Hedge Funds Are the New Mutual Funds

Oh, dear.

This was the year of hedge funds. The largely unregulated pools of private capital—generally available only to institutions and the rich—have proliferated nearly as fast as adulatory articles about them. Hedge-fund managers have historically been the Garbos of the asset management world: They want to be left alone by the media, by the public, and above all, by the Securities and Exchange Commission. But in recent years—and especially in 2005—they’ve had a coming-out party. Aggressive hedge-fund managers are seeking to shake up management and push restructurings at blue-chip companies like Time Warner and McDonald’s. Others, not content to flip stocks, have taken the reins at well-known companies, as Edward S. Lampert has done at Sears.

As the chart accompanying this article shows, the hedge-fund industry has doubled in the last four years; there are now an estimated $1 trillion in assets in 8,000 funds. Staid institutions like university endowments and state employee pension funds are plunging cash into hedge funds. And investment banks have rolled out funds that allow merely well-off people to invest in them.

Are hedge funds the next big thing in mass investing? And if so, will they suffer the same lousy fate as the last big thing in mass investing—mutual funds? In the 1990s, the mutual-fund industry doubled. Millions of new investors, lured by excellent recent performance, thronged into funds. Today, according to the Investment Company Institute, there are 8,000 U.S. mutual funds with $8.5 trillion in assets. Yet every year, the majority of them underperform broad market indexes—and charge fees for doing so. It turns out the mutual-fund industry expanded well beyond the ability of mutual-fund managers to run the money effectively. Today, mutual funds are a clunky business that relies heavily on marketing, survives on management fees, and fears new competitors.

Hedge funds are following mutual funds into mediocrity. A hedge fund could be somebody managing $10 million in family money or a large team managing $4 billion from a variety of investors. Hedge funds employ a dizzying range of strategies—some use quantitative and mathematical models, others focus on particular sectors, some make rapid-fire trades, others hold on to core positions. So it’s difficult to paint the largely unregulated industry with a broad brush. But here’s what is clear: Hedge funds are not doing so well. The S&P Hedge Fund Index, which tracks 42 funds employing different strategies, is up a measly 2.49 percent through mid-December. As of Dec. 19, the widely followed CSFB Tremont hedge-fund index was up a paltry 3.24 percent for the year. (And it’s quite possible these indexes are overreporting results. That’s because when a hedge fund folds, or when its managers are busted for fraud and investors lose hundreds of millions of dollars, as happened at Bayou Management earlier this year, it simply stops reporting results.)

Running a hedge fund is a fantastic business, if the markets are rocking and if you’re great. Hedge-fund managers get a small management fee—say, 1 or 2 percent of assets under management—plus 20 percent of the proceeds. If you manage a $100 million hedge fund and you’re up 20 percent for the year, you might collect $2 million from fees to spend on overhead and $4 million from profits to distribute to yourself and employees at the end of the year. But if you’re flat for the year, you’re left with $2 million to pay overhead, rent, expenses, salaries—plus the upkeep on the summer house. Worse, it means that your investors have just paid big fees for lame performance. After all, the S&P 500 has returned about 5 percent this year with minimal fees, and a certificate of deposit guarantees 4.25 percent with no fees.

Why are hedge-fund managers having such problems? The markets have settled down. They’re not going up parabolically as they did in the late 1990s, and they’re not crashing either, as they did in 2001 and 2002. This climate of lower volatility is bad news for people who seek to make money from short-term movements in the market.

But hedge funds, like mutual funds, are also victims of their own success. Hedge funds make lots of money from finding and exploiting tiny efficiencies, by piling into obscure undervalued stocks, or by building up stakes in weak companies that can be prodded and put up for auction. The problem is that there are now too many of these efficiency-seeking hedge funds in Greenwich and Midtown Manhattan. When too many people try to engage in the same strategy at the same time—buying shares in a retailer in the hopes that a private-equity firm will buy it for its real estate holdings, for example—that strategy weakens.

Hedge funds are also abandoning their penchant for secrecy. Barron’s has a monthly section where hedge-fund managers sit down for interviews and talk about their investments. Some like the publicity because they think it helps raise funds, and others go public because they’re seeking to create volatility by getting involved with public fights against entrenched management. But as carnivorous as hedge-fund managers like Carl Ichan sound, the business has matured and mellowed. Large investment banks—who have plenty of experience running underperforming mutual funds—are now seeking to bring that expertise to hedge funds. J.P. Morgan Chase last year bought Highbridge Capital Management, for example. The same mentality guides these big companies in their hedge funds as guided their mutual funds: Don’t worry too much about performance—just keep the cash flowing in. A large infrastructure of marketing, lobbying, public relations, and consulting professionals has sprung up to service the industry and raise funds. The hedge-fund business now has everything the mutual-fund industry has—even a Washington trade group.

This is not to say hedge funds won’t be around for a long term or that they can’t be a great investment for those fortunate enough to afford them. There are plenty of brilliant hedge-fund managers out there, many of whom will beat the market this year—and next year. The problem for the industry—and for investors, many of them new—is that while there may be 8,000 hedge funds, there are nowhere near 8,000 good hedge-fund managers.