What's Driving the Hedge Fund Boom?

Date: Friday, October 13, 2006
Author: Ted Gogoll, BusinessWeek.com

With many investors clamoring for these risk takers, it's time for an S&P guide to what's facing them now

Little did Alfred Winslow Jones know in 1949 that an investing strategy he's said to have created would turn into a $1 trillion-plus industry. Back then, the U.S. journalist began taking offsetting or short positions in shares to hedge equity market risk. And for much of the next 50 years, what we've come to know as hedge funds progressed slowly—before exploding in the late 1990s.

Now, as these investment vehicles have become ingrained in the global capital markets, Standard & Poor's Ratings Services sees the need for the public to better understand hedge funds and some of the misconceptions associated with the industry. This is particularly relevant these days because institutional investors, while still somewhat reluctant when it comes to hedge funds, have increased their interest and are incorporating them more and more into their portfolios.

Here are answers to some frequently asked questions about the industry.

How big is the hedge fund industry today?
First, it's worth noting that although commonly grouped together and sometimes referenced as an asset class, hedge funds, in S&P's opinion, aren't anything but a structure for investing. That structure is a private-investment partnership. Investments in these partnerships have historically been dominated by wealthy, private individuals—but perhaps not for much longer, as hedge funds continue to grow in size and diversification.

As far as the size of the industry, because hedge funds aren't required to report their numbers, it's impossible to know exactly how much is invested each year. Still, according to estimates by JPMorgan Chase, their assets grew twenty-fold, to $817 billion in 2003 from $38 billion in 1990, while the number of funds grew four-fold during that period, to more than 8,000 today from 2,000.

The SEC estimates that assets under management are in the neighborhood of $1.2 trillion. Van Hedge Fund Advisors forecasts that by 2008, 11,700 hedge funds will be operating globally, with $1.7 trillion in assets. Most industry players agree that more than $200 billion found its way into hedge funds globally in 2005.

If hedge funds aren't doing anything wrong, why are they so secretive?
Because they're generally structured as private-investment partnerships, hedge funds have been legally prohibited from advertising or widely distributing information about product offerings to individuals and institutions that don't meet certain minimum financial tests.

Moreover, many hedge fund managers practice strategies in which they make profits for their investors by taking advantage of pricing discrepancies between related securities. Therefore, they believe that real-time disclosure of their positions would be disadvantageous to their clients.

Similar to major investment banks, these managers aren't required to disseminate positions of their proprietary trading operations to the public. However, hedge fund holdings of long equity positions can be found on the SEC Web site, just like those of other institutional investors.

Why aren't hedge funds regulated?
Regulation is the biggest evolutionary step the market will face. As it stands, hedge funds are exempt from SEC oversight under the Investment Company Act of 1940 as long as they meet certain requirements, such as having no more than 99 investors or selling their funds only to qualified institutional purchasers that have $5 million or more in investable assets.

However, the SEC did try to impose registration rules earlier this year, only to have a federal court strike them down. That being the case, there is little transparency of hedge fund managers' trades and strategies, at least in the U.S. Still, institutional investors—especially pension funds—have asked for more information. They are seeking much better disclosure so they can be more comfortable with the risks they are taking and the investment process.

But hedge funds have been reluctant to disclose this information because many managers fear they would be exposing their most hidden proprietary secrets, risk losing their advantage over competitors, and possibly be opening themselves to predatory trading (see BusinessWeek.com, 9/12/06, "Do Hedge Funds Hold 'Trade Secrets'?"). Conversely, however, additional disclosure could potentially draw in more investors that would be attracted by the comfort of seeing how the returns are achieved.

Hedge fund managers often argue that their funds are already regulated (albeit indirectly) since they cannot operate without the help of banks. And nearly anywhere in the world, banks are heavily regulated and closely monitored. Also, the antifraud provisions of the Securities Act of 1933 and Securities and Exchange Act of 1934, as well as state laws against investor fraud, do apply to hedge funds and their activities. As a way of fending off potential regulatory interference, some hedge funds have also begun implementing best practices, such as those developed by nonprofit groups like The Greenwich Roundtable.

Regulatory requirements for hedge funds, however, are quite different in Britain than in the U.S. (London and New York are far and away the most active hedge fund territories in the world). The British Financial Services Authority requires information on the hedge fund companies' compliance systems and risk controls, and they must publish an annual report.

The larger hedge funds "receive closer scrutiny, including monitoring visits, from the authorities," according to the Sept. 2, 2006, issue of The Economist. In addition, The British Alternative Investment Management Association notes that "hedge funds are often more precise and explicit about the risks they are undertaking—they are more risk aware—than traditional managers because there is no benchmark concern to obscure the risk measures."

What has been driving the recent growth of the hedge fund industry?
Hedge funds were not exactly an overnight sensation. Even into the early 1990s, they had barely entered the financial market's psyche in any meaningful way. Global markets were in what would become one of the largest ever bull runs, so mutual funds with their high double-digit returns were the investment vehicles of choice.

The coming-out party for hedge funds started in the late 1990s, with names such as George Soros and Julian Robertson leading the charge. Stories about how these "secretive" managers were able to "break the Bank of England" and earn hundreds of millions of dollars captivated the imaginations of investors who were sitting on plenty of money, thanks to the bull market.

But it was during the subsequent market decline that hedge funds really came into their own. As investors lost years of profits almost overnight, they saw that hedge funds were actually making money, or at worst, that they were generally losing far less than investment alternatives.