This content is from: Home

Who wants to be a billionaire?

That's the loaded question Wall Street is asking hedge funds as it avidly courts their business. Profits are huge, but so are the risks. Is this the next new thing?

That's the loaded question Wall Street is asking hedge funds as it avidly courts their business. Profits are huge, but so are the risks. Is this the next new thing?

By Hal Lux
June 2002
Institutional Investor Magazine

Morgan Stanley & Co. kicked off its invitation-only hedge fund conference in January with a dinner at the Breakers Hotel in Palm Beach. As the plates were being cleared, the 150 or so guests - a who's who of investors in the secretive hedge fund world - awaited a presentation on stocks by the firm's stock market strategist, Byron Wien.

Suddenly, the lights went out, and two Morgan Stanley hedge fund marketers appeared on giant television screens. The comely pair - both men - sported blunt-cut blond wigs and cheerleader outfits with pleated skirts. Giving a new twist to the term "bulge bracket," this peculiar pep squad launched into an arm-waving cheer: "Chilton, Chilton, he's our man, if he can't short it, no one can."

These days plenty of investment banks are all too happy to shake their booty for Richard Chilton or, for that matter, any of his competitors. After all, the hedge fund veteran runs Stamford, Connecticut-based Chilton Investment Co. With $5 billion in assets, it ranks as the 13th-biggest hedge fund in the world (see the Hedge Fund 100, page 43). That alone assures him of Wall Street's ardent affection: He's a prized Morgan Stanley client.

Wall Street has been doing business with hedge funds for years, providing a wide array of services that range from the financing, stock lending and clearing that have long been the core of what's known as prime brokerage to equity research, complicated derivatives structures and balance transactions that allow funds to pare taxes. Increasingly, banks are helping hedge funds raise capital as well, directing wealthy individual clients their way, or, more recently, through so-called capital introduction activities steering institutions like pension funds, endowments and foundations into this rapidly expanding investing corner. "The largest hedge funds are very sophisticated," says Art Mbanefo, head of the prime brokerage and equity finance unit of Credit Suisse First Boston. "They touch everything in an investment bank."

The competition to provide these services has never been more fierce or the stakes higher. With Wall Street's traditional moneymaking activities all but moribund - revenues from underwriting, advisory work and brokerage have dried up - rapidly proliferating hedge funds represent one of the few big growth businesses around. And they are notoriously generous as customers; unlike mutual fund complexes that demand deep discounts, hedge funds, eager for any leg up they can get, happily pay full freight.

At last count more than 6,000 hedge funds around the globe were managing $600 billion in assets, according to hedge fund consulting firm Van Hedge Fund Advisors International. That's up dramatically from 2,000 funds with $67 billion under management a decade ago. Goldman, Sachs & Co. calculates that hedge fund assets will swell a further 26 percent this year.

"The hedge fund business now is where the boutique money managers were in the 1970s, when institutions began to move assets away from bank trust departments," says Michael Litt, a partner at Greenwich, Connecticut-based hedge fund management company FrontPoint Partners.

For managers of hedge funds, the rewards can be breathtaking, even by Wall Street's jaded standards (see story, page 33). Thanks to the typical "rake-in" of 20 percent of all investment profits (and sometimes even sweeter deals), some top hedge fund managers have been earning hundreds of millions of dollars each year, despite the dispirited U.S. stock market.

The business is equally lucrative for Wall Street. With their appetite for leverage and their typically frenetic trading styles, hedge funds can generate more than $10 million in annual investment banking revenue just in basic brokerage and financing services for every billion dollars that the funds have under management. "There are hedge funds that do 40,000 trades a day," beams John Dyment, Deutsche Bank's hedge fund fundraising chief.

The numbers add up in a hurry. Goldman Sachs and Morgan Stanley, two firms dueling it out with longtime leader Bear, Stearns & Co. to be the leading brokerage to hedge funds, are each estimated to generate at least $600 million in hedge-fund-related revenue annually.

"It's difficult to say exactly how much investment banks earn from hedge funds," says Sanford C. Bernstein & Co. financial services analyst Brad Hintz. "The one thing you can safely say is that the number is huge."

