September 6, 2003
Hedge Funds Remain Shrouded
As more investors become interested, the chances of greater transparency and regulation
grow. But will the industry balk at changing?
By Analisa Nazareno, San Antonio Express-News
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Because his clients are curious about hedge funds, San Antonio money manager Charles Robinson is, too.
"We're running a hypothetical portfolio, in the hopes of starting a hedge fund," said Robinson, a chartered financial analyst and a partner at Robinson & Wilkes, a small money management firm in North Central San Antonio. "Right now, they are so popular as an alternative investment."
For MBA candidate Holly Goodrich, hedge fund research or management may be one of the few frontiers where graduates could confidently seek employment after schooling.
"It's the only area of Wall Street that's growing," said Goodrich, who founded the Texas MBA Hedge Fund Organization at the University of Texas at Austin last year.
"You can put two and two together, especially when you see Merrill Lynch laying off their research and development staff, vs. the area of hedge funds, where they're hiring them," Goodrich added.
Hedge funds, once regarded as risky and obscure investment venues for the very wealthy, have become more popular among the moderately affluent since the collapse of technology and telecommunications stocks in 2001.
But as more investors and money managers become involved with hedge funds, scrutiny and criticism of the alternative investment tool has also been increasing.
Last year, the Securities and Exchange Commission held a fact-finding commission on the $600 billion hedge fund industry, and before summer held a two-day roundtable discussion about the subject. At the discussion, SEC Chairman William Donaldson alluded to possibly more regulation of the now minimally regulated hedge fund industry, which currently is required to report its activities to no government body.
"As the markets and the hedge fund industry have continued to evolve, I believe the time has come for us again to review hedge funds and how they are operated, managed and regulated," Donaldson said.
"We are looking to ensure investor protection, and are focusing on issues such as the 'retailization' of hedge funds, transparency, risk management, conflicts of interest and fraud."
The term "hedge funds" refers to a private partnership of high net-worth individuals - people who earn $200,000 a year or more and have $1 million in liquid assets - headed by a fund manager who also has invested a large sum of money to start the partnership.
Because the partnership is private and the players are wealthy, the activities of hedge fund managers have faced little regulation from the SEC.
Within hedge funds, managers are able to trade in stocks and bonds, but are also able to take speculative positions in derivatives, short-sell stocks, and borrow to leverage their purchasing and selling position.
Hedge fund managers also stand much to gain from opening and profitably operating hedge funds - initially 1 to 2 percent of initial investments, and then as much as 20 percent of any profits made.
"It's a bit of the Wild West out there," said Michael Serio, portfolio manager and senior vice president at Stein Roe Investment Counsel in Chicago. "It doesn't mean that it should be avoided, but people should know what they're doing prior to getting into it."
Serio said changes in government regulations would strip hedge fund managers of their competitive edge.
"I don't think anybody in the hedge fund industry wants to be regulated," Serio said.
"What I worry about is making them available to the masses of people who are not sophisticated, and then having a blowup occur and then all of the sudden, we're having hearings on Capitol Hill, with people calling for the regulation of the hedge fund industry," Serio added.
But to a certain extent, this "retailization" of hedge funds is already happening on a smaller scale.
Though most hedge fund private partnerships involve very wealthy individuals and institutional investors, a type of investment product called a "fund of funds" became available last year to the less affluent investor for a $25,000 minimum investment. There are about 20 such "fund of funds" available today.
"There is a reason why the government is looking into hedge funds, for the protection of the public," said Bonny Brill, director of industry relations for Denver-based Investment Management Consultants Association.
The association's Journal of Investment Consulting published a study of hedge funds by Ross Barry of Macquarie University's Applied Finance Centre in Australia.
Barry's study examined a database of self-reporting hedge funds, looking specifically at the causes and effects of hedge fund managers shutting down their partnerships.
Among his findings, he wrote: "We also found evidence in the risk return properties of defunct funds to suggest that many of these funds close themselves down following a period of sub-par performance due to their incentive fee structures."
In other words, because the incentive fees greatly favor a fund manager showing a profit, some hedge fund managers who experience a sustained dip below that minimum level will shut down their funds. "Because they don't make their money on their 1 percent (initial fee), where they make their money is on incentive fees, the 20 percent of the profit," Serio said.
"If the fund has had a bad event, and the manager doesn't think he can get back to the high water mark, they tend to shut down or start anew or do something else," Serio added.
Venkat Eleswarapu, an assistant professor of finance at the Cox School of Business at Southern Methodist University, said any investor considering hedge funds to diversify their investment portfolios must consider the high risks involved.
"They do take on riskier strategies," Eleswarapu said.
"It is clearly more risky than mutual finds. There's more volatility of performance, and a lot of hedge funds just disappear. They're around for a couple years, and then they do poorly and then just get out," Eleswarapu added.
Hedge fund manager Jeffrey Dabbs of Kercheville & Co. in San Antonio said that because the game is risky, players have to do their due diligence.
"It's like any other kind of investment," Dabbs said. "They should do background checks of the manager and lawyers and have lawyers check the legal documents for the agreement and look at the strategies that they employ and see if it's a sound strategy."
Investigating the criminal and professional background of a hedge fund manager and his or her associates will help an investor learn about the integrity of the manager.
But because of the secrecy and the lack of oversight and mandated reporting, investors considering hedge funds would have difficulty independently verifying past performance of a hedge fund manager. "You have to be really careful," Serio said. "We have employed firms that do due diligence for us. And to do the proper due diligence is extremely costly and time consuming."
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