From Mutual to Hedge Funds, and Back Again

Date: Sunday, January 8, 2006

ARE mutual funds making a comeback among Wall Street's best and brightest?

In recent years, lured by the potential to earn tens of millions annually, dozens of promising young traders have quit their jobs at established firms to start hedge funds.

In contrast, the world of mutual funds was sometimes belittled as pedestrian, a refuge for second-rate talent too timid for the fast-paced hedge fund business.

In a well-publicized acid e-mail exchange last March between the hedge fund manager Daniel S. Loeb and a potential hire, Mr. Loeb dismissed the trader with a sharp retort: "There must be an insurance company or mutual fund out there for you."

Now, the tide may be turning. After a period of uninspiring performance for hedge funds, some managers are throwing in the towel and taking jobs with prominent firms like Fidelity Investments and Legg Mason.

At these companies and elsewhere, the lines are blurring between the investment styles of mutual fund and hedge fund managers. A new breed of mutual fund is trying to emulate, within limits, the aggressive bets of hedge funds by borrowing money, making bearish stock bets and taking concentrated positions, among other strategies.

The managers of these mutual funds hope to appeal to investors who are frustrated by the weak returns of more conventional investments but unable to commit the $1 million that hedge funds often require as a minimum investment.

"The ability to generate superior performance does not rest with the hedge fund industry," said Brian S. Posner, a onetime Fidelity star manager who is winding down Hygrove Partners, a $200 million hedge fund firm of which he was a co-founder, to run a new $110 billion unit at Legg Mason, the eighth-largest manager of stock and bond mutual funds.

For Mr. Posner, the chance to oversee a large pool of assets at a fast-growing, publicly traded company was irresistible. "The opportunity to be able to work for a platform like this was very compelling," he said. "There are few times in one's life when you get called up to the Yankees."

The vast size and resources that stand behind the largest mutual fund firms are enticing to hedge fund managers, many of whom are struggling to attract assets.

CONSULTANTS say they are seeing a rising number of traders move back to mutual funds or to other conventional money managers.

"It used to be a one-way street, with all the traffic going to the hedge funds," said Jeff Garrity, a managing director at Russell Reynolds, the recruiting firm. "Now, for the first time in years, we are starting to see movement in both directions."

Fidelity has filled three top positions with hedge fund veterans recently, reversing a decade-long trend.

Last month, Fidelity hired Seema R. Hingorani as director of stock research for Pyramis, a new division catering to institutional investors. Ms. Hingorani came to Fidelity from Mirador Capital Management, a hedge fund where she was a co-founder. Previously, she worked at Andor Capital, a large technology hedge fund firm.

Earlier, the firm hired Brian Conroy to oversee its global stock trading business. Mr. Conroy is the former chief operating officer of an affiliate of SAC Capital, a $7 billion hedge fund manager, and was previously that firm's head trader.

And J. Fergus Shiel, 48, a Fidelity veteran who left two years ago to start his own hedge fund, returned in September to take over portfolios with close to $8 billion in assets. A spokesman for Fidelity said that none of the recent hires were available for comment.

"For years, there was a brain drain from Fidelity to hedge funds," said James H. Lowell III, editor of The Fidelity Investor, an independent newsletter. "But some of these managers have discovered that being an entrepreneur is not what it's cracked up to be."

Few of the Fidelity veterans who left to start their own hedge funds went on to attract substantial assets, Mr. Lowell said. One notable exception is Jeffrey N. Vinik, the former manager of the Magellan fund, whose hedge fund grew to $4 billion before he returned outside investors' money five years ago to focus on his personal investments.

Consultants predict that weak performance will drive other big names from the volatile hedge fund business, where managers make most of their money by taking 20 percent of any profits.

After a strong November, driven by a surge in domestic stocks, the average hedge fund was up 7.7 percent for the first 11 months of 2005, according to Hedge Fund Research in Chicago, compared with a 4.9 percent return for the Standard & Poor's 500-stock index.

But hedge fund performance was uneven in 2005, with the average one actually losing money in 4 out of 11 months. In 2004, the average fund lagged behind the S.& P. index. The rocky results follow a period of torrid growth for hedge funds, whose assets more than doubled in the last five years, to more than $1 trillion, according to Hedge Fund Research. In contrast, mutual fund assets rose just 23 percent during the same period, to $8.6 trillion.

