Following the Money Trail: Increasing Numbers of Traditional Investment Managers Move Over to Hedge Fund Management: An Analysis

WEST PALM BEACH, FL (HEDGECO.NET) – During the decade of the nineties, assets managed by hedge fund industry in the United States experienced an exponential growth; assets grew from about US$40billion in late eighties to over US$650 billion in 2003. Assets managed by Mutual Funds exceeds those of hedge funds, total assets managed by Mutual Funds are in excess of US$6.5 trillion.

However hedge fund assets continue to grow at an accelerated rate, some hedge fund industry analysts linked such growth to the booming global equity markets, particularly the technology sector. However the meltdown in the global equity markets of the past three years totally revolutionalized the hedge fund industry as many Wall Street investors lost faith in the stock market as they watched their accumulated wealth wash away.

Asset growth in Hedge fund portfolios were indirectly the result of many Wall Street investors seeking other methods of investing money, differently from the traditional �buy and hold� strategy mostly used by mainstream investment money managers . The growth of alternative investment strategies were to some degree at the expense of mutual funds, as many mutual fund companies lost significant amount of capital following the equity market decline.

Mutual fund performance is generally correlated with equity indexes, part of the reason stems from the fact that mutual funds generally take long positions in the stock markets, expecting that stocks would continue to grow from one year to another. Such expectation failed during the later stages of the decade of the nineties; as a result, many mutual fund companies had negative returns during that period.

On the other hand, hedge funds continued to produce absolute returns to investors in such strategies. Increasing numbers of financial advisers and planners started investing in hedge funds according to a new study. The study, conducted by AdvisorBenchmaking .com showed that about 40% of investment advisers put their client�s assets in hedge fund vehicles, up from 5% in the year 2000. Many traditional equity investors who believed that the bull market would last forever are now seeking for other methods of investing, and battered stock market bulls are discovering hedge funds as well.

Joseph Nicholas, chief executive officer of HFR Asset management said, �It is now clear that there was a lot of spin out there, people should have been invested in hedge funds, any audience that is considered suitable for stock investments is more than suitable for hedge fund investments�, Nicholas added.

Hedge funds, the traditional investment vehicle of the affluent, seems to be gradually moving into the mainstream, as more mutual fund companies began considering ways to adopt hedge fund investment philosophy. There is no agreement however if such democratization would be a positive development or not.

While mutual funds believe that the equity markets would continue to grow from year to year, hedge funds in contrast have a more robust and flexible investment strategy, by going long and or short depending on management analysis, guts and perceptions of what direction the investment pendulum points. Such investment flexibility enables hedge funds to continue to outperform mutual funds in recent times.

The past few years have been particularly hard for mutual fund companies because of the collapse of the global equity markets. Hedge funds very easily beat the major market indexes in both the short term and long term performance categories. For instance, during the first quarter of 2002 [Bear Market], the S&P 500 had 0.3% return, while the NASDAQ had a negative return of 5.3% the average hedge fund beat both indexes with a 1.4% net return.

Comparing longer term performance of mutual funds to hedge funds shows an even greater margin in favor of hedge funds. In a new released book, �Hedge Funds: Investment vehicles for the global economy, and what investors must know about them�, author Paul Oranika compared long term mutual fund performance to that of hedge funds, according to Oranika, �from 1987 to 1998 hedge funds had annual return rate of 18.4%, compared to 10.2% for MSCI World Index, 13.8% for an average US mutual fund, while the average mutual bond fund had an annual return rate of 7.7%.� What are the implications of this dynamics to managers in mutual fund industry?

Mutual Fund Managers are following the money trail

It has been reported that many fund managers in mutual fund industry have been moving over to hedge funds in larger numbers. Hedge fund managers receive much more in compensation than Mutual fund managers. While Hedge fund managers are traditionally rewarded with a performance fee, mutual fund managers are paid mainly on the basis of the amount of assets managed, regardless of whether the fund is up or down.

Mark Anson of the California Public Employees Retirement System was once asked what in his view motivates traditional investment managers to migrate towards alternative investment strategies. Anson replied �Money. The investment management industry is in the business of gathering assets; like any other business, the industries looks to increase its revenue base and its income. Hedge funds allow traditional-long only managers to collect more assets and earn higher fees. Any industry will naturally attempt to exploit those venues that offer them highest growth opportunities� Anson said.

There is another widely held belief that because hedge fund managers are required to invest their own capital in the fund as well, such inclination propels them to want to work harder. On the other hand, mutual fund managers are not required to invest their capital in the portfolios they manage, they are still paid regardless of the market outcome. However it is still in the interest of mutual fund managers that their funds do well, on the long run, if their funds consistently make money, it is reflected on their track records over time.

Recently, two senior members of Morgan Stanley European equity analysts left to start their own hedge funds. Stephen Galbraith a well respected Morgan Stanley strategist based in New York joined Maverick Capital Management LLC according to released statements. Galbraith would have broad responsibilities, and would be made part of the principals at the new company. This follows hundreds of such scenarios in which many traditional investment managers change over to hedge fund management, some of those managers eventually launches their own hedge fund.

The trend is also being mirrored internationally, William de Winton and Colum McCoole, both research analysts with Morgan Stanley in London have also left to take up jobs at different hedge fund companies. According to the report, Mr. de Winton is joining Lansdowne Partners, a hedge fund asset management firm overseeing about US$1 billion, while Mr. McCoole will be moving over to Plutus Capital Management.

Management houses are competing for top managers in the market, undoubtedly the hedge fund industry is attracting top traditional fund managers, who in turn are offered greater compensation packages than what they are currently earning. There is another case of European�s top celebrity manager moving over to hedge fund arena. Richard Woolnough for 3 consecutive years was the best performing manager at Old Mutual Corporate Bond fund. Woolnough is slated to join M&G Fixed income team early in 2004.

The recent mutual fund/hedge fund trading scandals have implications for the growing dynamics where lines between mutual funds and hedge funds are increasingly difficult to draw. In fact increasing popularity of hedge funds due to its absolute return strategies is slowly but steadily being noticed by mainstream investors. The advent of Funds of funds [hedge funds investing in other hedge funds] means that smaller non-qualified investors can pool their resources together to invest in hedge fund managers.

Some mutual fund companies have branched into hedge funds, claiming that their traditional investors are interested in such vehicles. When mutual fund groups create and manage hedge funds, it becomes problematic, because on one hand, mutual funds are regulated by the Securities and Exchange Commission, while on the other hand, hedge funds are generally not, but they must conform to the general and broad requirements for hedge fund investors, such as qualifications etc.

These dichotomies have led to some potential conflict of interest allegations for instance, a mutual fund manager could buy a stock that hedge fund manager may sell short, such scenario may lead to a situation where the mutual fund client may see heavy losses while the hedge fund client sees gains. Such problem ultimately draws the attention of the SEC and the Congress to implement new regulations governing such industries. Hopefully hedge fund�s independence would largely be left intact, because the hedge fund industry has pretty much held itself in check since the collapse of Long Term Capital Management of the late nineties. In addition hedge funds today offer a greater transparency to its investors through hedge fund web- based portals, such as HedgeCo.net.

Do not write your obituaries yet for the mutual fund industry, it is a very powerful industry, with over US$6.5 trillion under management. Once US regulators implement new laws governing the asset management industry, the anticipated continued recovery in the global equity markets would help mutual fund industry find its feet once again, in the mean time growth in hedge fund management portfolios seem unstoppable in the years to come.

Paul Oranika
Editor-in-Chief
HedgeCo.Net
Email: editor@hedgeco.net

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