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Hedge fund holdouts

They're suspicious of reported returns, balk at fees and fear a major meltdown. These skeptics must be persuaded of the power of hedge fund investing if the anticipated institutional rush into the sector is to be more than a trickle.

When Robert Maynard hears investors boast about making a killing in hedge funds, he's reminded of gamblers coming back from Las Vegas.

"You only hear about people who have won," says Maynard, 52, chief investment officer of the $8.7 billion Public Employee Retirement System of Idaho. "You don't hear about the people who are supporting the casinos and the big hotels."

Maynard reckons that "the Vegas effect" has inflated the reported returns of the hedge fund industry. And because so many funds operate under a veil of secrecy, he figures the odds of hiring a top-performing manager are not much better than those of beating the house at blackjack. It's no surprise, then, that Maynard, a plainspoken attorney who has been CIO since 1992, has steered Idaho's pension plan clear of hedge funds.

Many of Maynard's peers, however, are putting quite a few chips on the table. The hedge fund industry has close to $1.1 trillion in assets, up from just $39 billion in 1990, according to estimates by Hedge Fund Research in Chicago. Many experts expect the flood of money to continue. TowerGroup, a consulting firm in Needham, Massachusetts, predicts that hedge fund assets will surge to $2 trillion by 2008.

Much of that growth is expected to be driven by institutional investors -- especially pension funds -- as they search for alternative sources of alpha to balance their traditional investments in uncertain equity and fixed-income markets. Hedge funds offer the promise of positive returns regardless of the direction of the market by using a variety of investment tools, including short sales, swaps and leverage.

What's more, adding hedge funds to a portfolio can, so the argument goes, reduce risk by creating a level of diversification well above what investors can get blending only traditional asset classes. The returns of such hedge fund strategies as merger or convertible-bond arbitrage tend to have little correlation with the direction of the overall stock or bond markets. Hedge funds are also far more liquid than other alternative investments, such as private equity or timber.

Hedge fund returns have generally lived up to the hype. For the 12 months ended September 30, 2005, hedge funds returned 13.2 percent, compared with 12.3 percent for the Standard & Poor's 500 index, according to HFR. Hedge funds performed even better over longer periods. For the five years ended September 2005, hedge funds had an average annual return of 6.9 percent; the S&P 500 fell 1.5 percent a year on average.

Still, many institutional investors, like Idaho's Maynard, continue to view the industry with suspicion. They doubt that hedge funds actually deliver the returns reported, and they cite such distinguished economists as Burton Malkiel to help make their case (see box).

The skeptics worry that they don't have the expertise to select good managers and that even if they did, the best funds are closed to new investors anyway. They chafe at the lockups, blanch at the fees and dread a meltdown like Long-Term Capital Management's near collapse in 1998. Many also point to an age-old truth in investing: When capital rushes in, it's usually a sign that returns are about to fall.

"What concerns us most is the compensation structure, the lack of transparency, the amount of money flowing into that segment of the market and the availability of attractive investments," says Bruce Criel, 50, who manages $3.4 billion in pension assets for Sandia Corp. in Albuquerque, New Mexico. Sandia, which is an independent subsidiary of the aerospace giant Lockheed Martin Corp., conducts research on nuclear weapons research for the U.S. government. It declines to invest in hedge funds.

Sandia and Idaho are not lone voices in the wilderness. The list of hedge fund holdouts includes public companies AMR Corp. (the parent of American Airlines), Dow Chemical Co. and IBM Corp.; public employee retirement systems in Oregon and Washington; and retirement plans run by nonprofit groups like the Presbyterian Church. In fact, an October 2004 survey by consulting firm Greenwich Associates found that 68 percent of corporate defined-benefit pension plans with assets greater than $5 billion and 86 percent of all public plans don't invest in hedge funds.

Until recently, most pension fund managers wouldn't even have contemplated investing in hedge funds. For most of their more-than-50-year history, these high-octane investment vehicles were a rich man's game run by larger-than-life managers like George Soros and Julian Robertson Jr. Hedge fund investors tended to be wealthy families, Swiss banks and Wall Street insiders.

Institutional investors didn't start to take notice of hedge funds until the 1980s, when David Swensen stepped onto the playing field. Swensen was hired by Yale University in 1985 to head its investments office. In 1989 he came up with the concept of "absolute return" as an asset class after noticing that several of Yale's portfolio managers were trying to produce positive returns irrespective of the market's performance.