Andrew Dabinett, managing director for hedge fund services at UBS Warburg, suggests that the banks are finding that "major hedge funds can be as important to them as mutual fund companies."

Naturally, the banks have been competing vigorously to provide hedge fund services. But the rivalry is intensifying and expanding in scope.

"Two years ago I would have heard from only Morgan Stanley, and only once a quarter," says Mark Yusko, endowment chief for the University of North Carolina, a major hedge fund investor. "Last year I would have heard from Morgan and Goldman once a month. This morning I got e-mails from Morgan, Goldman, Bear Stearns and ABN Amro."

Considering the stakes, this may turn out to be Wall Street's most momentous battle for new business this decade. Just as investment banks chased leveraged buyout artists in the 1980s and Internet entrepreneurs in the 1990s, they now pursue hedge fund managers. "Every major financial institution is going to try to get into the hedge fund business," says John O'Connor, head of alternative investments at J.P. Morgan Partners.

"Morgan is going after Goldman," says a senior Wall Street hedge fund executive, "and Goldman is going after Morgan. Deutsche Bank is going after both of them. And everyone is going after Bear Stearns."

Firms are doing backflips to cater to hedge funds. Goldman Sachs runs a call-in service for traveling hedge fund marketers who want to hook up quickly with prospective investors in any city in the world. Morgan Stanley preps nervous new hedge fund managers for their first meetings with clients in mock Q&A sessions called "friendly fire." Last month J.P. Morgan Chase & Co. hosted a talk by hedge fund wunderkind Ken Griffin, who runs Citadel Investment Group, to the new networking group 100 Women in Hedge Funds.

Aggressive tactics abound. Firms are raiding each other for talented marketers, and rumors of price cutting are rampant. In April UBS Warburg grabbed Joseph Pescatore, the head of U.S. hedge fund fundraising at Lehman Brothers; in turn, Lehman lured away Laurie Stearn, the chief of fundraising for U.S. hedge funds at Bear Stearns. Also in April CSFB snatched up Rod Barker, a 14-year Morgan Stanley veteran, to head up sales for its European hedge fund services.

Giving new meaning to the phrase "priming the pump," investment banks have begun seeding start-up hedge funds, which then typically become clients of their brokerage services. In November Bear Stearns invested in Chicago-based BRI Partners, a hedge fund incubator that provides capital to new hedge funds. CSFB formed a unit last month that expects to help launch 12 hedge funds this year. Says Mbanefo, "We want prime brokerage to be a flagship business."

The banks envision a panoply of other hedge fund services, from M&A to underwriting. Last month J.P. Morgan Chase completed a $550 million securitization of assets for Glenwood Capital, a fund-of-hedge-funds, and CSFB priced a similar $250 million deal for Bahrain-based Investcorp.

In this fee-for-all, backbiting is commonplace. Deutsche Bank has made big inroads into the business using novel applications of structured products and derivatives to provide leverage for big hedge fund organizations. This rankles rivals because it can make traditional lending seem expensive.

"Some firms are now doing prime brokerage on the back of writing derivatives contracts," says Bear Stearns Securities Corp. president Richard Lindsey. "There are a few clients asking for rates on traditional prime brokerage to match derivatives-based financing. I think it's a risky business that will have problems at some point."

Counters Deutsche's Dyment: "Our competitors would like people to believe that because we've done very well. No prime broker is more conservative than Deutsche Bank. We're a bank, after all, and have to have a rigorous credit review process."

No matter who is right, some observers worry that this hedge fund frenzy carries risks for investors and for the wider market. Investment banks make money on the sheer volume of trading done by hedge funds, not on their performance. This gives banks tremendous incentive to hype hedge fund managers and employ any fundraising tactic. One concern: new programs in which banks guarantee the investment principal of investors in certain funds-of-hedge-funds (see box).

Others worry that in their efforts to please hedge funds Wall Street may once again lose its ethical compass. In January CSFB agreed to pay $100 million in fines to the Securities and Exchange Commission and NASD Regulation, for distributing shares in hot IPOs to customers, mostly hedge funds, in return for inflated commissions. There have been other allegations that investment banks used hedge funds to push up the price of hot IPOs in a strategy dubbed laddering.

