The hedge fund industry may have slowed down a bit during the quiet summer months. Then again, it may be continuing the strong growth that made the product the talk of Washington back in the spring. It all depends on who you talk to.

Because the industry has little regulatory oversight, firms that track the industry, its growth, success or failure, can come to very contradicting conclusions, such as they have in the second quarter.

"It is important to understand that databases are comprised of funds with varying standards regarding reporting, survivorship inclusion and size, and that all databases are not comprised of all of the existing funds," said James R. Hedges, IV, president and chief investment officer at LJH Global Investments. "Historically, it has been difficult to paint an accurate picture of the hedge fund industry in its entirety."

A recent report by Tremont Capital Management's TASS ResearchTM1 showed that hedge fund net inflows in the second quarter nearly doubled that of the first quarter, jumping up to $13.83 billion from $6.98 billion. The research also noted that by the mid point of this year, the hedge fund industry has surpassed the $16.28 billion in net inflows attained during all of last year. All this would indicate the industry is rolling full steam ahead.

"I believe the strong asset flows showing this year demonstrates the fact that institutions are embracing hedge funds as an asset class," Robert Schulman, co-CEO of Tremont, said in a statement. Schulman said many large investors have been watching the hedge fund industry for some time, but are just now allocating money to the investments, the start of what he sees as the beginning of a trend in the industry.

The study also showed that $1.7 billion of the net flows were directed at new funds, while $1.05 billion in net assets were returned to investors in the second quarter. That represents a drop from the $2.11 billion net returned in the first quarter, a decrease that Tremont attributes to a slowdown in the number of hedge funds closing due to performance-related issues. Tremont said its database covers slightly less than $400 billion in assets in the industry.

Performance-Driven Growth

Another notable report was recently released by Hedge Fund Research (HFR), but it showed a markedly different industry in the second quarter. The study indicates that the hedge fund industry soared to new heights, reaching $665 billion in assets, driven primarily by broad-based performance. However, of the $47 billion increase in assets in the second quarter, a mere $1.4 billion of that came from new assets, a far cry from the nearly $14 billion indicated in the Tremont study. While both studies show growth in the industry, it is attributed primarily to performance in the HFR report.

"We certainly have a far bigger universe than HFR," said Stephen Jupp, vice president and director of TASS quantitative research at Tremont. "What they're picking up are funds open to investment, and they may be missing some of the bigger funds. That's the only reason why they paint such a different picture," he said. "Even though we track two-thirds of the assets, we believe we are capturing the bulk of the flows, but we don't extrapolate it to the industry."

Hedge funds were aided by stronger economic data and a rally in the equity markets, according to the HFR report. The lower inflow number suggests a far lower level of new interest among investors and portrays the products as growing from within as opposed to attracting new investors. Calls to HFR were not returned by press time.

Adding yet another wrinkle to the complex picture of the hedge fund industry, recent data from The Hennessee Hedge Fund Index indicated that hedge fund returns produced a positive return of 1.24% in July, falling from the 1.5% return in June, and trailing the broad market indices. The S&P 500 Index gained 1.69% in July, the Dow Jones Industrial Average rose 2.76% in the month, and the Nasdaq Composite Index leapt 6.92%, according to Hennessee.

Charles Gradante, managing principal of the Hennessee Group, said that managers reluctantly increased their exposure to the equity markets, but the outlook was mixed due to increases in estimates for the fourth quarter earnings.

Proprietary Information

Hedges said a number of other issues that cloud the statistics in the industry include the fact that some funds do not report proprietary information. Many institutions are starting inhouse funds that aren't reflected in the databases, either, he said. "While recent hedge fund returns have been strong, they may not be in keeping with the very high expectations that some investors have regarding the achievement of superior returns," Hedges said. "Again, education is needed to help investors understand that hedge fund investing is about capital preservation in down markets and consistent, risk-adjusted returns in up markets."

However, gauging the industry will remain tough unless things change. The hedge fund industry is unique in that the laws governing the reporting of its holdings and information are very loose. Therefore, there are a lot of unknowns about the industry as a whole. With all the scandals plaguing corporate America in the last few years and a few well-publicized hedge fund blow-ups, transparency has been a big issue with hedge funds. Many hedge fund managers argue, however, that their industry is comprised of entrepreneurs who reap the benefit of their own unique expertise and research. If those managers are forced to reveal their holdings, their short positions or other competitive information, they will lose their edge and it will be more difficult for them to employ original strategies.

The Securities and Exchange Commission held a two-day roundtable event back in May to discuss this very topic. All the bigwigs from the hedge fund industry and several from the mutual fund industry, as well, showed up to voice their opinions about potential increased regulation of the product. Lack of information about the industry was so glaring that regulators relied on hedge fund industry estimates as to the size of the hedge fund universe, because reporting standards are so lax. Estimates now put the industry at between $650 billion and $700 billion.

Moving Toward Standardization

Hedges said there is a debate in the industry regarding the creation of standardized data and reporting guidelines that would provide investors and fiduciaries with an accurate aggregated overview of their portfolio for analytical purposes without jeopardizing the funds' strategy niche. "As educators in the hedge fund industry, we believe more standardized and uniform reporting is possible and indeed is beneficial," Hedges said. "Balancing investor demands with hedge fund managers' capabilities is the key issue related to transparency, and one that will have to be reconciled."

Hedges said that while the recent rally in the equities markets may have lured some investors back to the traditional markets, it is anticipated and studies have shown that allocations from the high-net-worth and institutional investors will continue to be strong. He said quarter-to-quarter flow figures are not always the best gauge for success in the industry. "So while interest may wane somewhat, with strides made in transparency, risk controls and education, hedge funds will gain more confidence from investors globally, and prove to be competitive in asset allocation."

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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