By 1995, 21 percent of Yale's endowment was invested in hedge funds. Other institutions slowly followed Swensen's lead. That year the average institutional investor allocated just 2.2 percent of its assets to absolute-return strategies, according to the Yale endowment's annual report. Those that invested more heavily in hedge funds tended to be endowments at such universities as Stanford and Princeton and private foundations, like the Rockefeller Foundation. By 2004, 48 percent of college endowments were invested in hedge funds.

Institutional interest in hedge funds has picked up since the stock market bubble burst in 2000. "The pressure for finding investment returns is leading institutions to hedge funds," says Kevin Quirk, a principal at Darien, Connecticut­

based consulting firm Casey, Quirk & Associates. In 2001, U.S. institutions accounted for 10 percent of global hedge fund inflows, according to a September 2004 report by the firm. It estimates that this year institutions will kick in about 40 percent of all hedge fund inflows.

Casey, Quirk projects that total U.S. institutional hedge fund assets will grow from $66 billion at the end of 2003 to $300 billion by 2009. That estimate may be low, says Donald Putnam, a managing partner at investment adviser and merchant bank Grail Partners and a former CEO of Putnam Lovell NBF Securities, an investment bank specializing in asset management. Putnam says global pension investments in hedge funds already eclipse $300 billion and could rise to nearly $1 trillion by 2010.

Putnam's target, however, could take significantly longer to reach if hedge funds are unable to persuade refuseniks like Sandia's Criel and Maynard of Idaho to join the party. To achieve that, they need to understand, both philosophically and practically, why these investors are holding out. Here are some of the arguments:

* HEDGE FUNDS ARE TOO BIG NOT TO FAIL. Historically, when too much capital pours into a stock, a sector or an asset class, returns eventually suffer. Many managers themselves agree that too many hedge funds with too much money are chasing the same investment ideas. Today there are about 6,600 single-manager hedge funds, double the 3,300 funds at the start of 2001, according to HFR.

"The asset class is overcrowded," says Christopher Li, 45, president of Diamond Capital Management, a Dow Chemicals subsidiary in Midland, Michigan, that manages the company's $13 billion in defined-benefit-plan assets. "The laws of supply and demand tell you that the return on those assets will not be very high. The alpha is getting crowded away."

Li says that the crush is particularly problematic for the hedge fund strategies of short-selling, where a limited supply of stock exists to borrow, and convertible arbitrage, where an increase in the number of investors narrows spreads.

He should know. Li worked from 1996 to 1999 managing money in New York for Bruce Kovner's Caxton Corp., one of the world's biggest hedge funds, with $11 billion in assets. Li, who was born in Hong Kong and moved to the U.S. to get an MBA from Stanford, began his career at Dow in 1990 as a financial risk manager in Michigan. He says returning to the company was in part a lifestyle decision. While at Caxton, Li would often get up at 3 a.m. to check markets.

The holdouts argue that the sheer number of funds belies the claim that hedge funds have superior managers because of their potential to make gobs of money and to freely pursue any investment strategy they want. "There are more hedge funds than there are stocks in the U.S. -- that's crazy," says Jay Vivian, managing director of IBM Corp. Retirement Funds. "Even if you have smart people chasing assets, it's harder to find inefficiencies. It's got to be harder for hedge funds to make the same returns as before."

Vivian manages $82 billion in defined benefit assets for IBM, the second-largest corporate retirement plan in the U.S. according to pension consulting firm Milliman. Vivian, who has worked for IBM in a variety of financial roles since he got his MBA from Harvard University in 1978, is generally skeptical about the ability of active managers to beat the market. He doesn't invest in hedge funds.

"Hedge funds are like active managers on steroids," says Vivian, who chairs the investment subcommittee at the Committee on Investment of Employee Benefit Assets, an industry group representing about $1 trillion in pension assets. "You have to really believe in active management to add steroids to the mix."

When this year began, Vivian had invested IBM's retirement assets in a traditional mix of 65 percent equities, 32 percent bonds and 3 percent real estate. The majority of its equity investments are indexed. The plan had an average annual return of 5.6 percent for the three years ended December 30, 2004, compared with a 7.0 percent average for the 100 biggest U.S. pension plans, according to Milliman.

* INVESTING IN HEDGE FUNDS ISN'T WORTH THE HIGH PRICE OF ADMISSION. Hedge fund managers have been taking 20 percent of the profits since former journalist Alfred Winslow Jones invented the modern hedge fund in 1949. What most people don't know is that Jones didn't charge a management fee.