Some observers are simply concerned that all the competition may end up hurting the business. Exact numbers are hard to come by, but some Wall Street executives say fees on hedge-fund-related services - from stock lending to balance sheet leverage - though still very profitable have fallen by as much as 30 percent over the past year. Says Henry McVey, a financial services industry analyst at Morgan Stanley: "The competition between banks appears to be creating significant pressure on margins in this business."

Investment banks have long provided prime brokerage services to hedge funds. But the latest efforts to cultivate relationships with the funds have escalated well beyond that.

Morgan Stanley runs dozens of road shows each quarter for hedge fund start-ups. Goldman Sachs employs 20 professionals who do nothing but introduce prospective investors - funds-of-hedge-funds, foundations, private clients and, increasingly, pension funds - to hedge fund managers. Deutsche booked 25 hotel rooms for important hedge fund clients at the Winter Olympics in Salt Lake City.

Trying to ice deals in its own way, Goldman Sachs held its annual European hedge fund conference on the Lido in Venice. ABN Amro hosts a private Internet chat room where hedge fund managers can talk shop and share their concerns with fellow managers. And to show how seriously it's committed to the hedge fund industry, Lehman has taken to passing out copies of a three-part University of Massachusetts study that it partly underwrote on hedge fund investing practices.

Wall Street's whirlwind courtship of hedge funds signifies a shift in the firms' relationship to that industry. Just in the past year, all major investment banks have begun to compete aggressively for brokerage business by promising to help fledgling and established hedge funds raise assets. Morgan Stanley pioneered this practice, known as capital introduction, five years ago.

"The capital introduction process has clearly become much more of a formalized and systematic effort for the investment banks," says Averell Mortimer, founder of pioneering hedge-fund-of-funds Arden Asset Management. "It has become a very significant part of the hedge fund business."

Observing the battle from the trenches, Bear Stearns' Lindsey relates this typical story: "I recently heard about a hedge fund dinner that another bank was holding. Half of the hedge funds speaking were Bear Stearns clients."

Many hedge funds parcel out their brokerage business expressly with an eye to which investment banks can help them bring in the most - and the most stable - assets. "The way hedge fund managers get rich is by earning performance fees," points out the head of one Wall Street hedge fund capital introduction group. "The way to earn big fees is to run a lot of money. It's pretty straightforward." Adds FrontPoint's Litt: "We take capital acquisition very seriously. [Banks'] performance on this front will clearly play a role in how much business we allocate to each of them."

Hedge fund matchmaking on Wall Street is a strange dance, however. Fearful of lawsuits or of getting entangled in compliance issues, investment banks don't accept money for helping hedge funds market themselves, except in kind, in the form of brokerage business. Investors say the banks rarely follow up on their initial introductions to hedge fund managers. Often they don't even know if an investor went on to put money in a hedge fund.

"Capital introduction is not an advisory service," emphasizes Thomas Lynch, co-head of capital introduction at Goldman Sachs, whose 20 hedge fund introduction arrangers, operating out of Boston, Hong Kong, London, New York, San Francisco and Tokyo, never bill anyone. Adds David Barrett, one of two managing directors in Morgan Stanley's capital introduction group, which also charges no fee: "We are explicitly not giving advice to investors or doing the fundraising for hedge fund managers."

Yet while they insist that they're not endorsing particular hedge funds, officials of Morgan Stanley and Goldman Sachs have implicitly allowed their firms' lustrous reputations to serve as a Good Housekeeping seal of approval for the hedge funds they parade before investors - at least in the eyes of some.

"Am I more likely to invest with a hedge fund I don't know because they're working with Morgan? Absolutely," says an investor at a $1 billion endowment.

Hedge fund marketing executives are well aware of this halo effect. "There is a palpable difference as a hedge fund when you are introduced to an investor for the first time by a Goldman or a Morgan," confides the marketing chief of one multibillion-dollar fund. "Their capital introduction programs have become the most efficient way to raise money."

Many of the more elite hedge funds scorn Wall Street's matchmaking efforts. "There is no investor Morgan and Goldman can introduce us to that we can't get to," scoffs a partner at one major fund.

