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August 16, 2004 at 08:00 PM
After attracting a massive influx of capital and talent, hedge funds now face the challenge of stepped-up regulatory scrutiny.
The public profile of the hedge fund industry is increasing dramatically–which is only fitting for an investment opportunity that is growing worldwide. And with that increased visibility comes differing views on the effect of this burgeoning industry.
Federal Reserve Chairman Alan Greenspan thinks that hedge funds create “a very significant amount of liquidity in our system,” helping to stabilize the financial markets–and do not need the kind of regulation that would come from registration with the Securities and Exchange Commission.
SEC Chairman William Donaldson, on the other hand, would like to see mandatory registration for hedge funds, which would permit the agency to gather information about fund management and operations. A proposal that would require registration was approved by the SEC and released for public comment in July, and the SEC has budgeted for increased staffing for next year to accomplish these goals.
To Warren Buffett, hedge funds are still “a fad” that is more about Wall Street marketing than sound investing. He told the annual meeting of Berkshire Hathaway stockholders that he believes hedge fund fees are “unfair.”
Meanwhile, the California Public Employees’ Retirement System, Sacramento, the nation’s largest public pension plan, has shown its continued faith in the industry by stating its intention to raise its hedge fund allocation to as much as US$5.2 billion of its US$105 billion in global equity investments, making CalPERS the industry’s largest known investor. Harvard University, Cambridge, Mass., with about US$2.5 billion in these funds, is second largest.
An Industry on the Rise
U.S. investors searching for new investment opportunities poured almost US$75 billion into these private investment pools in 2003–more than they invested in the previous four years combined. Total hedge fund assets are now close to US$1 trillion and are divided among more than 6,000 U.S. and offshore hedge funds. Over the next five years, assets are expected to reach US$2 trillion as an additional 7,000 new funds are formed. Indeed, hedge funds have become a standard allocation class for many corporations, including General Motors, which pioneered their use in pension funds; educational institutions such as Yale and Duke universities; and state and local pension funds.
In Europe and Asia, too, the industry is booming, both as management centers and investments, and has widened its appeal in some cases. Germany has made hedge funds available to investors with no minimum investment requirement (although they must be purchased through private placements), rather than only to the high-net-worth individuals and institutions for which they were originally intended.
A Matter of Performance
What accounts for the explosive growth of hedge fund assets over the last few years? Wall Street insiders say the reason for their [hedge funds] success in the marketplace is simply that their performance has outdone other investments, in good times and bad. For the past five years (first quarter 1998 through third quarter 2003), the average hedge fund has outperformed the average mutual fund, with the top 10% of hedge funds earning five-year compound annual returns of 30.3%, compared with 14.8% for the top 10% of mutual funds.
Comparison of Best- and Worst-Performing U.S. Hedge and Mutual Funds
Five-Year Net Compound Annual Returns, 1Q98 to 3Q03
| Hedge Funds | Mutual Funds | |
| Top 10% | 30.3% | 14.8% |
| Top 25% | 23.5% | 10.7% |
| Bottom 25% | 0.6% | -1.4% |
| Bottom 10% | -4.9% | -4.2% |
Source: Van Hedge Fund Advisors International
Moreover, the superior returns provided by hedge funds in most multi-year periods also have been realized at lower statistical volatility than the Standard & Poor’s 500 stock index or mutual funds (see below). As a result, risk-adjusted returns, as measured by the Sharpe ratio, show hedge funds handily beating mutual funds.
U.S. and Offshore Hedge Fund Net Returns
1/1/88-9/30/03
| Net Compound Annual Return | Standard Deviation | Sharpe Ratio | |
| Van US Hedge Fund Index | 17.0% | 8.9% | 1.7 |
| Van Offshore H.F. Index | 14.3% | 9.0% | 1.4 |
| Van Global H.F. Index | 15.8% | 8.7% | 1.6 |
| MSCI World Equity | 5.4% | 16.3% | 0.3 |
| S&P 500 | 11.9% | 15.5% | 0.7 |
| Morningstar Avg. Equity Fund | 9.2% | 16.0% | 0.5 |
Source: Van Hedge Fund Advisors International
Hedge funds have demonstrated a particular ability to protect investments during market downturns. From January 1988 through September 2003, the S&P 500 experienced 16 negative quarters, dropping 69.4%, while the average hedge fund lost only 10.7% in those 16 quarters. In the U.S. market recovery of 2003, in contrast, hedge funds posted average gains of only 19%, compared with 32.7% for the average equity mutual fund, 28.7% for the S&P 500 and 50.8% for the Nasdaq.
What is indisputable is that hedge funds have enormous performance potential. This largely is driven by their ability to attract the most talented individuals and the wide range of strategies those managers are able to employ, including short selling, swaps, merger arbitrage and derivatives. Hedge fund managers can invest in almost any opportunity in any market where they foresee impressive gains without increasing risk, based on their style and dedication to that strategy as outlined in the funds’ offering documents.
Issues Facing Hedge Funds
Not surprisingly, hedge funds have been dealing with the same issues that other areas of the financial services industry have been struggling with in the wake of corporate scandals, including, most recently, improprieties in the mutual fund sector. The primary issues facing hedge funds center on governance, transparency and reporting, and regulation.
Governance
Governance, which has become such an intense issue for most types of investments– including mutual funds– in the wake of recent corporate scandals, also has captured the attention of hedge funds. However, this increased interest in governance is more likely to be evolutionary than revolutionary. It was only a matter of time before governance concerns would reach the hedge fund sector, but so far, at least, governance is not the great battle cry it has become in other industries or for investors. At the moment, the governance debate relating to hedge funds mainly is focused on the responsibilities of the boards of offshore funds, which have been somewhat formalized. Domestic U.S. hedge funds are not yet required to have boards, although this is seen as an eventuality.
Transparency and Reporting
Transparency and reporting provide additional credibility and investor confidence. As demand for greater transparency increases, hedge funds must walk a fine line between providing valuable information to investors and not providing details that could give a competitor the keys to understanding their unique trading strategies.
