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Aziz Nahas is a student of failure.

In 2006, following the collapse of hedge fund Amaranth Advisors, which lost an eye-popping $6 billion in less than two weeks late that summer betting on natural gas, Nahas, who was working at a rival firm, interviewed former Amaranth employees to find out what had gone wrong. Two years later, Nahas — by then managing his own fund, 1798 Fundamental Strategies — experienced investment adversity firsthand when markets went into free fall after the September 2008 bankruptcy filing by Lehman Brothers Holdings. To Nahas’s horror, his equity-focused multistrategy fund plunged in value as the global credit contagion worsened.

“I lived through 2008 as the toughest and most challenging year of my professional life,” says the Moroccan-born Nahas, 39, who in his previous 14 years of trading never had a down year.

Nahas was worried that his dream of running his own hedge fund, something he had been meticulously planning for years, was in jeopardy. But what bothered him the most was that he felt he had let down the people who had trusted his ability to preserve capital.

Swiss private bank Lombard Odier Darier Hentsch & Cie. staked Nahas in 2007 to launch his hedge fund business, now part of Lombard Odier Investment Managers. Although the majority of Nahas’s 60-person team is based in New York, he spends most of his time working out of the bank’s staid Geneva headquarters. During the crisis he spoke daily with Hubert Keller, CEO of LOIM, whose parent firm had avoided the problems that befell many other European financial institutions at the time. The conservative Swiss bank stood by Nahas and Keller, even extending them capital to pay staff and hire more talent.

“If I had partnered with the usual European seeders, my fund would have ended in November 2008,” says a grateful Nahas, who as CIO of LOIM runs the 1798 Fundamental Strategies Fund.

The fund — named after the year the original partners of Lombard Odier established the bank — might not have lived up to its manager’s own high standards, but it came through 2008 remarkably well. The fund fell 15.9 percent, outperforming the typical hedge fund, which lost 19 percent that year, according to Chicago-based Hedge Fund Research, and trouncing the Standard & Poor’s 500 index, which plummeted 37 percent. In addition, because the fund uses only moderate leverage and has a small and stable investor base, strong agreements with counterparties and highly liquid positions, Nahas didn’t face the steep margin calls and redemption requests that led many of his competitors to anger investors by blocking redemptions or moving illiquid assets into so-called side pockets to be accounted for separately. Such foresight left him well positioned to bounce back in 2009, a year that saw his fund return 50.31 percent.

During the financial crisis, the hedge fund industry teetered on precarious ground — assets declined precipitously, funds seemed to be closing almost daily, and scandal stalked the business. Now, two years later, the industry isn’t just in good shape, it is positively booming. At the start of 2011, hedge funds were managing nearly $2 trillion in assets. Pension funds and other institutional investors — still feeling the effects of the market meltdown and desperate for the downside protection that hedge funds can offer — have been plowing money into many of the largest managers. But in their haste, these investors may not only be missing the opportunity of a lifetime, they might be taking on unnecessary risk and forfeiting returns.

Nahas is one of a new generation of managers who represent the best hope for a healthy and profitable future hedge fund industry. ?They have learned not just from the economic collapse but also from the bubble that preceded it. ?They are younger, hungrier and, for the most part, smaller than many of their more established hedge fund peers. These emerging stars talk about the importance of financial stewardship and actually mean it. ?They are acutely aware of their responsibilities to their investors, as well as their obligations to build a strong, sustainable business. ?They want to do it the right way, focusing on counterparty relationships and risk management. They are not as much interested in the trappings of wealth — the fast cars, society functions, glamorous friends — that defined the previous generation of managers. Theirs is a newfound seriousness that comes from having seen how easily, and quickly, success can be taken away.

Craig Perry and Erez Kalir hired a sports psychologist when they started Sabretooth Capital Management in the spring of 2009 to keep them intellectually honest — making sure they would be willing to disagree, change their minds and admit mistakes. Boaz ?Weinstein, one of the pioneers of the credit derivatives market, founded Saba Capital Management at around the same time. As co-head of global credit at Deutsche Bank, he managed a proprietary trading fund that had made billions of dollars for the bank before losing $1.8 billion in the last quarter of 2008, when the credit markets seized up. Gregory Lippmann — who launched LibreMax Capital late last year — was previously head of the Deutsche’s nonagency residential mortgage-backed and asset-backed securities trading and became famous by shorting the subprime mortgage market.

