Brokerages, banks and mutual fund companies are all climbing on the hedge fund bandwagon. Their goal: to offer the once-exclusive funds to - gasp! - retail customers.
By Hal Lux
December 2001
Institutional Investor Magazine
John Murphy was just about to cross Broadway on his way to work at the World Trade Center on September 11 when the first hijacked plane plowed into Tower One. For the OppenheimerFunds CEO, the horror was particularly vivid: 598 of his employees worked in the complex.
Miraculously, none were lost, and by the next day 50 were hard at work in the Rye, New York, offices of a small money management operation called Tremont Advisers. The loan of office space wasn’t merely a generous gesture: Oppenheimer had reached an agreement to purchase Tremont in July. Although the attacks caused executives at companies in New York and all over the country to reconsider plans, they only redoubled Murphy’s commitment to closing the deal. So on October 1, Oppenheimer, which manages more than $120 billion in mutual fund assets, bought Tremont, a 76-person operation that manages just $1.5 billion in proprietary funds, for $140 million.
What made the small suburban firm so attractive to a giant like Oppenheimer? Tremont structures funds that invest in collections of hedge funds, and no segment of the money management business is hotter right now. Murphy believes that funds-of-hedge-funds are the mutual fund industry’s next big-ticket item. Currently, analysts estimate that such funds-of-funds manage about $100 billion. “I think this market could grow to $500 billion,” says Murphy. “In the near term it’s going to grow faster than the mutual fund business.”
Murphy is not alone in his thinking. A growing number of mass-market financial institutions are pushing into the clubby world of hedge fund investments. In October 2000 Bank of New York Co. bought fund-of-funds operation Ivy Asset Management Corp. Unit investment trust giant John Nuveen Co. acquired alternative-investment operation Symphony Asset Management in July. Mellon Financial Corp. in October bought 15 percent of Optima Fund Management, the fund-of-funds operation run by hedge fund veteran and socialite D. Dixon Boardman. And Charles Schwab & Co. is expected to announce a hedge fund program that will be run with the assistance of an undisclosed hedge fund consulting firm.
And more deals are in the works. Says David Lamere, president of Mellon Private Asset Management, “I think you’re seeing just the beginning of this trend.”
With minimum investments of $1 million or more, hedge funds have long been the province of the very wealthy. In recent years a number of hedge funds have taken in institutional investors, like pension funds and endowments, in part to stabilize their capital: Institutional money tends to be less skittish and more focused on the long term than private money.
The mainstream money managers that are moving into this area won’t be marketing direct investments in high-flying hedge funds to mom-and-pop investors. Rather, they will peddle stakes in funds-of-funds, under the investment banner of diversification.
Still, this new wave of retail interest is likely to take hedge fund investing a bit down-market. Schwab, for example, plans to offer its funds-of-funds to investors with as little as $1.5 million in net worth - pretty low rent by hedge fund standards. “We always used to talk about a million-dollar minimum to invest and $10 million to $20 million in net worth for hedge funds - and sometimes $400 million,” says Optima’s Boardman. Mellon clients will be able to invest in Boardman’s funds with an initial investment of as little as $250,000.
Certainly, the money management business could use a hot new product. After a decade of astonishing growth, the $6.6 trillion mutual fund industry is in a serious slump. Thanks to the collapse of equity prices, inflows to stock funds have plunged, from $273.5 billion in the first nine months of 2000 to $13.5 billion this year. Managed accounts, the most popular high-net-worth product in recent years, have also experienced a letdown: New accounts slowed and assets under management dropped by 8.6 percent between the second and third quarters of this year, according to the Money Management Institute. If the bear market drags on, investors are expected to continue switching from high-margin equity mutual funds to less profitable fixed-income offerings.
“It’s a tough market for fund companies selling high-fee products,” sums up Jack Brennan, CEO of Vanguard Group.
Hedge funds seemingly have a far better story to tell. Through September of this year, the CSFB/Tremont hedge fund index, which measures the performance of 2,600 hedge funds, was up 2.2 percent, compared with a decline of 21.2 percent for the Standard & Poor’s 500 index. Hedge funds also offer investors the promise of noncorrelated returns that don’t move in lockstep with the overall market; this dramatically increases their risk-adjusted value to an overall investment portfolio.
Hedge funds are hardly a new concept. Conceived in 1949 by sociologist and former Fortune magazine reporter A.W. Jones, they’ve had a history of booms and busts. Macro funds, like those pioneered by George Soros, came into vogue during the late 1980s, making leveraged bets on the world’s assorted stocks, bonds and currencies. But many of those wagers went bad during the 1994 global bond swoon. The hedge fund business quickly rebounded and enjoyed several more years of success, until the even bigger bond debacle of 1998, in which the near collapse of Long-Term Capital Management almost took down the entire global financial system.
Three years later hedge funds are proliferating as never before. Today there are more than 6,000 of them, overseeing $500 billion in assets, according to Van Hedge Fund Advisors International. That’s up from 2,000 with $67 billion under management a decade ago. Hedge funds have become the leading edge of active money management, appealing even to such sophisticated institutional investors as the California Public Employees’ Retirement System, which plans to invest $1 billion in the asset class.