Today's managers are much bolder. A typical hedge fund pockets a management fee of 1 to 2 percent of its assets and a performance fee of 20 percent of the investment gains, although some charge much higher fees. James Simons of Renaissance Technologies Corp. charges 5 percent for management and 44 percent of performance. In theory, the hedge fund fee structure is designed to align the interests of managers with their investors, because the higher the return, the more they both profit.

Dow's Li believes fees are stacked against the investor. "The hedge fund structure motivates managers to take more risk," he says. "If there's an upside, the hedge funds take it. If there's a downside, you take it." Li thinks that hedge fund managers should have to pay a penalty when returns go south.

Although he shuns hedge funds, Li targets 15 percent of Dow's portfolio to alternative assets, including private equity and commodities. Of the remaining assets, 50 percent is allocated to equities, 30 percent to bonds and 5 percent to real estate. Dow had an average annual return of 6.6 percent for the three years ended December 2004.

Some holdouts complain that hedge fund fees border on usury. "One hedge fund wanted to charge us fees on the amount invested, including leveraged money," says Robert Maggs Jr., president and CEO of the Board of Pensions of the Presbyterian Church (U.S.A.) in Philadelphia. "It struck me as unconscionable. I could borrow money all day long to make my fees go up."

Maggs, 61, who joined the pension board in 1999 after concluding a 25-year career as a lawyer, doesn't invest in hedge funds; he believes the costs are too high. In running the pension fund, which has $6.5 billion in assets, he must keep a careful eye on expenses. The plan, which serves about 40,000 individuals, mostly clergy and their dependents, receives $67 million in annual contributions and pays annual benefits in excess of $240 million.

Maggs's asset allocation is suitably conservative: The fund had 68 percent in equities, 30 percent in fixed income and 2 percent in cash and other assets at the end of last year. Nonetheless, returns have beaten the fund's target of 5 percent above the rate of inflation. For the three years ended December 31, 2004, the plan had an average annual return of 8.5 percent.

* INVESTING IN HEDGE FUNDS IS LIKE BUYING A CAR WHOSE OWNER WON'T LET YOU LOOK UNDER THE HOOD. For most of their history, hedge funds have operated largely in the shadows. Unlike mutual funds, they aren't required to disclose their portfolio holdings or trading strategies -- and most of them don't.

"I'm not a big believer in the 'trust-me' strategy," says IBM's Vivian. "When we hire managers, we want to know where their inputs come from, how their strategy has been tested, when it might not work, what happens if it doesn't, and how long it will take until we get our money back. This is the exact opposite of the secrecy of the hedge fund world."

That's starting to change, largely because the big institutional investors, like the California Public Employees' Retirement System (CalPERS), that invest in hedge funds are clamoring for greater transparency. A growing number of hedge funds are providing portfolio information to third parties, such as New York­based RiskMetrics Group, which then analyze the data and send risk reports to investors while maintaining the privacy of the hedge funds' strategies and positions. "It's not so much transparency as translucency," says veteran investment banker Putnam. "It's like looking through a bathroom window. You can see shapes but not details."

For the hedge fund holdouts, that view is far too blurry. "Transparency has improved but not quite to the level we feel comfortable with," says William Quinn, 57, president of Fort Worth, Texas­based American Beacon Advisors, a unit of AMR that manages $41 billion in assets, including more than $20 billion in the American Airlines pension plan.

Quinn was assistant treasurer of American Airlines for seven years before taking on his current role in 1986 at what was then called AMR Investments. Acknowledging the turbulence of the airline industry, Quinn says his investment goal is to hit "singles and doubles and avoid striking out." That means no hedge funds. Quinn keeps 40 percent of AMR's pension plan in long-duration bonds, 30 percent in U.S. equities, 20 percent in international stocks and 5 percent in emerging markets. He gets his exposure to alternative assets by allocating 5 percent of the plan to private equity. That strategy proved effective in 2004. AMR's pension assets returned 17.8 percent, the third-best performance among the nation's 100 biggest corporate pension plans, according to Milliman.

* PICKING GOOD HEDGE FUND MANAGERS IS EVEN HARDER THAN PICKING GOOD STOCKS. Most pension funds are daunted by the prospect of choosing among the thousands of hedge funds, the majority of which have been in existence less than three years. Public pension plans in particular don't have the time or staff to comb through hedge fund databases, attend capital introduction events and do whatever else it takes to find managers. They are also the first to admit they don't have the investment expertise to make a truly informed choice.

