NEW YORK - Call it growing pains. As much as hedge funds have impacted the investment community in recent years, the increased interest in, and significant inflows to, hedge funds from institutional investors have changed the way the $1.1 trillion industry operates.

"It's an entirely different game than it was 10 years ago," said Robert Schultz, who heads alternative fund services in the Americas for HSBC in New York.

These changes have resulted in new strategies, new products and even new regulations, according to panelists at The National Investment Company Service Association's Hedge Funds Conference held here recently.

Once a small community of a few hundred funds targeting high-net-worth individuals with unconventional investment ideas, the hedge fund industry has grown exponentially in the past two decades. In fact, between the late 1980s and 2003, the industry swelled from $40 billion under management to $650 billion, according to HegdeCo Networks, an industry information clearinghouse and consulting company based in West Palm Beach, Fla. Today, there are more than 8,000 funds, about 5,000 of which are registered, with $1.1 trillion under management. Analysts do not expect the growth to slow, either.

Much of that surge comes from institutional investors, such as endowments and pension funds, which are plunking down sizeable amounts of money in hopes of gaining alpha, any alpha, in a climate where most other investments are delivering single-digit returns.

Unlike yesterday's hedge fund investors, who sought supersized returns, these investors simply want reliable growth. "Pensions and endowments are not opportunistic investors," said Paul N. Roth, a partner at Schulte Roth & Zabel, a New York-based law firm with a large hedge fund practice. "They don't care about outsized returns."

This shift in philosophy has impacted the way the industry operates.

"The old hedge fund manager was the guy who grabbed the bat, stepped up to the plate, and swung as hard as he could to hit the home run," Roth said.

Today's managers, playing to institutional investors' interests, are swinging for a base hit, which may mean tempered strategies and perhaps fewer risks. Hedge funds are keen to attract this business, since most institutional investors have more money to invest than individuals, and the funds that win this business will grow the fastest, Roth said. That means small hedge fund boutiques will face more competition.

"Morgan Stanley, Goldman Sachs, Bear Stearns, we all [offer hedge funds]," said Barry J. Cohen, senior managing director of alternative investments at Bear Stearns of New York. "But if you look at the websites, you barely know they're there," he said.

That's because the increased popularity of hedge funds has also attracted the attention of regulators and spawned strict rules about the marketing and sales of registered funds.

"Regulators are very, very concerned with the trend toward retailization," Roth said.

Since February, hedge funds, formerly lightly regulated, have been required to register as investment advisors with the Securities and Exchange Commission and provide some basic data. Firms that meet certain hurdles, such as those with less than $100 million in assets under management, are exempt.

Cohen estimates that about 85% of all operating hedge funds have registered with the SEC, collectively representing more than 5,000 funds and almost 1,200 advisors.

Last week, during a speech in Minneapolis, SEC Chairman Christopher Cox announced that Federal regulators plan to comb through the recently submitted registration data. The analysis may lead to new rules for the industry, Cox said.

Another result of the rapid growth of hedge funds is a proliferation of products. Cohen predicted a continued rollout of registered hedge fund products. As a result, both the cost and the time required for approval should shrink as the SEC becomes more efficient at handling hedge funds, he said.

The biggest trend among new hedge fund products has been hedge funds-of-funds, which are hedge funds that allow investors to buy into a pool of other hedge funds. In part, these products themselves are a result of a growing practice among hedge fund managers to do business with one another, Cohen said. Previously, hedge fund managers were notorious for protecting their investment strategies.

Hedge funds-of-funds are also growing in popularity due to an increased demand for transparency, especially from institutional investors, speakers said. That means that investors will know not only what other hedge funds their fund has chosen, but the holdings of those underlying funds, as well.

"Open architecture would have been unthinkable 10 years ago," Cohen said. "Now it's common."

Funds-of-funds also typically can absorb a large amount of money, and allocate it through a diverse network of underlying funds, which addresses the challenge many fund managers face when they attract institutional investors who have large amounts to invest.

"There's a lot of money trying to come into the industry, said Virginia Reynolds Parker, president and chief investment officer for Parker Global Strategies of Stamford, Conn. "You have to be able to make allocations in a way that's nimble."

But just because funds-of-funds address some of these concerns, doesn't make them easy to manage.

"I call them a funds-of-headaches," Cohen said. Not only must fund-of-fund brokers ensure that investors are qualified for their product, according to SEC standards, but they must also ensure that the funds they invest in have no added requirements.

Unregistered funds in the funds-of-fund basket may have lock-up periods, during which investors cannot redeem shares. Furthermore, those lock-up periods affect the liquidity the funds offer, and affect managers' ability to implement some of the split-second strategies that, in the past, set hedge funds apart.

Properly pricing funds-of-funds is also challenging, said HSBC's Schultz. "We as administrators have historically failed in getting the net asset value right," he said.

The increased presence of institutional investors creates demand for service providers that can deliver real-time pricing and calculations for clients, especially the larger, more sophisticated clients.

"If I'm CalPERS [the California Public Employees Retirement System], and I bring in a few million, I'm not gong to settle for monthly statements. I need that information today and tomorrow," said Thomas A. Ayers, a partner with Deloitte & Touche in New York.

To do that, about 90% of hedge fund companies have turned to outside service providers for their back-office operations, said Mike Fisher, a director with Investors Bank and Trust Co. in Boston.

Schultz said that HSBC is outsourcing significant amounts of back-office work, and presently building a site in Calcutta, India, where the company expects to employ 3,000 people by 2009.

Companies will increasingly rely on back offices to meet the more stringent documentation and due-diligence functions, said Sean McKee, a partner at KPMG, which provides audit, consulting and accounting services. "Hedge funds will aggressively spend on technology when it means more money coming in," he said.

The increased call for information also means that investors are paying more attention to how their hedge fund managers are investing their portfolios, Parker said.

Registered funds have to adhere to the investment strategy stated in their prospectus, Roth said.

Where many investors want to see their funds invested is in emerging markets, Parker said. "But there is much more significant exposure," she added. "You have larger and growing exposure to operational risk, with more complicated types of assets and more complicated types of strategies."

Parker and Cohen agreed that Asian markets, while performing well now, probably cannot sustain their growth, citing problems Asian managers are having raising and placing money in their own countries.

Many of these changes are shrinking the outsized returns that first attracted attention to hedge funds. "People look for absolute return," Cohen said. And as long as other segments of the investment world struggle to deliver guaranteed returns, "people will tolerate a lot of beta in return," he said. And that affects how aggressive fund managers are willing to get.

Roth said that means investors can expect fees to go up so that managers, who traditionally take a cut of returns, can continue to profit. But when stocks and other investment vehicles begin offering more attractive incentives to institutional investors, Roth said, the hedge fund industry will likely return to its roots.

"People will need to be opportunistic again to sustain returns," he said.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

http://www.mmexecutive.com http://www.sourcemedia.com

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.