Nevertheless, Ezra Mager, manager of Torrey Funds, a fund-of-hedge-funds, suggests that in the uncommunicative hedge fund world, capital introduction meetings can "also be an opportunity to speak with people you are already invested with."

Rarely, however, has Wall Street been able to keep its worst instincts in check when competing for lucrative new business, and hedge funds aren't likely to prove the exception.

For starters, investment banks are promoting a niche market that many think suffers from too many mediocre managers running too much money. And firms piling in with their rich clients and marketing prowess doesn't help matters, many say. "Investment banks have probably accelerated the flow of capital into this business," laments one hedge fund investor. "That's not a good thing for investors who are already in hedge funds. Funds will get larger quicker and close sooner."

Matchmaking in the murky hedge fund world, moreover, can be a risky business. This year an investor in a new hedge fund called DMG Advisors (no relation to the former Deutsche Morgan Grenfell) discovered that one of the firm's senior analysts had been convicted 12 years earlier of possession of chemicals with the intent to manufacture methamphetamine - a fact that the fund had neglected to disclose. After word leaked out, the analyst resigned and some investors redeemed their holdings. (DMG's trading results have been solid, and most investors did not pull out of the fund.)

Morgan Stanley's capital introduction group had helped DMG raise money. Given the time that had elapsed since the conviction, few people in the hedge fund industry blamed Morgan Stanley for not knowing about the analyst's criminal record. And Morgan Stanley, like all investment banks, says up front that it does not perform due diligence on hedge funds or recommend them; it merely arranges introductions. (The firm won't comment on the DMG matter.)

Still, some of Wall Street's other capital introduction executives fear that just this sort of hands-off approach may come back to haunt the banks. "At some point a hedge fund is going to blow up, and some investment bank is going to be slapped with a big lawsuit," says one Wall Street executive. "Everyone thinks they're going to be shielded because they're not taking money for capital introduction. What do you think happens when a lawyer starts reading off the prime brokerage fees that the bank earned?"

Some observers worry that investment banks' bid to simultaneously provide hedge funds with start-up capital, fundraising assistance and brokerage services is ripe for abuse because of the inherent conflicts of interest.

In their rush to cater to hedge funds, investment banks are also aiding and abetting the creation of new types of fundraising vehicles that make even hedge fund managers nervous. So-called guaranteed hedge-funds-of-funds notes - a structured product that is meant to ensure that investors get back their initial outlay even if their hedge fund blows up - have been marketed extensively to Japanese and European investors.

Commercial banks provide the requisite credit guarantees to protect investors' principal, although they generally don't sell guaranteed products themselves. Many hedge fund and structured-product specialists say that the products are often a bad deal for investors and a potential menace to the whole hedge fund market. Some trading experts warn that because these products virtually compel banks to be big sellers of hedge funds during moments of market stress, they could conceivably set off a landslide of sales that would spread panic in the wider market (see box).

Hedge funds have always seemed a little racier and a little riskier than ordinary investments. Yet they're hardly a new invention, and understanding how they evolved helps explain why Wall Street finds them so alluring now.

Dreamed up in 1949 by sociologist and former Fortune magazine reporter A.W. Jones, who ran a "hedged" book of long and short positions, hedge funds have a history of booms and busts.

Macro funds run by managers such as the durable George Soros (page 34) were fashionable during the late 1980s, making headline-grabbing bets on the world's stocks, bonds and currencies and enraging the occasional central banker or prime minister. The 1994 global bond bust put a dent in their reputations, but the hedge fund business quickly recovered, growing even faster until the various financial crises of 1998 nearly took down Long-Term Capital Management and the rest of the financial world. After a pause for the filing of lawsuits and some reflection, the hedge fund business characteristically revived.

Wall Street has always played a role in hedge funds. Small organizations with no credit ratings and little infrastructure, the funds have needed to rent the clearing and settling abilities, stock loan inventories and balance sheets of large banks.