"The underlying issue is, What is our confidence in our ability to pick a manager with skill?" says Joseph Dear, 54, executive director of the Washington State Investment Board, which manages $49 billion in defined benefit assets. "That's what makes a difference."

For Idaho's Maynard finding a good manager isn't enough when it comes to hedge funds. "I can pick a good manager," says Maynard, an avid hiker and fisherman who worked for the general counsel's office of the U.S. Department of Agriculture in Juneau, Alaska, from 1980 to 1997. "It's much more difficult to pick a great manager. With hedge funds, distinguishing the great from the good is key."

Maynard, who represents exactly one half of Idaho's investment staff, invests about 72 percent of the fund's assets in equities and the rest in bonds. The portfolio delivered a 10.7 percent annual return for the three years ended June 2005.

For pension plans, especially public ones, retaining staffers with hedge fund expertise can be as hard as finding good managers. The top talent is being scooped up by money management firms and hedge funds that can pay multiples of what an analyst or money manager can make working for a public plan.

A recent case in point: CalPERS chief investment officer Mark Anson, who led the pension giant into hedge funds back in 2002. In January he is leaving to become chief executive of Hermes Pension Management, one of the U.K.'s largest money management firms. At CalPERS, Anson's salary and bonus could total $756,000 this year. At Hermes he will receive a base salary of $521,000, plus a bonus that will depend on one- and three-year performance. Last year his predecessor earned $2.3 million.

* FUNDS OF HEDGE FUNDS AREN'T A PANACEA; THEY'RE PART OF THE PROBLEM. Institutional investors lacking the expertise or resources to pick hedge funds often turn to funds of hedge funds, whose staffs are experienced in selecting and monitoring managers, constructing portfolios of funds and monitoring the risk.

The expertise doesn't come cheap. Funds of hedge funds typically charge a 1 percent management fee and 5 to 10 percent of the investment profits. Add that to what the underlying managers charge and fund-of-funds investors could easily be paying a 3 percent management fee and 30 percent performance fee.

"Funds of funds might diversify the risk a bit, but they only make the fee problem worse," says the Presbytarian Church's Maggs, who was elected an elder in his church in Rochester, New York, at the age of 30 and now belongs to the Bryn Mawr Presbyterian Church in Pennsylvania.

The real cost may be far greater. Putnam explains that the gains generated by one manager in a fund of hedge funds may be canceled out by another manager's losses. In that case, the net return would be zero but the fund of hedge funds -- and by extension, the fund-of-funds investor -- still pays a performance fee. "If you play it out, fund-of-funds performance fees are never less than 30 percent and can easily be 60 to 70 percent of gains," says Putnam.

Picking a good fund-of-funds manager is challenging in its own right. Today there are an estimated 1,950 funds of hedge funds, up from 540 at the start of 2001, according to HFR. Funds of hedge funds represent 36 percent of all hedge funds assets. Putnam believes that their growth has peaked and that their popularity will wane as institutions turn instead to multistrategy funds for diversification and greater transparency with a single layer of fees.

* THE HEDGE FUND PLAYING FIELD IS UNFAIRLY TILTED IN FAVOR OF THE MANAGERS. Essentially, hedge funds are free to invest in anything anywhere to generate absolute returns. Hedge fund investors, however, find their hands tied when they want to take their money out. Many hedge funds impose lockups, gates (limits on the percentage of assets an investor can withdraw on a given date) and penalties for early withdrawal.

Says Washington's Dear: "We looked at hedge funds in 2002 and saw a lack of constraints, a lack of transparency and very high fees. We decided that it was not the right time to consider hedge fund investing. As of today, nothing has really changed."

Although Dear avoids hedge funds, he is a strong advocate of other alternative assets. He invests 14.6 percent of Washington's retirement plan in private equity. The rest is split among U.S. equity (32.8 percent), international equity (16.3 percent), fixed income (26 percent), real estate (9.3 percent) and cash (1 percent).

That mix has worked. The Washington plan returned 13.3 percent for the 12 months ended June 30, compared with a 9.9 percent average return for public funds with assets greater than $1 billion, according to Wilshire Associates.

