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They can’t all be masters

Date: Sunday, April 22, 2007
Author: Economist.com

These days the bigger the hedge fund, the better

“THE New Masters of the Universe” was the cover splash chosen by Portfolio, a business magazine that launched last week, to highlight a feature about hedge funds by Tom Wolfe. The headline may have left some wondering if the editors or Mr Wolfe, author of “The Bonfire of the Vanities”, had fallen behind the curve. Egos in Greenwich and Mayfair have taken some hits in recent months. True, the best hedge-fund managers—or those with the best luck—continue to pull in ten-figure salaries. But the average fund returned much less than the S&P 500 (including dividends) last year. In the fourth quarter, moreover, hedge funds’ net inflows slumped as faith waned in their ability to outperform traditional assets and the world digested the collapse of Amaranth, a hedge fund that had bet disastrously on gas futures.

But perhaps Mr Wolfe and his editors had been given a sneak preview of the latest data from Hedge Fund Research (HFR), published a few days after Portfolio hit the news-stands. It showed an impressive rebound.

Hedge funds’ net inflows in the first quarter of this year reached a record $60.2 billion, four times the level of the previous three-month period (see chart). This brought the total amount held by such funds to $1.57 trillion. If money were to continue to pour in at its current pace, 2007 would see total net inflows of $240 billion, double the previous annual record.

Moreover, hedge funds are beating the indexes once again. They made an average return of 2.8% in the first quarter, compared with 2.1% for the MSCI global stock index and a paltry 0.6% for the S&P 500. The best-performing funds were those focused on emerging markets. Hedge funds are increasingly becoming activist investors in stockmarkets in developing countries, and reaping the benefits, according to a recent report from Citigroup.

More ominous for the markets in general, another lucrative strategy is to invest in distress. The typical fund in this area is up by more than 14% over the past 12 months. Indeed, the subprime-mortgage crash has been good for hedge funds, on balance.

Some financial-sector funds that had bought stakes in subprime lenders have suffered. But many funds saw the crisis coming and sold mortgage stocks short, borrowing shares before selling them, in the hope of buying them back later at a lower price. Some made returns of over 50% by buying credit-default protection on tranches of mortgage-linked securities, says Kenneth Heinz, HFR’s president. Others, such as Citadel and Farallon, two of the biggest hedge funds, have since moved in to buy discounted loans, extend credit to troubled lenders or snap up distressed subsidiaries. As other types of investors have fled, hedge funds have become the main source of liquidity for mortgage firms, says Mr Heinz. They are now the leading buyers of leveraged loans.

The latest pick-up in performance will allow all but the worst-performing funds to continue charging “2 and 20” for their services: up to 2% of the assets under management plus 20% of any investment gains. There is no shortage of new investors looking to plough money into the sector. According to a study released last week by Greenwich Associates, a consultancy, more than 42% of American public pension funds are planning to significantly increase their allocations to hedge funds, which now receive only 0.5% of pension-fund assets. A survey last year found that endowments, public pension funds and corporate retirement plans were expecting to triple their investment in hedge funds to $1 trillion by 2010.

But doubts linger, despite the latest rebound. The number of funds has risen relentlessly—from 1,000 in 1992, when George Soros “broke the Bank of England”, to more than 9,500. This has raised fears that the market is becoming overcrowded and that the stellar profits of the past are no longer achievable. Six times during the 1990s, hedge funds’ average annual returns exceeded 20%. Since 2000 they have not done so once.

This may explain a shift that is taking place within the industry: investors are gravitating towards the biggest funds, which offer more trading strategies and are thus seen as having a better chance of creating enviable returns. They also have better access to capital and tighter risk management.

The largest 100 funds now hold more than two-thirds of all the money in the industry, up from less than half in 2003, according to Morgan Stanley. The bank says that only $10.5 billion went into newly launched funds last year, much less than was expected. This is a far cry from the situation a few years ago, when many investors preferred to put their money in young funds that were promising fresh thinking.

HFR’s latest numbers suggest that hedge funds have not yet passed their peak. They may even be set to scale dizzying new heights—at least in terms of size, if not performance. But in future, it seems, there will be fewer masters and many more struggling minnows.