Large Dollar Inflow Stresses Industry

George Van

The worldwide demand for hedge funds has reached unprecedented levels and is beginning to stress the industry, according to George P. Van, Chairman of Van Hedge Fund Advisors International, Inc. (VAN) a leading hedge fund investment advisory firm. “Notwithstanding new hedge funds continuing to spring up like mushrooms after a hard rain”, noted Mr. Van, “the unprecedented growth in demand in the most recent twelve months is outstripping the increase in supply”. Mr. Van noted that this surging demand for hedge fund products is causing many changes in the industry, some unfavorable.

Liquidity Driving Demand, Causing Hedge Fund Closings

“The same flood of liquidity that is sweeping over mutual funds, causing them to close to new money in record numbers, is also filling many hedge funds”, he stated. “In the mutual fund industry, approximately 15 mutual funds with assets in excess of $1 billion have closed their doors to new investors in the last year, the four largest being Fidelity funds including Fidelity Magellan, at $64 billion dollars and Fidelity Growth and Income at $44 billion. Hedge funds both large and small have had the same tide of money rush over them, many with the same result. Perhaps an extreme example is the new hedge fund started by Magellan’s Jeffrey Vinik; after opening his doors to new investors in late 1996, he raised his asset target of $800 million within months and closed his fund to new investors.

Like Vinik, many hedge fund managers, both large and small, are feeling the need to turn down additional investors either because they have filled their 99 slots or because they feel they cannot responsibly manage more money than they already have. Many hedge funds obtain superior returns for their investors, with lower-than-market risk, by exploiting relatively small market inefficiencies. These managers know that, with more assets, they will have to spread them into less profitable opportunities. This is frequently true of various “market neutral” strategies which are increasingly popular, such as convertible bond arbitrage, mortgaged-backed securities arbitrage, regulation D arbitrage, and other forms of arbitrage. A prime recent example of a manager recognizing his strategy size limitations is John Meriwether of Long Term Capital Management; in September, 1997 his Fund returned $3 billion, nearly half of his fund, to its investors. In doing this, Meriwether and his colleagues followed the example set earlier by other hedge fund luminaries including George Soros, Paul Tudor Jones and Bruce Kovner. In contrast to the large funds run by Soros, Jones and Kovner, many funds recently closing their doors to new money are much smaller, in the $75 to $300 million range.

Larger inflows of investors’ money are speeding up life for both hedge fund managers and investors. In the early 1990’s, investors could monitor a fund for several years before making an investment decision. Now, oftentimes, if an investment decision is not made in the first 6 to 24 months, it is too late.

With fewer established funds to choose from, due to funds closing to new money, the average investor often is left to decide among relatively new funds that have not yet weathered the storms of prolonged bad markets.

Robertson and Soros Continue To Grow

While some have closed their doors, others have opened them wider. Some such notable exceptions include the largest players in the industry like Robertson and Soros, whose macro styles and broad organizations permit them to continue absorbing assets. Last year, Julian Robertson’s Tiger Management offered still another feline, the Ocelot Fund, through a DLJ syndication. In about 7 months, investor appetite for hedge funds swallowed up $1 billion of Ocelot’s slots. Robertson’s hedge fund assets now reportedly stand at approximately $18 billion.

Similarly, Soros’ assets keep growing and now apparently approximate $20 billion.

To their credit, good performance has been an important factor in the growth of both Robertson and Soros funds.

More Hedge Fund Problems Caused By Size

Hedge funds closing to new investors is only one problem that has been created by investors’ ravenous appetite for hedged investments. Another is the diminishing returns of some managers who test the limits of their strategies by continuing to accept new money until returns ultimately decrease. A number of well-established specialty funds which have produced stellar returns for their investors over recent years now are struggling, to some extent for this reason. Some of these funds with specialized strategies have attempted to increase their capacities either by changing their strategies or by adding related strategies. A change in strategy might involve moving from micro or small-cap stocks to larger cap equities; adding a related strategy could involve, for example, a merger arbitrage manager beginning to do non-merger event-driven deals.

Some funds which have approached or reached the 99-investor limit have taken advantage of new flexibility permitted by the National Securities Markets Improvement Act of 1996. It permits them to start a second fund, run pari passu with the first; the new fund can take up to 500 qualified investors (with higher net worth requirements). The Act also permitted hedge fund managers to change their existing funds to accept in future more highly qualified investors up to a total of 500 investors. How these managers will fare, with expanded capacities, remains to be seen.

Notwithstanding the tidal wave of money rushing over most hedge funds, some have been left high and dry with low assets. Why? Reasons include very short track records, inadequate marketing, low returns and weak pedigrees.

More Than Liquidity Driving Demand

The surge in worldwide liquidity helps to explain why many hedge funds are being deluged with money. However, in past periods of monetary expansion, the hedge fund industry, while benefiting, has not experienced anything approaching the current levels of demand. Numerous additional factors have more recently come into play. They include: an increasing recognition by investors of the variety of different strategies employed by hedge funds, and their advantages; increasing recognition of the various benefits of hedge funds over other forms of investing, including the inherent risk protection offered by many hedge funds; the growing accessibility of hedge funds to investors; the credibility given hedge funds by “marquee managers” leaving other areas to start hedge funds; and the coming to fruition of institutional investor interest in hedge funds.