The prime brokerage business began in the early 1950s when A.W. Jones hired Neuberger & Berman to clear his trades. In 1971 Lou Ricciardelli, an ambitious clerk at the small New York brokerage firm Seiden DeCuavas, a predecessor of Furman Selz, began cultivating a hedge fund clientele. "There were no computers," recalls Ricciardelli, now a senior adviser to Deutsche Bank Securities' prime brokerage group. "I kept the books and records by hand."

In the 1970s he created Compuport, a computerized portfolio tracking system especially for hedge funds. After building Wall Street's first dedicated prime brokerage operation, Ricciardelli moved in 1982 to Morgan Stanley, where he developed a large hedge fund servicing unit over the next decade.

By the late 1990s the business of servicing hedge funds would be dominated by five brokerage firms: Bear Stearns, Goldman Sachs, ING Baring Furman Selz, Morgan Stanley Dean Witter and NationsBanc Montgomery Securities.

Some of the more active prime brokerages helped new hedge funds get off the ground, even renting them space in warrens of offices - dubbed "hedge fund hotels" - in New York buildings. But hedge funds generally remained a curiosity and didn't get much backing from investment banks. "Prime brokerage was nothing but a transaction business," recalls James Hedges, CEO of LJH Global Investments. "Furman Selz and Bear Stearns had their hedge fund hotels on Park Avenue. Bear Stearns published a directory. That was it."

Fundraising for hedge funds was typically dominated by third-party marketers, which often took a cut of future fees for the assets they raised.

There were exceptions. Merrill Lynch raised a then-staggering $1.25 billion for Long-Term Capital Management in 1993, but that fundraising was for former Salomon Brothers fixed-income arbitrage chief John Meriwether, the most fabled bond trader on Wall Street. And Donaldson, Lufkin & Jenrette helped gather about $1 billion in 1998 for a hedge fund called Ocelot, but it was being run by Julian Robertson, already the manager of the second-largest hedge fund in the world.

Both LTCM and Ocelot turned out to be unhappy experiences for the investment banks and some of their senior executives. Merrill, a major counterparty to LTCM, was one of the banks forced to step in and prop up the failing hedge fund five years later. And DLJ executives dropped millions of their own money when Ocelot suffered losses in 1998 and 1999.

To be sure, hedge funds were becoming important Wall Street trading and financing customers throughout the 1990s. Too good, on the fixed-income side, as it turned out.

In their rush to accommodate a new group of profitable and fashionable fixed-income arbitrage hedge funds, such as LTCM, Wall Street investment banks provided them with vast amounts of leverage through their repurchase desks. In the summer of 1998, a plunging bond market and the Russian government bond default triggered a chain reaction of margin calls and hedge fund portfolio write-downs that nearly sank LTCM.

Wall Street soon discovered just how overboard it had gone. Two of LTCM's biggest creditors, Merrill and Salomon, put their exposure to hedge funds during that period at about $2 billion apiece. Sources at the time said that Salomon's notional swaps position with LTCM was a staggering $118 billion.

The fallout in the fixed-income world roiled many firms. Angry over losses that they still insist were triggered by needless margin calls, major hedge funds, including MKP and Ellington Capital Management, filed lawsuits against the brokerages that pulled their credit lines. The suits continue to wind through the courts to this day, with the investment banks disputing the claims.

Brokerages cut way back on the leverage they extended to fixed-income arbs. But they didn't sour on hedge funds. Quite the contrary. Says LJH's Hedges, "It was in 1998 that investment banks began seeing what a major business hedge funds could be." So a 50-year-old financial product that had just caused one of the greatest debacles in financial history surged in popularity.

A confluence of events appears to have set off the explosive growth. A major selling point of hedge funds is that they purport to produce investment returns uncorrelated with those of the stock market. Such returns are certainly a lot more attractive when the market is plunging, as it has been in recent years. Last year the CSFB/Tremont Hedge Fund index rose 4.4 percent while the Standard & Poor's 500 index dropped 13 percent and the Wilshire 5000 fell 10.96 percent.