But the average hedge fund remains small, with less than $200 million in assets, Hedge Fund Research said. That compares with $1 billion for the average mutual fund.

To managers of smaller hedge funds, the large, relatively stable assets of mutual funds are appealing, Mr. Garrity said. Mutual fund investors, particularly those in retirement accounts, are also perceived as less fickle.

"The money coming into the hedge fund business now is somewhat hot," Mr. Posner of Legg Mason said.

Some investment managers, meanwhile, are finding ways to run mutual funds with some of the flexibility of hedge funds.

The average hedge fund has a broad mandate in terms of its range of investments and its ability to make concentrated bets, to borrow against its portfolio and to short stocks.

In contrast, mutual funds tend to focus on a more defined set of opportunities. And there are legal restrictions that prevent mutual funds from putting a high proportion of their money into illiquid investments.

But in recent years, laws have changed, giving managers greater flexibility. The trend gained momentum in August 1997, when Congress repealed rules that had restricted short-selling by limiting short-term trading to 30 percent of a mutual fund's profits. (Mutual funds are still required to keep liquid assets on hand that are of equivalent value to the shares sold short.)

Mutual funds also can take greater advantage of derivatives, which now trade more often and are less likely to be considered illiquid securities, said Jay G. Baris, a partner at Kramer Levin Naftalis & Frankel who advises investment companies. Rules regarding mutual funds' trading of futures and options have also been loosened, he said.

Mutual funds that take advantage of less conventional investments are increasingly attractive to some investors who have been disappointed with the stock market's performance.

And by investing in a mutual fund, these investors avoid the hefty fees charged by hedge funds - typically 2 percent of assets and 20 percent of profits. In contrast, the average mutual fund charges 1.4 percent of assets, according to Morningstar.

"Hedge funds are mutual funds without as many limits, but with much higher fees," Mr. Baris said.

One of the most popular of these hybrid mutual funds is run by William H. Miller III, better known as the manager of the $19 billion Legg Mason Value Trust, which has beaten the S.& P. 500 for the last 15 years.

Six years ago, Mr. Miller started Legg Mason Opportunity Trust, a fund in which he can invest in stocks, bonds, derivatives and other financial instruments of companies worldwide, with no restrictions on market capitalization or industry concentration. In contrast, Value Trust tends to invest only in shares of United States companies, and its more measured approach to stock picking means that its performance is less volatile, Mr. Miller said. Legg Mason Opportunity has had an average annual return of 11.9 percent over the last five years, more than 11 points ahead of the S.& P.

Ronald Baron, the growth stock picker who once ran the hedge fund Baron Partners, converted that fund to a mutual fund in 2003. Assets have grown to $1.3 billion from $100 million. Last year, the fund was up 14.4 percent, 10 points ahead of the S.& P.

"This is me unplugged," Mr. Baron said.

These mutual funds have attracted investors partly because individuals who are familiar with the track records of the managers are willing to trust them with more aggressive bets.

BUT more recently, mutual funds have been set up by hedge fund managers, whose ability to discuss the hedge funds' performance is limited by the Securities and Exchange Commission. These managers are hoping in part to attract individual investors by capitalizing on the allure of the hedge fund business itself.

In November, J. P. Morgan unveiled plans to start the Highbridge Statistical Market Neutral fund, a mutual fund to be run by a team from Highbridge Capital, a hedge fund firm with a 13-year track record; Morgan acquired the firm a year ago.

Another mutual fund started in December, the QCM Absolute Return fund, will be run by Jerry Paul, a former manager of Invesco's junk-bond mutual funds who left to start his own hedge fund firm four years ago. Mr. Paul's firm, Quixote Capital Management, focuses on investing in takeovers and other one-time corporate events.

"I've had so many investment advisers approach me saying I have clients who don't qualify for hedge funds who would love to invest with you," Mr. Paul said. His fund has a minimum investment of just $2,500, compared with a minimum of $250,000 for his hedge fund.

Some fund managers say they think that there are limits to hedge funds' crossover appeal, and worry that smaller investors may not appreciate the risks.

"Investing in hedge funds today is like buying Cisco in 1999," said Mario J. Gabelli, whose investment firm runs both hedge funds and mutual funds. "They are not appropriate for everyone."