Hedge funds go crazy from heated demand

The hedge fund industry had another banner year in 2001, and according to the latest research, investor appetite at all levels is close to outstripping supply.

From endowments and foundations to corporate treasury departments to individual investors fitting into a redefined mass-affluent market, hedge funds are being viewed as the surest alternative to stagnation in the broad equity markets.

“The new capital moving into hedge funds right now is largely coming from traditionally managed assets,” says Charles Gradante, president and CEO of Hennessee Hedge Fund Advisory Group LLC, a New York hedge fund consulting company.

plans for buying

“The money is being moved from one pocket to another,” he adds. “It’s not really a bubble happening here,” as some critics of the industry have charged.

According to Hennessee’s survey of investors and asset managers, 54% said they planned to increase their hedge fund allocation in the coming year.

While total hedge fund assets grew by 38% last year, according to Hennessee, the increase is broken down to 31% new capital and 7% performance gains.

caution advised

For some in the financial services industry, the flood of new money, which has pumped the industry to beyond $560 billion, is all the more reason to be cautious.

Robert Levitt, president of Levitt Capital Management LLC in Boca Raton, Fla., says hedge funds have become so hot that the emphasis has shifted from managing portfolios to asset gathering.

“When the hedge funds start marketing to me, I start to look more cautiously at the construction of their portfolios,” says Mr. Levitt, whose firm manages $170 million. “There are so many funds out there with an emphasis on gathering assets, yet the more experienced hedge funds are all closing to new investors.”

Mr. Levitt points specifically to the increased use of funds of hedge funds as vehicles committed primarily to gathering assets.

The risk, he says, is that the fund of funds will have to turn to less experienced hedge funds to meet the growing demand.

According to Hennessee’s research, total hedge fund assets have increased by 480%, from $97 billion at the end of 1996, while the number of hedge funds has more than doubled to 5,500 during the same period.

As the overall pie has gotten larger, only corporations and funds of funds have increased their shares of the assets.

Individual investors currently represent 48% of hedge fund assets but were responsible for 62% of the pie in 1996.

Corporate treasury portfolios, which made up 5% of all hedge fund assets in 1996, have grown to 15%. And funds of funds, over the same period, have increased to 20%, from 16%.

Endowments and foundations have remained steady at about 7%, and retirement assets have kept level at about 9% of the total asset pool.

James Hedges, a fund-of-funds operator and president of LJH Global Investments LLC in Naples, Fla., says that as hedge funds increasingly become “part and parcel to core portfolio allocations,” funds of funds will become the primary vehicle for gaining access to the market.

“There are so many funds and so many strategies that it’s impossible for a layperson to do the kind of due diligence necessary,” he says.

Mr. Hedges adds that as the fund-of-funds industry grows a projected 30% to 35% over the next five years, industry leaders will emerge, and the smaller firms will become less significant.

In the meantime, financial advisers may be left scrambling to separate the wheat from the chaff.

“The problem with hedge funds is the due diligence,” says Harold Evensky, managing principal of Evensky Brown & Katz, a Coral Gables, Fla., company that oversees about $350 million.

“Particularly when it comes to funds of funds, there are a lot of moving parts, and the information is not very good,” he adds. “If I knew we could get what they say they had returned in the past, we’d be in them yesterday.”

While Mr. Evensky acknowledges that he believes hedge funds “make sense,” he says his clients are not pushing him in that direction.

Still, it is difficult to ignore the performance numbers in comparison with the broad equity markets.

The Hennessee Hedge Fund Index – equally weighted and including about 10% of all hedge funds, representing 40% of all capital – has outperformed the Standard & Poor’s 500 stock index for three years running.

The Hennessee index was soundly beaten by the S&P in 1998, when hedge funds gained 1.8%, and the stock index gained 28.6%. The S&P also had outperformed the hedge funds index in 1997, 33.4% to 15.6%, respectively.

defensive

Mr. Gradante says hedge funds are becoming the defensive play of choice, particularly among institutions with fiduciary responsibilities.

“The last few years have been terrible for traditional money managers,” he says. “And endowments, foundations and pension plans can’t afford to have a 17% down year.”

But for the mass-affluent market, there still may be many reasons to sit cautiously on the sidelines.

“The forbidden fruit is always going to be more attractive,” says Burton Greenwald, a Philadelphia financial services consultant. “When it comes to hedge funds, the lack of such things as transparency and independent performance reporting and regulatory oversight should be a huge blinking red light that gets your attention.

“People know the stock market has been a lousy place to be over the past few years. But in the world of hedge funds, you’re operating in a world of hearsay. Bottom line is, you should only go into hedge funds if you’re prepared to lose 100% of your investment.”