Investment: Tomorrow's hedge funds are flourishing

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As we all know, forecasting in investment is a mug's game, to be engaged in only if the amount you are paid to put your head above the parapet exceeds the cost of the inevitable disappointment when your predictions turn out to be off-beam. But there is one prediction I am prepared to make with some confidence - we are going to hear an awful lot more about hedge funds in the next few years.

I am 100 per cent confident they are gradually going to become a part of mainstream investment management and sold to retail investors on a much broader scale than before.

A recent report by KPMG, the management consultants, predicts that the amount invested in hedge funds will grow from $350bn to $3,000bn by the year 2005. This would continue a trend which, say the specialist consultants TASS, has seen the amount of money invested in hedge funds grow by an average of 25 per cent a year (excluding performance gains) since 1990.

Hedge funds historically have been predominantly a US and offshore phenomenon, but they are attracting a much greater following in Europe and Asia, taken up and marketed by mainstream fund management groups. Mercury Asset Management, HSBC and Gartmore are among the well-known firms considering offering hedge funds to their investors.

But didn't we read just a few months ago that the collapse of Long Term Capital Management (LTCM), the hedge fund with all those Nobel Laureate economics professors on its books, had put a stop to the hedge fund bandwagon? It is true that if you look back through the cuttings, there are a lot of headlines predicting the demise of hedge funds, and reports that the regulators were about to stamp hard on hedge fund activities. Not for the first time, the headlines are misleading.

Regulators are making it harder for banks to support high-risk hedge fund operators with easy credit. Many banks are taking heed of this trend. In a separate but not unrelated development, most of the biggest investment banks on Wall Street have cut back heavily on proprietary trading activities, after losing a packet last year trying to do much the same thing as LTCM.

But there are reasons why hedge funds are not down and out, but still prospering. One is the now near-universal realisation that what did for LTCM was its absurdly high level of gearing, with the fund running debt- financed positions at its peak which were worth more than 200 times its equity capital. The fact that one fund took on all this gearing does not in itself invalidate the basic principles that make investing in hedge funds look attractive (most hedge funds don't have anything like the same amount of borrowing).

Second, one of the many image problems from which hedge funds have suffered is the mistaken assumption that they all pursue similar investment strategies. Everybody has heard of George Soros and his high-profile global currency speculation, just as everybody has now heard of LTCM. Yet LTCM for the most part was following a different strategy to Mr Soros, which involved betting on interest rate differentials between different types of security. And there is nothing which says a hedge fund has to pursue either of these approaches.

As my table shows, there are a many strategies hedge funds pursue, and each has a different risk/reward profile. Global macro funds, of the kind run by Mr Soros, are at the high- risk, high-return end of the spectrum. This is reflected in their high volatility (standard deviation) and high drawdown statistics (drawdown tells you how far a fund's value fell from peak to low point during its worst period).

At the other end of the spectrum, arbitrage and long/short funds offer below-average volatility and drawdowns. The truth is that the case for hedge funds rests in large measure on the way they are set up and operate, rather than on the specific investment strategies they pursue.

Hedge funds are run by bright and ambitious individuals, who have a much more flexible mandate to invest than anyone running a conventional fund. If you run a hedge fund, you are free not to just to buy equities and bonds, but to invest in a wide variety of different instruments and use techniques (such as arbitrage and long/short strategies) which in theory allow you to make money when markets are falling as well as when they are rising. At the tail end of a record bull market in bonds and equities, it is no surprise this kind of approach should have found favour amongst sophisticated investors. What could be more appealing than the idea of making money out of a down market, and having a young hotshot running your money with a huge incentive fee to do well?

Hedge fund managers often have their own money invested in their funds and typically stand to keep 20 to 25 per cent of profits they make in the fund. More subtly, most hedge funds can produce statistics showing their strategies have low correlations with the direction of the mainstream markets. This holds out the prospect of additional diversification benefits.

It sounds like a good bargain, provided you can live with the risks, are happy to tie up your money for at least a year (as most funds require) and believe superior investment talent will eventually produce superior investment results. Such an attractive package, at least on the surface, underpins my confidence that hedge fund growth will continue. The bottom line is that hedge funds have a good marketing story to tell in a business where selling has always been the dominant influence. Investors, I am sure, will go for the hedge fund story.

The question remains: are they right to do so? Two hurdles have to be overcome. One is that the performance of hedge funds is not quite as good in the cold light of day as you might have been led to believe. The hedge fund index recently launched by CSFB and Tremont/TASS is a helpful development, since it publicly quantifies the performance of hedge funds for the first time in Europe.

The figures in the table showing the average rate of return (12 per cent over the period 1994 to 1999) are respectable, but not spectacular, when you allow for the higher than average risk many strategies (but not all) entail. The figures underline how important it is to know exactly what kind of fund you are buying.

The second problem is that it is still difficult for retail investors to buy the vaunted expertise of hedge fund managers in a serious way. Steps are in hand to create packaged products (typically fund of funds) which in time will be easier to sell through standard retail channels.

For regulatory reasons, historically hedge funds have been open only to high net worth individuals who are prepared to accept the unregulated offshore regime in which most hedge funds operate. There is still a serious shortage of information sources for ordinary investors to tap into, and the regulators are not encouraging them to do so.

Given the ingenuity and effort of the fund management industry, this second problem will be the easier one to resolve. My main concern is that, even if you buy the concept and accept the regulatory risks, finding the right hedge fund manager will remain much harder than finding a well-managed conventional fund (which is hard enough).

Strip away the rhetoric and the supporting statistics, and the ultimate call remains whether or not you believe superior risk-adjusted returns can be consistently earned by employing a hotshot fund manager.

You can be sure some will - but a good number of those investors who flock to the cause will be disappointed, just as they were in the last great heyday of hotshot managers, which was the 1960s.