Hedge funds are down but not out

Neil Wilson, managing director of HedgeFund Intelligence says the latest survey shows that the hedge fund industry "has continued to thrive and attract increasing asset flows. While these figures are only to July, and don't yet take account of the turbulence the industry endured in August, they indicate an industry still in robust health."

The fanfare about hedge fund troubles at Bear Stearns, among others, due to the financial meltdown in the subprime mortgage market has put a spotlight and a question mark next to hedge funds as of late: Will they blow up?

August's numbers lend validity to the question. According to the Hennessee Hedge Fund Index, hedge funds were down 0.72% in August while the Dow Jones Industrial Average was up 1.10%, the S&P 500 Index was up 1.29% and the Nasdaq was up 1.97% for the month. For vehicles that often require million-dollar investment minimums and tout superior performance to justify their whopping management fees -- which are exponentially higher than any mutual fund -- underperforming the markets amounts to the kiss of death.

However -- and this is a big however -- hedge funds have too much money and are too entrenched in the markets to be put out of business, try as many might.

Congress and the Securities and Exchange Commission have been trying for years to find ways to regulate hedge funds, to no avail. The issue of hedge fund regulation has even made its way to the Supreme Court. But so far, hedge funds operate largely outside the purview of laws designed to regulate and monitor investment companies.

The reason is that hedge funds say they are private investment partnerships for sophisticated individuals, or what the SEC calls "accredited investors." Moreover, many hedge funds are incorporated overseas, so they aren't technically U.S. entities.

As it stands, the U.S. Senate Finance Committee is considering changing tax rules to prevent offshore hedge funds from sidestepping taxes. This might further provide a link to regulation. But industry experts say that won't be any time soon. The U.S. Treasury loses more than $1 billion in potential tax revenue each year through this practice, according to industry reports.

Slippery? Sure. Expensive? Yes. Underperformers? Mostly. Yet people can't seem to get enough of hedge funds.

Be that as it may, an investment strategy that follows the hedge fund market is sure to pick up some positive returns. Here's why: When more money gets plowed into a sector prices rise. Eventually, of course, prices settle but there will always be that initial period when demand inflates.

Charles Gradante, managing principal of Hennessee Group says, "Recognizing that $1.2 trillion of adjustable rate mortgages are expected to reset in 2007-2008, most managers believe earnings will slow the most in consumer-focused industries, while companies levered to corporate spending should fare relatively well."

That is a good tip, if not signal of things to come. Companies, as he says, levered to corporate spending might include service providers, suppliers and, of course, lenders. Many of those lenders are the same ones whose share prices have even been beaten up because of their association with the subprime mortgage fiasco.

I can think of one, Bear Stearns, that Warren Buffett is rumored to be eyeing. Not a bad signal either, and a sign that hedge funds aren't going anywhere anytime soon -- just maybe up