulled interest in hedge funds, says Barry Barbash, a Washington law partner with Shearman & Sterling of New York.

“Mutual fund companies are thinking more carefully about whether it’s a line of business they want to go down,” he says. “In terms of setting up hedge funds, it’s less of a quick response. It’s more of a considered response.”

But it’s the stock market that is really giving fund companies pause. Hedge funds – once viewed as the magic elixir to investor woes during bear markets – have lost their appeal as stock market conditions have improved this year.

“It doesn’t seem as if as many fund groups are viewing hedge funds as an absolute necessity,” says Mr. Barbash, a former director of the SEC’s division of investment management. “That’s because mutual fund performance has come back, and hedge fund performance is perceived as being somewhat more erratic this year.”

The average hedge fund was up 10.23% year-to-date through July 31, according to Hennessee Group LLC, a New York-based adviser to hedge fund investors.

That pales in comparison with the 16.23% gain posted by the average stock fund, according to Lipper Inc. in New York.

The Standard & Poor’s 500 stock index climbed 12.56% during the same period, while the Dow Jones Industrial Average rose 10.70%.

That’s a different picture from 2002, when the average hedge fund lost 3.43%, far less than the 20.4% drop posted by the average stock mutual fund. The S&P 500 and Dow Jones Industrial Average fell 22.19% and 16.76%, respectively, last year.

“But for the economic changes, I’m not sure that the concerns about conflicts would have inspired [fund companies] to get out of the hedge fund business,” says Kathryn McGrath, a partner at law firm Crowell & Moring LLP in Washington.

To be sure, some fund companies are still interested in hedge funds.

New York’s BlackRock Inc. bolstered its hedge fund business in May by acquiring HPB Management LLC, a fund-of-funds manager also based in New York.

The acquisition follows BlackRock’s purchase last year of Cyllenius Capital Management, an all-cap-growth stock hedge fund manager in Boston.

“It sort of sends a smile to my face, one that says companies haven’t figured it out as well as we have,” says John V. Murphy, chief executive of OppenheimerFunds, which oversees $8 billion in hedge fund assets. “It looks like it was a move made out weakness rather than strength.”

Mr. Murphy, whose parent company paid $140 million in 2001 for Tremont Advisers Inc., a fund-of-hedge-funds firm in Rye, N.Y., says the marriage of mutual funds to hedge funds continues to make sense. This year, Oppenheimer expects hedge fund assets to rise by 33%, mostly on new sales, he says.

“The use of hedge funds will continue to grow,” Mr. Murphy says.