* THE ODDS OF INVESTING IN THE NEXT LTCM ARE GREATER THAN MAY BE APPARENT. The holdouts say that one of the principal reasons they don't invest in hedge funds is to avoid disaster. They're not talking hedge fund fraud. They can shrug off a small-scale blowup like the recent unraveling of Bayou Management. What many investors fear is a collapse of the magnitude of LTCM -- the meltdown, set off by Russia's sudden default on its debt, that briefly threatened the global financial system.

"Who knew when Russia defaulted that LTCM would get the big hit?" asks Washington's Dear. "It's the unforeseen chain of events that we worry about."

Ronald Schmitz, director of investments at the Oregon Public Employees' Retirement System, is convinced that such a blowup is coming.

"We want to sit and watch what type of carnage comes out," says Schmitz, 52, who worked at the Illinois State Board of Investment before moving to Oregon at the beginning of 2003. "Then we can pick up the pieces and make some money."

Schmitz has done pretty well without investing in hedge funds. The Oregon plan had an average annual return of 11.4 percent for the three years ended June 30, compared with 9.7 percent for the median Wilshire state pension plan. Schmitz allocated its assets among international and U.S. stocks (58 percent), bonds (27 percent), private equity and other alternative assets (9 percent) and real estate (6 percent).

Sandia's Criel is equally spooked by the specter of an LTCM-like disaster. "Risk is always high on everyone's mind here," says Criel, who has been managing money for the company for more than 22 years.

Sandia, whose roots go back to the Manhattan Project during World War II, would rather play it safe. Criel invests 73 percent of its pension assets in equities -- half of which are indexed -- and the remainder in bonds. That produced a 7.3 percent average annual return for the three years ended December 2004, slightly better than the 7 percent average annual return posted by plans in the Milliman universe.

Hedge fund proponents, however, predict that many holdouts like Sandia will eventually drop their objections. "If we see another bear market, more institutions will invest in hedge funds for protection," says George Van, CEO of George Van & Co., a hedge fund marketer in Nashville. A bear market may be the true test.

A not-so-random skeptic

Princeton University economist Burton Malkiel famously quipped that a blindfolded chimpanzee throwing darts at the financial pages could pick stocks as well as M expert. Now he's aiming his own darts at a new target.

"Hedge funds aren't as good as they're cracked up to be," says Malkiel, 73. "Over the long haul, hedge funds are not better than equities, and they're extremely expensive."

Malkiel makes a powerful case for that judgment in "Hedge Funds: Risk and Return," a paper he co-authored with Atanu Saha, a managing principal with the AnalMysis Group of New York. It appears in the November/December issue of the Financial Analysts Journal.

A professor at Princeton for the past 41 years and author of the 1973 investment classic A Random Walk Down Wall Street, Malkiel is one of the most respected figures in modern finance. "He's built his career on careful, empirical analysis," says William Goetzmann, a professor of finance and management at Yale University. "When he does work in something, it's never to be taken lightly."

Malkiel's central charge, which no hedge fund manager takes lightly: The leading hedge fund indexes, compiled by CSFB/Tremont, Van Hedge Fund Advisors International and Hedge Fund Research, are upwardly biased by an average of more than 300 basis points. He also challenges the argument that there is only a slight degree of correlation between hedge funds and the Standard & Poor's 500 index. He concludes that there is no persistence in performance among top managers -- that is, no statistical evidence that above-average performers tend to be above average from one year to the next.

Not surprisingly, hedge fund data providers dismiss these conclusions. "Malkiel's study is a nonevent," says George Van, former chairman of Van Hedge Fund Advisors, which was acquired by Muirhead Holdings, a private equity firm, in November.

The dispute centers on the extent to which the data providers have corrected for two main types of distortion. The first is "backfill bias," which occurs when managers set up a hedge fund but begin reporting results only at a later date and if the numbers are favorable. The second is "survivorship bias," which occurs because unsuccessful funds close, leaving only successful funds in the index.

Lots of losers fall by the wayside, Malkiel finds. Among a group of 331 hedge funds that he tracked in 1996, fewer than 25 percent were still reporting

results in 2004. What's more, failing funds sometimes do not report losses in their last months. Goetzmann, however, defends the database providers. "I don't think that data from the past ten years of performance is grossly misleading," he says.

What about funds of hedge funds, the favored vehicle for many investors? Malkiel concedes that they offer diversification and show less volatility than single-manager funds. But he argues that their fees are prohibitive. "The problem is that hedge funds might charge 2 and 20 and the fund of funds charges an additional 1 and 10," Malkiel says. "And then there's really nothing left." -- S.B.