Money management companies that advise mutual funds are entering the hedge fund business to increase profitability, reach affluent investors and to retain portfolio managers who might otherwise leave their firms.

Companies are making forays into the hedge fund business despite the negative publicity which hedge funds or limited partnerships -- as some advisers prefer to call hedge funds -- have received as a result of the near failure of Long-Term Capital Management LP. Wall Street firms bailed out the Greenwich, Conn. hedge fund in September when $4 billion in highly leveraged investments began to unravel.

Financial services companies are distancing themselves from the leveraged investments and secretive style of Long Term Capital. But, they still are investigating the hedge fund business as a natural extension of their money management expertise. Last week, for example, Mercury Asset Management, a subsidiary of Merrill Lynch & Co., said it was surveying clients to see if there was a demand for hedge funds, Bloomberg News reported. That is happening throughout the industry, according to officials at money management firms and fund industry consultants.

"Mutual fund companies are turning to hedge funds as a means of both keeping their high-net-worth clients and keeping their top money managers," said Cerulli Associates, the Boston fund consulting firm, in a report last month. "At this point, the biggest question at some traditional asset management firms is whether to buy into the hedge fund business or start one from scratch."

Cerulli identified a handful of companies known for mutual fund management which are sponsoring hedge funds, including Alliance Capital, Gabelli Funds and Montgomery Asset Management. Wellington Management and State Street Research are also advising both mutual and hedge funds, according to published reports.

Hedge funds are not permitted to advertise, a fact which has discouraged firms from promoting their services widely. Anecdotal evidence suggests the trend toward mutual fund companies sponsoring hedge funds is increasing, but there is little hard data to confirm it.

Officials of money management companies do say though that eventually, the trend will take hold as money management firms offer a wider variety of services to retain client assets. Adding hedge funds as an offering simply makes sense as a business proposition at many firms, said money managers at fund firms and hedge funds.

"There is so many different ways to provide the same services" to investors, said Jan van Eck, president of Van Eck Global, a money management firm which offers mutual funds and hedge funds. A hedge fund is "just another product that a money manager can sell" to provide clients the services they seek, van Eck said.

There are substantial differences between hedge funds and mutual funds. Hedge funds receive far less oversight from the SEC and have less onerous reporting requirements. Hedge funds do not report net asset value prices daily, for example. They are not required to redeem investments if requested on any business day, as open-ended mutual funds are required to do. Hedge funds also have more freedom than mutual funds to invest in securities which do not trade frequently.

And, as Long Term Capital's problems have made evident, hedge funds have far more discretion to use leverage as part of their investment strategy than do mutual funds. Hedge fund managers can short stocks or stock indices believed to be overvalued to a far greater degree than mutual fund managers can. Investors would like managers to have as much leeway as possible.

"If you think a manager is a good stock picker, then let him buy the better stocks and go short the losers," van Eck said in a recent report discussing the advantages and risks of hedge fund investing.

The hedge fund business has the potential to be highly profitable for money managers. Hedge fund advisers typically charge one percent or more in an annual management fee and have a 20 percent stake in hedge fund profits, hedge fund managers, sellers and industry reports say.

If a hedge fund has reasonable performance "the compensation is significantly greater" than what a company earns from managing a mutual fund, said Michael Bois, manager of the Timberline Fund in Boston, a hedge fund which opened in June and now has about $4 million in assets.

Bois said that hedge fund investments offer potentially larger returns and more personalized investment styles than "off the rack" mutual funds. Those features can appeal to the affluent investor looking for a distinct investment strategy or manager, he said.

Hedge funds "definitely offer a more interesting and tailor-made product for the high-net-worth individual," Bois said. High-net-worth investors are highly sought after by fund companies who hope to provide them with a variety of services. The number of households with more than $1 million in investable assets will grow from approximately 2.5 million in 1996 to more than 15 million by 2010, according to industry estimates cited in an SEC filing by Gabelli.

The affluent investors in those households are candidates for hedge funds. Although requirements vary, hedge fund investors typically must show a minimum net worth of $1 million excluding the value of their home or annual income of at least $200,000. Hedge fund investments frequently start at $250,000.

"Mutual fund companies are very interested because the high-net-worth dollar is the best dollar to have," said Ryan Tagal, a Cerulli analyst who was one of the authors of that firm's hedge fund report.

Hedge funds also offer fund companies a means to reduce portfolio manager turnover. By increasing compensation, mutual fund advisers have an opportunity to keep managers who have a proven investment record and are a known commodity to the adviser. Managers in recent years have left mutual funds to start their own hedge funds.

Matthew Fink, president of the Investment Company Institute, said in written testimony submitted to Congress in September that hedge funds were putting "upward cost pressure" on mutual funds because of the compensation hedge funds offer managers.

"That's the reason everyone is leaving" mutual funds to run hedge funds, Tagal said. "It's the money." George Wilbanks, a managing director at the executive search firm of Russell Reynolds Associates in New York, said that culture is at least as important as pay for many portfolio managers. Managers are attracted to hedge funds because of the independence they afford and their entrepreneurial culture as much as the compensation packages they often can offer, Wilbanks said.

Nevertheless, hedge fund compensation has forced mutual fund companies to boost pay to remain roughly competitive. Some money management firms are using creative corporate structures so they can keep managers both running mutual funds and advising hedge funds for the same money management firm, Wilbanks said. Compensation in such cases is based on a combination of performance fees and the amount of assets under management, Wilbanks said.

"It's about these firms trying to ... keep these managers happy," Wilbanks said.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.