Although the average hedge fund manager, like the average traditional money manager, doesn't appear to be able to beat an index, there have been some exceptional performances, net of fees, by individual managers. These include David Tepper of Appaloosa Management, who has averaged 30 percent in his Palomino Fund since 1995 (page 35); James Simons of Renaissance Technologies Corp., who has racked up average annual returns of 37 percent over the past 12 years (page 35); and Lee Ainslie III of Maverick Capital, who has posted net annual returns averaging 23.5 percent since 1995 in his Hedge Equity Strategy fund (page 40).

Returns like these attract attention. And the decision in 2001 by the California Public Employees' Retirement System, the country's largest pension fund, to invest $1 billion of its $150 billion portfolio in hedge funds has been an important endorsement for the hedge fund market. "Five years ago you had hedge funds starting with $5 million," says Robert Sherry, head of prime brokerage at ABN Amro. "Now they're starting with $100 million."

All of this is splendid news for Wall Street, where the spoils of the hedge fund business are spread widely among major investment banks. The big hedge funds do business with dozens of brokerage firms, but they concentrate their business and fees with their prime brokers. The term is a misnomer, however, because multibillion-dollar hedge funds almost all have multiple prime broker relationships.

When Pequot Capital Management partner Daniel Benton split off to form $7.5 billion hedge fund Andor Capital Management, he selected five prime brokerages: ABN Amro, Bear Stearns, Goldman Sachs, Morgan Stanley and UBS Warburg. He later added Lehman.

But adding up the prime brokerage mandates as a way of keeping score can be deceiving. Just as universal banks are wielding their enormous size and credit expertise to win underwriting business, institutions such as Deutsche Bank and UBS Warburg are using their balance sheets and derivatives know-how to win hedge fund accounts.

"People don't realize it, but Deutsche is huge in the hedge fund business," says one hedge fund investor. "If you look at where the giant convert hedgers actually keep their balances, it's at the banks. Investment banks can't compete on cost of funding."

Banks are also involved in hedge fund activities not tied to prime brokerage. J.P. Morgan Chase, for example, has been working on new types of offerings that turn hedge funds into structured products. "As the hedge fund business grows, you have to start creating products that are more recognizable to a broader group of investors," contends Dana Pitts, the bank's head of hedge fund services.

But as any Wall Street marketer knows, peddling image is every bit as important as selling substance. Morgan Stanley's annual do at the Breakers is arguably the hedge fund world's answer to Mrs. Astor's ball. The firm even enlisted chairman Philip Purcell as a glad-hander. Morgan Stanley, say hedge fund executives, was inundated this year with hedge fund investors pulling strings to get an invitation to the exclusive event.

Goldman, however, also knows how to throw a party and whip up a little excitement at its hedge fund soirées.

At Goldman's April 2001 European hedge fund dinner - at the aquarium in Monte Carlo - Karel Van Miert, former European Union competition commissioner, gave a long-winded but prescient talk. He explained in some detail to attentive arbitrageurs in the audience why the then-pending General Electric Co.-Honeywell International merger might violate EU antitrust rules. The deal was killed soon after by Van Miert's successor as competition commissioner, Mario Monte.

Competitors are determined to one-up Morgan Stanley and Goldman. At its major hedge fund conference in December, Deutsche turned the Ritz-Carlton Hotel in Amelia Island, Florida, into a kind of hedge fund bazaar: Usually aloof hedge fund managers were persuaded to sit in rooms so that investors could cruise the halls checking them out. Deutsche even pulled the beds out of 40 hotel rooms to create private meeting space for individual managers.

To its credit, Wall Street has brought some measure of sophistication and rationality to the inbred, fly-by-the-seat-of-the-pants hedge fund world. Secretive and far from pristine, the industry has long been notorious for providing scant information (if any at all) and for suspect fundraising practices. A persistent rumor has been that consultants take payments from hedge funds to recommend them to investors.

But in focusing on hedge funds, investment banks have forced changes, making it easier for qualified investors to get reliable performance information. Wall Street firms have also developed useful investor tools and services, such as real-time reporting and risk management systems.

"Capital introduction has grown in importance because it tapped into a legitimate need of both parties," says Morgan Stanley's Barrett. "The introductions are a positive step in addressing the hedge fund informational void."

Wall Streeters make good cheerleaders. But will hedge fund investors be cheering Wall Streeters a year from now?

