Hedge funds are developing into a formidable competitor to mutual funds, as brokers, pension funds and insurance companies join the high-net-worth investors who bankroll most funds. Even mutual fund companies and insurers have recently bought hedge fund companies.

In 2000, hedge funds had $344.5 billion in total assets under management, according to a Freeman & Co. study of the industry. By 2005, Freeman. estimates that hedge funds will manage $915 billion.

It is not just aggressive investors who are putting more money in hedge funds. While some classes of investors were expected to double the percentage of their holdings in hedge funds, insurance companies will triple their share, to 0.3% of assets in 2005 from 0.1% in 2000. In dollar terms, insurance company investments in hedge funds will increase to $18 billion from $4.1 billion, Freeman predicted.

Coming of Age

"The hedge fund is coming of age," said Jan Van Eck, co-president of Van Eck Global, speaking at the last week's National Association of Variable Annuities conference in Boston. The California Public Employees Retirement System announced last year it would invest $1 billion in a hedge fund program, which Van Eck called a "watershed event." Blackstone Alternative Asset Management was chosen in May as the fund adviser.

Van Eck pointed to OppenheimerFunds' recent purchase of Tremont Advisers as proof of hedge funds' increasing appeal to financial services companies. Tremont Funds is one of the oldest hedge fund companies, established in 1984. "Tremont advises on more than $7 billion in alternative investments and has more than $1 billion of client assets in its proprietary funds," the company said in a statement.

Other financial services companies owning hedge funds include Nationwide Mutual, which owns U.K.-based Gartmore Investment Management, and Germany-based Allianz, which "did a lift-out of Citibank's team," Van Eck said. Even regional brokerage Raymond James Financial set up an advisory committee for brokers whose high-net-worth clients are interested in hedge funds.

To increase diversification and reduce risk, investors turn to fund-of-funds hedge funds. Such funds will show rapid growth during the next five years, Freeman projected, a view shared by Christian Frei, director at Lazard Asset Management.

New Strategies

The early adopters created hedge funds within their companies but that strategy has fallen out of favor. "Institutions are throwing in the towel on that route because it's too costly and the in-house talent has a tendency to move on to specialist boutiques," Frei said.

Having just one in-house fund is also risky because it means placing all of the firm's money in one investment style. Hedge fund investment styles range from those in "the stay-rich corner," where returns are lower but volatility is more manageable, to the "get-rich area," where fund managers use tactical trading strategies that have both higher volatility and higher target returns.

"Stay-rich" fund mangers focus on relative value, using convertible or fixed income arbitrage or a market-neutral approach. In between are the event-driven funds, which invest in merger arbitrage or distressed securities, and the more volatile long-biased or short seller funds.

"Having three or four funds in your portfolio exposes you to a wide range of outcomes," Frei said. Some of those outcomes are not as desirable as others, because hedge funds, like conventional mutual funds, can rack up -20%, -40% and even -65% annualized returns, making the return-smoothing qualities of a diversified portfolio more important. "These don't tend to slowly get to -50%," Frei said. "They tend to do very well and then quickly get to a mushroom cloud."

Screening Room

In assembling a fund-of-funds portfolio, Lazard screens the 6,000 existing hedge funds for such factors as fund size, performance and manager experience. Investment skill is not enough to ensure a fund's viability. A lot of funds fail because of the way they organize their business, not because their managers lack skill, Frei said. "When both fail, that's when you get in trouble," he added.

The result is a portfolio of 25 funds chosen from the top 90 screened funds, which shows positive annualized returns accompanied by low standard deviations. "I wouldn't call it return enhancement. Rather, it's accident avoidance," Frei said.

However, hedge fund fund-of-funds are not common. To cite just one reason, there are the legal fees. "These things are really expensive to build," Frei said, adding that there are only about eight of them around.

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