Until the mid-1990’s, investors tended to form their perceptions of hedge funds from news reports of large macro funds such as those of Soros and Robertson. Notwithstanding their excellent returns over time, the short-term volatility of these funds was frightening to many. In the early 1990’s, the first large-scale research on a multitude of hedge fund investing strategies by Van Hedge Fund Advisors (VHFA) showed that numerous strategies provided better-than-market returns with lower-than-market risk. In mid-1994, for example, VHFA showed that, over the previous five years, the average hedge fund had produced returns 20% in excess of the S&P 500 with less risk of a loss . VHFA’s research caught the attention of the media; its broad coverage increased investor awareness as to the benefits of non-macro hedge fund investing styles.

Another recent development has greatly helped the credibility of hedge funds and consequently fueled investors’ appetite. An increasing number of highly visible money managers and analysts have been leaving mutual funds, prominent institutions and money management firms to start or join hedge funds. In the mutual fund world, Fidelity alone has lost Jeffrey Vinik, Larry Greenberg, Michael Gordon, Mark Kaufman, Mary English, Remy Trafelet and John Hickling, all leaving to form or join hedge funds. In the institutional investment world, Harvard Management Company, with about $14 billion in assets, is losing Jonathon Jacobson July 1; Jacobson managed $1.6 billion in a hedge fund for Harvard. And recent defections at Wall Street titans include David Slaine, co-head of NASDAQ trading at Morgan Stanley; Roger Gordon, managing director of high yield investment research at Donaldson Lufkin & Jenrette; Roderick Jack, managing director of Goldman Sachs in London; and Steve Mobbs, managing director of arbitrage trading at Deutsche Morgan Grenfell.

Investors Have Easier Access To Hedge Funds

The increasing appetite for hedge funds also has been fed by the increasing accessibility of hedge funds to investors. Lists of hedge funds have been available commercially for several years. Also, since conference organizers discovered in 1994 that hedge funds were a hot topic, today, hedge fund conferences are offered virtually monthly around the world. Consulting firms also have increased investor accessibility to hedge funds by becoming knowledgeable about them and offering access to their clients. Most recently, the Internet too has made it easier for investors to find hedge funds, with some offshore and U.S. funds listing their offerings.

As a result of easier access, not only U.S. Investors have moved to hedge funds. European, Asian and Latin American investors also have added to the demand. They are investing, in increasing numbers, both in European hedge funds and in the offshore clones established by U.S. hedge fund managers in numerous tax havens such as Bermuda and the Caymans.

Financial Institutions Increase Investor Access To Hedge Funds

Large international investment banks and brokerage houses have provided easier hedge fund access than ever before to European, Canadian and Japanese investors through a variety of public offerings of hedge fund products. While the specific offerings have been made in Switzerland, England, Canada and Japan, investors outside these countries, at least in some cases, can access these issues through local banks. In Switzerland, for example, at least three funds of funds and one hedge fund are now listed on the Swiss Exchange, a development that began in the mid-1990’s and has accelerated more recently. For no stated minimum investment, the average European investor now can have access to a variety of U.S. hedge fund clones and European hedge funds through the Swiss securities.

Britain listed its first quoted hedge fund in late 1996, Canada its first in mid-1997, and Japan has at least two listed hedge fund vehicles, one of which is available to investors for a minimum investment of only $1,000.

Some of the largest U.S. financial institutions also have jumped on the hedge fund bandwagon, reaping profits by acting as a conduit for investors to hedge funds. Merrill Lynch, among others, has offered a series of hedge funds to its wealthy clients, raising big bucks both for the funds and for itself. DLJ also has been on the hedge fund money-raising track. In 1997, they raised $1 billion for Robertson’s latest feline, the Ocelot Fund, in a short 7 months.

Another demand factor has been the increasing appetite for hedge funds shown by U.S. foundations, endowments and pension funds. A new study by the National Association of College and University Business Officers covering the fiscal year ended June 1997 showed that in their endowment-only sample, 87 responding endowments invested in hedge funds, up from 74 the previous year. In 1998, foundations, endowments and pension funds appear to be showing increasing interest.

A recent development further adding to the demand for hedge funds: large U.S. money management firms, previously focused on traditional investments, now are beginning to allocate a portion of their substantial clients’ assets to hedge funds. For example, Legg Mason Inc., with $70 billion in assets, recently announced that it wanted to own hedge funds to help protect its investors’ bull market gains. Legg Mason has been on the hedge fund acquisition trail; in January, it purchased Brandywine Asset Management Company, with $7 billion under management, for $129 million and in April, a spokesman stated they were in talks to acquire a hedged firm with over $1 billion in assets.

With Demand Outpacing Supply, What Will Be The Outcome?

In the short term, it seems clear that it will be harder for investors to get into funds with established records. Similarly, funds with “market neutral” characteristics, beloved of institutional investors, will tend to be in even shorter supply; brand new market neutral funds, with “name” managers, will fill relatively quickly.

Will the hedge fund community choke on the flood of money and produce degraded returns? In the short term, a minority of funds, unable to curb their appetites, will probably demonstrate reduced performance. In the longer term, the hedge fund industry likely will demonstrate flexibility and change and grow to meet the demand. There are some real uncertainties, however. In the plus column, we see more and more highly talented managers with proven records launching hedge funds that are destined to be large. In the minus column, the institutional investment colossus and the public have just begun casting their eyes to hedge funds. With an estimated $20 trillion in institutional and “accredited” private dollars in the U.S. alone, the relatively small capacity of the $300 billion global hedge fund industry could easily be swamped. A 15% allocation to hedge funds by these institutional and private portfolios represents ten times the current size of the entire hedge fund industry.

The direction the global equity markets take will definitely affect both supply and demand of hedge funds. In a significantly more difficult market, many hedge funds should outperform unhedged investments. Would that lead to increased demand? Overall, probably the contrary. Fear tightens most purse strings. The flow of money to hedge funds, as to other speculative investments, would likely shrink.

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