Hedge Funds Inc.

Hedge funds and their managers are known as high rollers. But some experts worry the funds are growing too corporate and too cautious

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Hedge funds have developed a reputation as the highest of high rollers. Huge risk and huge returns have gone hand in hand. Pioneer George Soros makes $1 billion for his Quantum Fund in a single day by making a massive bet against the British pound. Long-Term Capital and Amaranth Advisors collapse when highly leveraged bets go bad, leading to billions in losses. Members of Congress are even fretting that they need to tighten up oversight of the funds, for fear of smaller investors losing their shirts.

Now, however, finance experts are raising a very different kind of concern. They worry that hedge funds, as they grow and mature, are becoming too institutional, too bureaucratic, and too risk-averse. The fear is that the returns at many hedge funds are going to go from astronomical to average. "You have to take risks to produce market-beating returns. That's what we pay people to do," says Robert Discolo, head of hedge fund strategy at AIG Global Investment Group (AIG). "But a lot of managers are notching it down. I'm not happy about it."

He's not the only one. Russell Read, chief investment officer of the $225 billion California Public Employees' Retirement System, said at a recent conference that hedge funds taking on average risk are "inherently unsatisfying." There's evidence to support this point. In 2006, hedge funds overall actually lagged the Standard & Poor's 500-stock index, with the average hedge fund returning 12.9% to investors, while the S&P index rose about 13.5%. (see BusinessWeek.com, 5/14/07, "Hedge Fund Fees: The Pressure Builds").

Behavior Modification

Why the newfound caution? One important reason may be the changing nature of hedge fund investors. In the early days, hedge funds were backed by wealthy individuals and institutional investors like AIG that wanted them to swing for the fences. In recent years, however, pension funds have become much more important in the hedge fund industry, and their appetite for risk tends to be much lower.

Pension funds have been plowing money into hedge funds and other alternative assets because they want to diversify beyond the typical stocks and bonds. Yet while wealthy individuals are often looking for the highest returns possible, pension funds are more conservative. They want enough cash to meet their pension obligations, but they generally don't want the risk associated with chasing blowout returns. "We have been known to sell funds that have been knocking it out of the park because we thought they were taking too much risk," says Neil Petroff, senior vice-president of tactical asset allocation and alternative investments at the Ontario Teachers' Pension Plan. So big are pension funds like OTPP, which manages $92.5 billion, that hedge funds modify their behavior to suit them.

That's an issue for investors like AIG's Discolo. The 17-year veteran gains a broad perspective on the market by handling a fund of funds that invests money in hedge funds run by other managers. Even though there are now 8,000 to 9,000 hedge funds, he says it's tough to find exceptional performers. "They are managing the assets in order to keep the assets and not taking enough risk to create market-beating returns," he says.

Fishing for Big Fish

The phenomenon isn't unique to hedge funds, of course. The mutual fund industry became more institutional years ago. A similar transformation is now under way at private equity firms. They're building larger management teams, with human resources, public relations, and legal staff—all things that were once unheard of.