Hedge Funds in 2006

The hedge fund business has attracted a lot of attention in recent months. There are about 8,000 hedge funds today[1], with more than $1 trillion of assets under management. Most of these funds are clustered around a few centers like Connecticut and London.

What exactly is a hedge fund? According to Wikipedia, the term "Hedge Fund" is used to distinguish lightly regulated funds generally open to only a limited number of investors, from retail investment funds or Mutual funds, which are widely available to the general public. Because of limits on investor numbers or minimum investment amounts, hedge funds are normally open only to professional / institutional investors or high net worth individuals.

Mutual Funds typically go "long" the market and may not have much exposure to derivative contracts. But, hedge funds may be long or short the market and may use various derivative contracts. Thus, hedge funds pursue more complex investment strategies when compared to mutual funds.

But in recent times, the complexion of the hedge funds industry has been changing. Regulators are looking more closely at the sector than in the past due to the changing investor mix. Until recently, hedge funds mostly attracted the rich and super-wealthy. Today's hedge funds are increasingly monitored by professional managers at pension funds, endowments, foundations and even central banks. New investors are more demanding and, curiously enough risk-averse. This is forcing some hedge funds to change their investment style. A decade ago, investors wanted 30-50% returns. Now pension funds will settle for 8-10% returns[2], but want less volatility. Competition is also growing, as more traditional fund managers try to imitate the strategies of hedge funds.

It is estimated that 50-60%[3] of hedge-fund assets today come from institutions. Diversification is one reason motivating institutions to invest in hedge funds. Hedge funds have low correlations with other investments. Other advantages cited by institutions are the low volatility of hedge funds, their lack of correlation with economic cycles, and their greater risk taking predispostition.

Meanwhile, as hedge funds get bigger, the worry is that managers will become less entrepreneurial and more cautious. The distinction between mutual and hedge funds is also less clear than before. Mutual funds are acquiring hedge funds and pusuing some of their strategies, such as the use of leverage, short-selling and derivatives. For example, early in 2006, Schroders, an old British institution, decided to pursue a more aggressive investment style when it agreed to buy NewFinance Capital, a London fund of hedge funds[4]. Other big fund managers, including State Street Global Advisors and Goldman Sachs Asset Management, have also been trying to increase returns by using short-selling techniques. They are developing funds that will enable them to short-sell exposure to companies they do not like in an index. Both institutions would limit short-selling[5] to around 30% of a global portfolio, while keeping 130% long-only.

As short selling becomes more common, the distinction between mutual funds and hedge funds will get further blurred. In the US, mutual funds can sell short with some restrictions. In the European Union, recent changes in regulation allow fund managers to take short positions by using derivative instruments. As a result of all these changes, some traditional asset managers are planning to charge hedge fund-like fees to manage hedge fund-like products. Others charge like a hedge fund only when they beat their benchmarks. Because of all these options for investors, there is likely to be a paradigm shift. The exact impact of this shift, however, will be known only with time.

References

“The long and the short of it,” The Economist, 25th February 2006, pp 77-78.
“Growing pains,” The Economist, 4th March 2006, pp 63-66.
www.wikipedia.org
[1] “Growing pains,” The Economist, 4th March 2006, pp 63-66.

[2] “Growing pains,” The Economist, 4th March 2006, pp 63-66.

[3] “Growing pains,” The Economist, 4th March 2006, pp 63-66.

[4] “The long and the short of it,” The Economist, 25th February 2006, pp 77-78.

[5] “The long and the short of it,” The Economist, 25th February 2006, pp 77-78.