While much has been written about the long-term viability of hedge funds in the mainstream and business media over the past five years, most of the managers interviewed agree that hedge funds are here to stay. Several expressed concerns that there could be some decline in the performance levels of some hedge funds compared with the past several quarters.

“In the past year hedge funds are not outperforming the market,” says Robert Bliss, “but in the past five years, hedge funds were vastly outperforming the market, and the funds accumulated during those years provided those protections during the downward market turn.”

Several months before the federal appeals court ruled against the SEC’s attempt to regulate hedge funds, Cliff Asness thought it likely that either the states or the SEC would impose regulations, mainly because of the risks that investors have faced recently. Which is not to say that he is enthusiastic about the idea.

“When it comes to regulating hedge funds, I prefer a solution with less direct regulation but increased tests for who can invest,” he says. “I think rich people and knowledgeable institutions should be able to make their own decisions, but we need to protect mom-and-pop investors. I don’t want retail investors. They tend to leave quickly when investments head south. One thing about wealthy people though, they tend to chase trends more than institutional investors, and that can get them in trouble.”

Neil Kuttner WG’78, chief operating officer of Cross Shore Capital Management, a small New York-area fund, noted that hedge-fund investors of all financial strata who do not know about hedge strategies or how much a particular hedge fund utilizes leverage can be engaging in risky behavior. Investors, no matter how wealthy, must do their due diligence and research to ensure that the fund they invest in is not engaging in irresponsible behavior.

A similar outlook is offered by Dr. Chris Geczy C’90, assistant professor of finance at the Wharton School.

“Yes, hedge funds and private funds are here to stay,” agrees Geczy, “but a massive blow-up could diminish investing. Endowments and state pensions will continue to allocate their money into larger hedge funds, enabling their asset size to grow. We will see an increase in the number of large funds, but the number of hedge funds overall may not increase.”

According to Geczy, this is due to the high regulatory and other fixed costs which will likely increase as the SEC and states continue to try to regulate hedge funds. Some members of Congress and a number of state attorneys general are taking a closer look into which branches of the government would be most suitable for the regulation of hedge funds.

Such regulation would make it more difficult for smaller hedge funds and those looking to start their own funds to survive in the industry without having a minimum threshold of tens of millions of dollars. “By and large, there has not been a fee compression,” Geczy explains. “Investors with the best track records may maintain their level of performance fees or even begin increasing them, but there could be increased stratification in the level of fees between large players and small funds.”

Asked about the broadening influence of hedge funds on the finance industry and investing public, Geczy responds: “It is possible that middle-class investors could gain more private-fund exposure, though the SEC worries about the ability of average investors to evaluate risk correctly. We may see more hedging mutual funds—that is, mutual funds that use strategies similar to those of hedge funds in order to get greater returns.”

The demand for hedge-fund positions among Wharton undergraduates and MBAs is extremely high. Geczy’s Wharton classes on hedge funds, which he taught with retired hedge-fund manager Leon M. Metzger W’77, are consistently oversubscribed, and hedge-fund firms have been actively recruiting on campus through the traditional career-services channels.

All of this could certainly change. There is much talk among those in the business community of a hedge-funds bubble, and even experts like Asness believe that there could be diminished returns over the next decade. An increase in the number of hedge funds has led to more competition for spotting those market inefficiencies; as a result, succeeding at the same level as even five years ago has become significantly harder. Money managers are split into two camps over whether performance fees will drop precipitously in the future, though it remains likely that the most successful investors will continue to charge high performance fees. No one knows how the states will eventually choose to regulate the industry. In Connecticut, several high-profile fraud investigations have brought unwanted attention to individual firms, as well as promises from Connecticut Attorney General Richard Blumenthal to make necessary changes in the coming months.

Despite the uncertainty, most of the hedge-fund managers remained optimistic that hedge funds will remain a permanent way of investing in the future and will become as traditional as the mutual funds, investment banks, and private equity firms throughout the country.

As Alan Winters puts it: “The key for hedge funds to survive is for them to continue to outperform the market after all the fees are paid. If you don’t outperform, you have no reason for being in existence.”

Aaron Short C’03 is a free-lance writer who works and lives in New York.

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Last modified 08/31/06

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FEATURE: Betting Their Hedges
By Aaron Short

Sept|Oct 06 Contents
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