Combining the distribution capabilities of big fund companies with the expertise of hedge fund veterans is likely to give the business another boost, markedly increasing sales of these products. “In the market we’ve had, hedge funds look like the best thing out there,” says Tremont chairwoman Sandra Manzke, who thinks boutiques will be hard-pressed in the future to compete with major financial institutions. “Oppenheimer has a huge distribution force, and those people need something to sell.”
All this could mean handsome returns for the mutual fund companies. Even by the high standards of the money management business, retail hedge funds are a lucrative business. “Margins are four to five times as high in hedge funds as in mutual funds,” says one fund-of-funds manager.
Consider the fees. UBS PaineWebber, a pioneer in this area, has created 15 funds-of-funds, with $3 billion invested in hedge funds and private equity, since 1998. Its most recent hedge fund offering charges an annual management fee of 1.25 percent of assets plus a performance fee of 5 percent of profits. On top of that the individual hedge fund managers take a 1 to 2 percent annual management fee and a 15 to 20 percent performance fee. OppenheimerFunds will charge an even higher 1.95 percent asset fee and 10 percent of profits. A stock mutual fund, by contrast, charges 1.6 percent of assets. “The hedge fund business is all about net returns,” says PaineWebber alternative- investments group co-head Mitchell Tanzman. “Ultimately, we will need to produce returns net of our fee structure. Some of the best-performing funds charge the most expensive fees.”
To be sure, not all mainstream money managers see hedge funds as a panacea. Fidelity Investments, Vanguard and T. Rowe Price Associates have no plans to sell hedge funds, according to firm officials. And large firms getting into the business stress that these alternative investments will remain an ancillary product, designed for only a small percentage of customer assets.
Still, even moving a small percentage of traditional money management assets into hedge funds could threaten to overwhelm what has long thrived as a niche business. Already, hedge fund managers with relatively unimpressive or short performance records are building large funds. And a number of major institutional investors are beginning to make their first hedge fund investments, ensuring that demand will soon overwhelm supply and performance will fall sharply. “Some investors will do spectacularly,” says Morningstar funds analyst Scott Cooley. “But I think you’ll end up with a lot of high-priced, mediocre funds.”
Keeping the talent happy won’t be easy, either. One month after Oppenheimer closed on Tremont, the hedge fund specialist’s top London-based executive, Nicola Meaden, defected to Blackstone Alternative Asset Management (see People).
Nevertheless, some new entrants to the business say that the connections and expertise of hedge funds specialists are worth the acquisition costs and risks they entail. “It would have been a very difficult process to get into this business by ourselves,” says Bank of New York senior executive vice president Newton Merrill, who notes that Ivy’s $2.5 billion in assets have doubled since the bank acquired the hedge fund consultant a year ago. “It’s been a great partnership for us.”
The greatest risk to big institutions wading into the hedge fund market may be that they could end up getting entangled in one of the periodic scandals that seem to plague the industry. Hedge funds still tend to be small organizations dominated by one personality, subject to little scrutiny or disclosure and operating with little back-office infrastructure. “You cannot get away from these facts in the hedge fund industry,” says another fund-of-funds manager. “You will have cases where back offices will turn out not to exist.”
But in a bear market, the returns appear to outweigh the risks - for now. “The idea of just selling people a mutual fund that only invests long is not working now,” says one hedge fund executive. “Traditional firms want other products to put in front of their high-net-worth investors.”
The mutual fund business has experienced sustained growth partly because it has served a truly useful purpose, moving retail investors into diversified, higher-return stock portfolios. Do high-net-worth investors really need to be in convertible bond arbitrage?
Modern portfolio theory doesn’t discriminate. Millionaires investing in hedge funds receive the same theoretical benefits as billionaires - in particular, uncorrelated returns that don’t just swing with the overall direction of the stock market. But regulations and practical considerations may still end up reducing the benefits of hedge fund investing for less wealthy individuals.
Funds-of-funds would be much more valuable to investors if they were cheaper, but ironically, regulations meant to protect smaller investors are likely to keep fees high. Investors with only a few hundred thousand dollars to plunk down cannot invest directly in hedge funds. Nor can they obtain the benefits of hedge fund-like strategies from cheaper mutual funds, because Investment Company Act regulations restricting leverage make it difficult for mutual fund companies to offer trading strategies like convertible bond arbitrage within a traditional mutual fund vehicle. These regulations, designed to protect investors, also end up giving privately placed funds-of-funds a virtual monopoly on the retail hedge fund business.
Even some hedge fund advocates worry that high expenses in these funds-of-funds will eventually turn off investors. “The structure doesn’t work,” says an executive of one big hedge fund. “Either funds-of-funds take it out of the manager’s hide, in which case you end up with bad managers, or you charge investors so much that they’re only happy when the managers produce 100 percent returns.”
Still, managers say high fees are better than low returns. “There are fees on top of fees,” admits Tremont’s Manzke. “But I think they will be very well earned.” Then again, she would.
