The most encouraging sign for the hedge fund industry last year isn't found in market statistics, or total returns, or even rising asset values. No, that sign is found in scandal, and the spectacular collapse of Greenwich, Conn.-based Amaranth Advisors LLC.
If Amaranth cast a temporary blight on the hedge fund world, it also showed how the industry has come of age. Despite the dire predictions and the crush of media attention, little actually happened when Amaranth disappeared. Talented staff were scooped up by `rivals. Other firms picked over the carcass of Amaranth's investments. The message? Hedge funds have become far more diverse, and the financial markets had enough liquidity to digest the problem with barely a burp.
So Amaranth's collapse was as much of a non-event as a $6-billion (U.S.) flameout can be. Hedge funds are now a $1.1-trillion industry, where 8,000 companies are focusing on everything from activist investing, to conventional long-short strategies, to convertible arbitrage, merger arbitrage, and even private equity. The diversification has taken such root that the term hedge fund has become something of a cipher, making it difficult to make generalizations about the industry.
One thing seems certain, though: The money will continue to pour into these alternative investments throughout 2007. One of the key drivers will be large institutional investors such as pension funds, which are under pressure to stockpile enough cash to meet the needs of retiring baby boomers. Many of these investors are becoming more comfortable with hedge funds, and like that they have low correlation, financial-speak for investments that don't move up or down in value with market movements.
These deep-pocketed institutional investors, however, aren't accustomed to paying the sort of high fees common to the hedge fund industry, and their arrival should help bring fees down, said John Longo, a finance professor at Rutgers University and chairman of the investment committee at Parsippany, N.J.-based MDE Group Inc.
He believes this phenomenon may also force the secretive industry to become more transparent, and predicts that smaller, more nimble hedge funds will enjoy an advantage as the sector evolves.
"The bigger you are, the harder it is to generate returns. Both smaller managers and niche strategies should do the best, but it's not a free lunch," Mr. Longo said.
The problem is that finding these niches has become an increasingly difficult game. With so much competition in the hedge fund industry, managers must scour further and further afield for unique investing opportunities. Some, like Amaranth, try esoteric markets, such as natural gas futures. Others focus on emerging markets, or don their activist cloaks to force mergers and acquisitions.
"There is every strategy known to man -- and there are a lot of strategies not yet known to man, because they're going to be invented in 2007," Mr. Higdon said. "What's pushing demand is assets under management. It's the institutional investors coming up to speed with their allocations for hedge funds."
So far, however, fees have stayed stubbornly high. Some of the best funds charge "3 and 35" -- taking a 3-per-cent slice of the assets, and then 35 per cent of all the profit they generate. Even with pension funds rapping at the door, many top hedge fund managers don't believe fees will meaningfully come down. "It's a very personality-driven business," said one New York hedge fund executive. "If you like the team, you'll put up with the fees."
He acknowledged the space is crowded, and predicted it will take a bear market to knock a lot of the substandard hedge funds out of the market -- something not expected to happen in the short term.
"A lot of dumb money enters our space when [interest] rates get low," he said. "It's tough to make money then. But when rates go up, they scurry back to the mainstream."
Proposed regulations in the United States will raise the minimum wealth requirements for hedge fund investments in an effort to shield average investors from what are sophisticated -- and sometimes risky -- strategies. This, in turn, could hurt some smaller funds that cater to less wealthy retail investors.
U.S. investors will need to have at least $2.5-million in investable assets to qualify for a hedge fund, under the new rules. In Canada, the rules are a little looser, requiring just $1-million of investable assets or $200,000 in annual income.
Yet Canadians have not embraced hedge funds to the same extent as their southern neighbours. One reason is the collapse of Portus Alternative Asset Management Inc. in 2005, which burned many retail investors who had been drawn by the promise of a "principal protection" guarantee.
"It just seems like it hasn't quite got that appetite in Canada," said Steve Kangas, head of Toronto hedge fund BluMont Capital Corp.
Mr. Kangas said funds of funds, which were heralded as the next big thing in the industry, have not done as well as expected, in part because it's difficult to produce solid returns when there are several layers of fees. He is forecasting more growth in multistrategy firms, which diversify like funds of funds, but do all the work within a single firm.
"The U.S. has set the pace in asset allocation," Mr. Higdon agreed. "But I think the rest of the world will catch up, including Canada."
© 2007 The Globe and Mail. All rights reserved.
Only GlobeinvestorGOLD combines the strength of powerful investing tools with the insight of The Globe and Mail.
Discover a wealth of investment information and and exclusive features.