Hedge fund managers are throwing a party for pension funds, but nobody knows how many will show up.
Investment managers and consultants are taking unprecedented steps to offer hedge fund vehicles to U.S. institutions, often using funds of funds.
With the hedge fund industry gearing up to take a bigger chunk of the $7.4 trillion market for U.S. pension fund assets, questions remain as to whether pension executives can stomach hedge funds' higher fees, and whether the funds truly act as a hedge.
Despite concerns, plan sponsors are putting money into hedge fund strategies, managers say.
Several firms have introduced or plan to introduce hedge fund products geared to U.S. institutions.
Among the firms that have increased their hedge fund efforts, are the following.
* CDC Investment Management Corp., a hedge fund firm owned by Caisse des Depots et Consignations, Paris, just hired prominent pension sponsor Jon Lukomnik, New York City's deputy comptroller for pensions, as a managing director in charge of strategic planning.
* Goldman Sachs & Co., New York, is stepping up efforts to promote hedge funds, backed up by research by Financial Risk Management Ltd., a London-based hedge fund research firm. The focus is on subcategories of hedge funds -- market-neutral and event-driven funds -- that have low correlations with benchmarks.
* Capital Resources, Chicago, the former consulting arm of SEI Corp., formed a joint venture with Hedge Fund Research Inc., Chicago, to offer hedge funds to U.S. institutions.
* Zacks Investment Management Inc., Chicago, will manage investments for an offshore long-short equity hedge fund run by Beacon Global Advisors Ltd., Nassau, Bahamas. And,
* Northern Trust teamed up last year with Caisse de Depot et Placement du Quebec to offer hedge funds to U.S. and non-U.S. investors. The Caisse de Depot seeded the funds with C$250 million.
There is even a United Asset Management Corp.-like umbrella firm focusing on hedge funds. Asset Alliance Corp., New York, reached $700 million in assets with its most recent purchase, a 50% share of Bricoleur Capital Management LLC, San Diego, a long-short value equity manager.
Asset Alliance firms offer styles in mortgage-backed securities market neutral, convertible and merger arbitrage and long-short equities, said Arnold L. Mintz, executive vice president of Asset Alliance.
The firms making a more recent push into hedge funds will join other managers already active with hedge funds, such as Alliance Capital Management LP, New York; Forstmann-Leff International, New York; M.D. Sass Investors Services Inc., New York; Collins Associates, Newport Beach, Calif.; BARRA RogersCasey, Darien, Conn.; and Evaluation Associates Capital Markets Inc., Norwalk, Conn.
"I'm seeing a tremendous surge of interest on the institutional level," said Martin D. Sass, chairman and chief executive of M.D. Sass. "We're seeing an unprecedented amount of interest from pension funds."
Sass offers various market neutral strategies in hedge funds totalling about $1 billion in assets.
Robert Arnott, president and chief executive of First Quadrant, agrees there is "an enormous amount of interest in market-neutral and hedge strategies."
First Quadrant manages $2 billion in market-neutral and a small amount in leveraged hedge fund investing, but not for pension clients.
Alliance Capital has seen tremendous growth in hedge fund assets from institutions and high-net-worth investors. Alliance manages $2 billion in hedge fund assets, $600 million of that with U.S. institutions, said Charles Schaffran, senior vice president for Alliance Capital and managing director of Alliance Hedge Fund Investors. Alliance got into hedge funds in 1994 with just $20 million, he said.
"With the traditional markets at quite high levels . . . (institutions) are looking for alternative havens where they think they can get returns in excess of 15% without correlation to traditional assets," Mr. Schaffran said.
Alliance offers five investment styles through 14 funds; three of those styles are closed to new investors.
U.S. hedge fund managers can handle a limited amount of additional money, experts say. A Hennessee Group survey indicated U.S. hedge fund managers, with about $210 billion under management, are at 52% of capacity on average.
Some of the hedge fund investment styles most popular with institutions have even less room to grow. Distressed securities managers were at about 70% of capacity; market neutral managers were at about 60% of capacity, according to the survey.
First Quadrant's Mr. Arnott acknowledged there is a limit on the amount of assets invested in long-short strategies that will lead to positive alphas. But underperformance at the margin, as new assets are added, won't mean that existing assets in the strategy also will underperform, he said.
WHAT ARE THEY?
The term hedge fund can have different interpretations for different people. Some view hedge funds in their traditional sense: as loosely regulated private partnerships that go long and short in securities, seeking to keep returns neutral to market moves.
But use of the term hedge fund has expanded for some to include any type of private investment partnership offered only to so-called sophisticated investors.
That broader categorization includes hedge funds using derivatives and leverage to execute their strategies, and take unhedged positions on markets. Some of the high-profile investment blowups involved hedge funds, such as those managed by David Askin and Victor Niederhoffer.
Moreover, hedge funds have exhibited poor performance in recent years when traditional markets were down.
Institutions are nevertheless showing interest, particularly in hedged strategies, such as long-short equities, and arbitrage.
"Hedging reduces volatility," said E. Lee Hennessee, managing principal of consulting firm Hennessee Group LLC, New York. "One day, not hedging will be considered imprudent."
The trick is in finding managers that truly will not be correlated with U.S. equities. It's harder than people think, some argue.
William J. Michaelcheck runs fixed-income arbitrage hedge funds for Mariner Investment Group and advises some of its clients on selecting hedge funds.
Said Mr. Michaelcheck: "Many hedge funds are stock pickers. Those people you would think as a group would have no more success than mutual fund managers.
"They're the very same people, basically. Institutions . . . are going to pick up on this very quickly," and likely to be disappointed.
FEES DRAW HEAT
Fees are another frequently cited problem.
Typically, hedge fund managers get paid 1% or 2% of assets as a management fee, plus 20% of profits.
"Everybody would like to call themselves a hedge fund because they get a bigger fee," Mr. Michaelcheck said.
For now, investors have agreed to pay the relatively huge fees.
"For some reason, these (hedge funds) have become cult objects," said Byron R. Wien, U.S. investment strategist for Morgan Stanley Dean Witter, New York.
"Today managing a hedge fund is the best way for an able money manager to accumulate really serious money quickly. It is better than being a rock star or a professional athlete. It is almost too good to be true. In my experience, things that are too good to be true are generally about to change," Mr. Wien wrote in a recent research report. (He is an investor personally in hedge funds).
Mr. Wien said the blame rests not with hedge funds that charge high fees, but with investors who pay them. In a perfect world, hedge fund performance fees would be compared against a benchmark, he wrote. Most are not.
Mr. Wien said he thinks the M-squared calculation is useful in evaluating risk-adjusted hedge fund performance. M-squared is an adaptation of the Sharpe ratio developed by a Morgan Stanley colleague, Leah Modigliani, and her Noble laureate grandfather, Franco Modigliani.
A recent evaluation of some popular hedge funds by Ms. Modigliani showed them offering good risk-adjusted returns when included in a portfolio of large-capitalization stocks.
Hedge funds are getting competition from traditional investment managers offering market-neutral -- often long-short equity -- styles that have posted good returns and grown in assets.
Ms. Hennessee sees that as a benefit, feeding into the idea that hedging is a good thing.
Taxes and hedge funds are an issue for pension funds. Funds governed by the Employee Retirement Investment Security Act of 1974 that invest in hedge funds using leverage will be subject to the going corporate income tax rate on those profits, said Jim Barry, partner with law firm Mayer, Brown & Platt, Chicago.