Big, traditional money management firms are offering more hedge fund-related products, prompting some to ask: Can these firms succeed as the hedge fund world evolves?
The answer seems to be a qualified yes.
The reason seems to be that growing interest in hedge funds among institutional investors will create enough demand so everyone gets a slice of the pie. At least in theory.
Numbers provide some proof. According to Chicago-based Hedge Fund Research Inc., after growing steadily but moderately in eight out of the past 11 years, estimated assets in hedge funds of funds doubled between the end of 2001 and the end of 2002. An estimated $103 billion flowed into fund-of-funds strategies in 2002, more than five times the amount of assets that went into funds of funds in 2001, according to HFR.
Similarly, the estimated number of funds of funds grew from 550 in 2001 to 781 in 2002, according to HFR. About half of that growth is attributed to new firms, HFR President Josh Rosenberg said. The other half is new funds of funds opened by established firms.
"I can think of two or three different firms that have spun out two or three separate funds, in addition to the five funds they already had," Mr. Rosenberg said. He did not name them.
The scenario painted by several money managers and hedge fund observers goes like this: In the short term, the big firms will win their share of pension fund business, mainly from plan sponsors that are more comfortable with a name they recognize that also has the deep-pocketed support of a large firm. Specialized hedge fund operations will hold their own by attracting institutional investors favoring companies that have specialized in hedge funds for years.
Five or 10 years down the road, the big firms will have built up their own experience and track records, which will level the playing field, but at the same time lead to another problem: The departures of the management teams that built those track records.
That already is happening at some firms.
Lazard Asset Management, which itself lifted a team of fund-of-funds managers from another big firm, J.P. Morgan Fleming Asset Management, recently saw some of its highest-profile hedge fund managers leave. Both firms are in New York.
One of the managers who left Lazard, William von Mueffling, plans to start his own hedge fund company. Others, including Thomas Ellis, Robert Cope and Ben Guest, have not commented publicly on their plans.
Philippe Bonnefoy, head of alternative investment strategies at Commerzbank Securities, New York, said he suspects the hedge fund managers who left were unhappy with Lazard's compensation package. He said compensation will be a critical issue for big firms that are getting into hedge funds.
"In many cases, Lazard did everything right," Mr. Bonnefoy said. "They created the hedge fund group, they allowed the star culture, and they did spectacularly well. But ultimately, you have these shops that can offer all these products but still can't work out compensation packages for the guys who are there. You have the resources and the talent, but can you keep it under control and offer outperformance in compensation to keep them from walking across the street?"
Some big firms have acquired hedge fund expertise through mergers. Citigroup Alternative Investments, part of Citigroup Asset Management, has hedge fund roots dating to the 1980s thanks to Citibank, Salomon Brothers, Smith Barney and Travelers, all of which had alternatives operations prior to the series of mergers and acquisitions that created Citigroup Inc., New York.
Dozens of firms
The number of big firms offering hedge fund products has grown in recent years. They include Deutsche Bank AG, Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan, OppenheimerFunds Inc., Bank of New York Co. Inc. and Credit Suisse Asset Management, all in New York; and Massachusetts Mutual Life Insurance Co., Springfield, Mass. Dozens of the largest financial services firms have delved into hedge funds by offering individual hedge funds, funds of funds or both, or by buying or investing in independent firms and making them subsidiaries.
Citigroup's 18-month-old alternatives arm, is making headway convincing pension fund clients on the traditional asset side that its hedge funds and funds of funds are good investments, said Patrick McNelis, head of Citigroup Alternative Investments' institutional advisory services for the Americas.
"We're banking that a large number of institutions will choose to make their alternative investments through a large institution such as us, with a long list of traditional investments," Mr. McNelis said.
He acknowledged, however, that Citigroup must overcome the perception among consultants that so-called boutique firms are the best way for pension funds to get started.
"The boutiques have the lead in market share right now," Mr. McNelis said. "In the long term, we see the competition pendulum swinging toward firms that see it our way: J.P. Morgan, Goldman, larger financial service firms. That's the way the market is going to go."
Jim McKee, vice president for capital markets research at consultant Callan Associates Inc., San Francisco, said as a consultant he prefers recommending established hedge fund players to his institutional clients, and he concedes that leaves out some of the big institutional players, who have only recently entered the hedge fund space.
"I'm the first to admit that I look for some funds of funds players who lived through 1998," Mr. McKee said. "It's a reasonable gripe (among the big institutional firms) that people prefer those veterans with that experience."
Marc Cohen, managing director of Fimat Group's New York-based Financial Services Group, which advises investors on alternative investments and provides services to hedge funds and funds of funds, said he sees room for both boutiques and large firms in the future. The large firms are not opening hedge fund operations just to say they offer hedge fund products, he said. They are responding to client demand.
Mr. Cohen described a "sea change" in thinking among pension funds - prompted by low equity market returns and rising liabilities - that makes hedge funds a more acceptable part of an overall asset mix.
"When you see all those sea changes heading your way and you're a brokerage firm or a bank, what do you do? You create teams of people to go and sell to them," Mr. Cohen said. "In five or seven years, I think you'll see many of the big traditional families of mutual funds offering hedge funds."