Hedge Funds Extend Gains, but Insider Probe Swirls

Date: Monday, January 3, 2011
Author: Steve Eder, The Wall Street Journal

Hedge funds notched another run of gains in 2010. But as the year closed, a wide-ranging insider-trading investigation spooked the industry and cast a cloud that will loom in the months ahead.

In 2010, hedge funds on average returned 7.11% through November, according to the latest data from Hedge Fund Research Inc. The Dow Jones Industrial Average climbed 11% in 2010, with December being particularly strong.

That solid return, while not as heady as the 19% return the industry saw in 2009, builds on the rehabilitation of the industry and its ability to rise in any type of market. The financial crisis contributed to a bleak 2008 for hedge-fund managers, in which they lost 19% on investments and some put up "gates" to stanch an exodus of investor funds.

This past year, managers who wager on and against stocks, those who make macro bets based on global economic and financial data, as well as those who trade beaten-down bonds were among the best performers, said Joe Omansky, who tracks hedge-fund performance for Trusted Insight, a platform for institutional investors to share investment ideas. Funds that focused on shorting stocks were less successful in 2010, he said.

Some managers feared the return of market-roiling woes this past spring, when the May 6 "flash crash" saw the Dow industrials nosedive before quickly recovering the bulk of their nearly 1,000-point decline and concerns mounted about Greece's debt crisis and its reach.

"The events of May—the combination of the flash crash and the Greek-euro crisis—led to significant disruption to what had been a strong start to the year," said Alex Ehrlich, who heads prime brokerage at Morgan Stanley

All in all, the events made for a volatile market, said Andrew Law, chief investment officer of Caxton Associates, a $10 billion fund manager that focuses mostly on macro bets.

"The reversals in the market have been hard to forecast and they have happened very abruptly," Mr. Law said. Caxton returned 10% for 2010 and 10% on average over the past three years, according to an investor.

Meanwhile, the insider-trading inquiry promises to be a wild card for the industry. While the probe hasn't resulted in any charges against hedge-fund managers, it has proved an attack on the way that some get information.

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Reuters

James Fleishman, right, leaves a federal court in San Jose, Calif., with his lawyer on Dec. 16, after he and three others were arrested on insider-trading charges. The case remains a wild card for the industry.

On Dec. 16, federal authorities arrested four corporate managers who worked as "expert" consultants, charging them with leaking inside information. More charges are expected in the months ahead in the wide-ranging government investigation.

At the center of the investigation are expert-network firms that pair up investors such as hedge funds with industry managers who can provide consultations on trends or specific products, technologies or treatments. Investigators are examining whether experts are giving away information that gives an unfair edge to investors receiving it.

Steve Nadel, a hedge-funds lawyer with Seward & Kissel LLP in New York, said his phone started ringing with calls from clients after the spate of arrests. "It is more of a concern," Mr. Nadel said. "When is it going to stop?"

Some fund managers already have decided to end their use of expert-network firms, lawyers say. Managers say even getting named in an investigation is potentially toxic for a hedge fund, as investors may quickly seek redemptions if a manager is under scrutiny.

In December, hedge-fund firm FrontPoint Partners disbanded its health-care investing team after a French doctor was charged with supplying inside information to one of its portfolio managers. FrontPoint wasn't named in court documents, but the firm has said that it is the hedge fund in the complaint against the French doctor, who is fighting the charges.

Still, investors continue to sink more money into hedge funds and other so-called alternative investments. Investment gains and inflows helped boost industrywide assets to about $1.77 trillion in the third quarter. Assets were about $1.9 trillion at the end of 2007, according to Hedge Fund Research. In the third quarter, more than $19 billion of net assets moved to hedge-fund firms, according to the research firm.

Among the winners of 2010 were Third Point Offshore Fund Ltd, which finished the year up 33.7%, according to an investor. The results of the $2.2 billion fund, which used an event-driven strategy, were bolstered by bets on the recoveries of companies like Delphi and CIT Group, which were operating under bankruptcy protection.

Another winner was Paulson & Co.'s $9 billion Advantage Plus Fund, which was up 14.3% through mid-December, according to an investor. That event-driven fund rebounded after being down 11% in September. Other Paulson funds saw similar or greater gains based on bets on gold or the recovery of the U.S. economy, the investor said.

For investors, 2011 may be the year they get to know more than in the past about the secretive hedge-fund industry. New rules are set go into effect that will result in managers having to register with the Securities and Exchange Commission. Although many managers are registered already, some of the biggest hedge funds like Tudor Investment Corp., Soros Fund Management and SAC Capital Partners haven't yet registered.

The new registrations, required by July, are a result of the financial-regulatory-overhaul package, which was passed in 2010. There also are new rules on trading, record-keeping and reporting.

"It was a year in which the regulatory oversight that had been discussed and attempted and debated for years finally crystallized," said Marc Elovitz, a hedge-fund lawyer with Schulte Roth & Zabel.

The legislative changes also prompted proprietary traders at major banks like Goldman Sachs Group Inc. and Citigroup Inc. to part ways with their employers. Some of those traders have latched on with hedge funds, and in one case, a group of Goldman traders were hired by private-equity firm Kohlberg Kravis Roberts & Co.

Others have gone off on their own, joining a growing number of players launching funds. There were 260 launches in the third quarter, up from 201 a quarter earlier. Overall, at the end of the third quarter there were 7,062 hedge funds, compared with 7,634 at the end of 2007, according to Hedge Fund Research.

The key in 2011 for managers will be their ability to stay "nimble" to take advantage of market opportunities, said Bill Ferri, who heads alternative and quantitative investments for UBS Global Asset Management. The business includes the O'Connor hedge funds and one of the largest fund of funds.

"We think it is going to make sense to look to smaller, nimbler managers," Mr. Ferri said. "We think the opportunities for bigger guys might be liquidity-challenged."

Write to Steve Eder at steve.eder@wsj.com