Guaranteed trouble?

It's an appealing proposition. Investors attracted to hedge funds because of their often spectacular returns and resilience in down markets, but wary of their inherent risks, can protect themselves by purchasing "guaranteed" hedge fund notes. These securities, also known as principal-guaranteed notes, assure investors that they will get back their original principal regardless of how much a fund loses because of trading reverses.

Veteran traders and other market experts, however, worry that as the popular notes proliferate, they could themselves pose risks for the hedge fund market. "These bank-guaranteed products could become a ticking time bomb for the hedge fund business," says structured-product specialist Robert Gordon of New York-based Twenty-First Securities Corp.

Developed and sold mainly by hedge fund specialists and private banks, guaranteed notes are structured almost entirely for funds-of-hedge-funds. In return for guaranteeing investors' principal, the sellers charge steep fees and require that investors give up a significant share of the upside of the underlying hedge fund.

Hedge fund specialists say many of these notes are a dubious investment because the guarantees come at too high a price. But that's not what alarms them. Their real fear is that the global banks that provide the credit guarantees that ensure the principal of the notes, including ABN Amro, BNP Paribas and J.P. Morgan Chase & Co., will exercise their right to sell out of the hedge funds they're guaranteeing when the funds' value plunges below certain levels to avoid incurring losses themselves.

That could set off a cascade of forced sales and redemptions of hedge funds, these professionals warn, triggering a wider market panic. The amounts involved are not negligible. One Wall Street structured-finance expert estimates that about $25 billion in notional value of the guaranteed notes have been sold to date. And the danger is greatest for certain leading hedge fund strategies, such as convertible bond arbitrage, in which hedge funds dominate trading activity and often hold similar positions, creating the conditions for herdlike selling behavior.

Some see ominous similarities between guaranteed notes and portfolio insurance, the discredited 1980s hedging vehicle that promised to protect institutional portfolios against steep market drops. Trading experts charged that portfolio insurance exacerbated the 1987 stock market crash by compelling institutions to sell - or dynamically hedge, as it was termed - into the market plunge. "One bank can dynamically hedge, but not every bank can dynamically hedge," points out the head of a multibillion-dollar hedge fund. Portfolio insurance fell out of favor after the crash.

Guaranteed hedge fund products come in several varieties, but the structure causing the greatest concern is one in which banks hedge their exposure to a fund as it falls in value. Twenty-First's Gordon notes that one common form of these products has set defeasance triggers to allow a bank to sell a portion of its positions in a hedge fund if the fund declines by a certain percentage.

"Let's say the convertible market falls and you hit the trigger," says Gordon. "Well, a lot of convertible hedge funds hold the same positions, so a lot of other funds get their positions marked down. The fear is that you end up triggering and triggering and triggering redemptions. A cascade effect is definitely possible."

Bank officials insist that such a scenario is extremely unlikely. They point out that they guarantee widely diversified baskets of funds, so that troubles in one or a few wouldn't have that much of an impact on any hedge fund sector. "I can only speak for J.P. Morgan products, and we take a very conservative approach," says Gary Krivo, head of hedge fund corporate finance activities at J.P. Morgan Chase. "The products we've worked on have extreme diversification. Guaranteed products that are based upon funds-of-funds as the asset class are not ones I really worry about." Adds Victoria Owen, head of structured products for alternative-investment shop Man Investment Products: "The banks have been very risk-averse. It would take extreme conditions for these products to start to have that effect. When I say extreme, I mean at least twice what you had in [the hedge fund collapses of] 1998."

Assessing the potential risk is further complicated by the lack of concrete information about the size of the market and the mix of hedge funds that are being guaranteed. But a number of hedge fund executives and investors, who asked not to be quoted, say that they are indeed concerned that if guaranteed hedge fund products continue to spread, the result could be systemic risk during a market upheaval.

"The real fear is that it becomes a retail product," says a senior official at one prominent hedge fund organization. "There's probably not enough of this product to create systemic risk now. But if this becomes how the retail market accesses the hedge fund market, then you're going to have systemic risk." It would be ironic - though not unprecedented - for a product designed to reduce risk to add to it instead.