Then there are the quants, managers who use mathematical and scientific techniques to build computer models to exploit price anomalies in liquid markets. Last November, Mark Carhart, a former co-head of Goldman Sachs Asset Management’s quantitative investments, began trading partners’ money for his new hedge fund, New ?York–based Kepos Capital. A few blocks north of Kepos’s Midtown headquarters, Peter Muller is working out of Morgan Stanley’s offices to start his own firm. Muller, the longtime head of Morgan Stanley’s Process Driven Trading quantitative group, and his 60-person team are part of the exodus of investment talent from Wall Street in the wake of regulatory reform.

The Volcker rule, named after former Federal Reserve Board chairman Paul Volcker, prohibits U.S. banks from engaging in proprietary trading. As a result, banks have to either spin out or dissolve internal trading units, like PDT, which have often been an incredible source of profits. Outside investors will now have to provide the capital for these former bank traders, a development that is making J. Tomilson Hill very happy.

“Hedge funds have been significant beneficiaries of the Volcker rule,” says Hill, CEO of alternative-investment firm Blackstone Group’s $36 billion hedge fund business. “The brain drain from the banks has accelerated dramatically.” In 2007, Hill’s group launched the $1.1 billion Blackstone Strategic Alliance Fund to partner with new managers, injecting $100 million to $150 million for a minority stake in their businesses. The fund has seeded eight managers, including George (Beau) Taylor, former head of commodities trading at Credit Suisse Group, and Nick Taylor, who had been running an Asian event-driven fund for Citadel (see “Philosophical Difference,” page 60). Blackstone recently raised $2.4 billion for a second Strategic Alliance Fund.

It wasn’t long ago that market pundits were predicting the demise of hedge funds. Some of the industry’s biggest criticism came from within. In November 2008, George Soros, arguably one of the greatest managers of all time, testified before the House of Representatives as part of a hearing on financial markets and regulation. “It has to be recognized that hedge funds were also an integral part of the bubble,” the billionaire Holocaust refugee told Congress. “But the bubble has now burst, and hedge funds will be decimated. I would guess that the amount of money they manage will shrink by between 50 and 75 percent.”

Soros’ prediction turned out to be too dire. Although hedge fund assets fell by nearly a third from their second-quarter 2008 peak of $1.93 trillion, by the end of last year, they were back up to $1.917 trillion, according to HFR. Still, ?Alex Ehrlich, head of Morgan Stanley’s prime brokerage unit, which provides financing and other services for hedge funds, says that it is harder for small firms and start-ups to raise money in today’s market than before the crisis. The main sources of capital — larger pension funds, foundations, endowments and insurance companies in need of both diversification and better investment results — are plowing their cash into the biggest players.

“The largest funds are getting larger,” says Citi managing director Alan Pace, regional head of the bank’s prime finance business for the Americas. Institutional investors favor managers like New York–based Paulson & Co., whose founder, John Paulson, personally made an estimated $3.7 billion in 2007 shorting the subprime market. His firm’s assets have grown from $6.4 billion at the end of 2006 to $32 billion when this year began.

“[W]e are not concerned about our size,” Paulson told investors recently. “Scores of smaller funds have failed or delivered subpar performance.”

But recent research by the New York–based investment management firm Spring Mountain Capital, an early Paulson investor, suggests that size matters an awful lot. “Size has a very significant impact on performance,” says Jason Orchard, a principal with the firm. “Smaller funds have historically produced higher absolute returns and greater alpha than larger funds.” Contrary to what many investors think, he adds, “larger funds are not in fact safer than smaller funds.”? When capital raising stops, and when redemptions start, the negative pressure on an investment portfolio can be even greater at larger funds, producing a more rapid downward spiral.

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