There’s an article in Sunday’s New York Times about hedge funds becoming victims of their own success. I’m not surprised about some of the things in the article given what I’ve been reading over the last week in Michael Panzner’s book ‘The New Laws of the Stock Market Jungle‘, which gives some great insights into what goes on with these hedge funds. (link via MaoXian)

I’ve archived the article below:

So Many Hedge Funds, So Few Strategies

By CONRAD DE AENLLE

Hedge funds have attracted substantial new money in the last few years, much
of it from investors disappointed with poor returns on conventional
assets. There are signs, however, that the funds are becoming victims
of their own success.

A proliferation of hedge funds has made it harder for managers to
wring value from the exotic techniques they employ, some specialists in
the field say. They emphasize that while some funds are worth owning,
investors must secure the right mix of managers and strategies,
something that advisers concede is often challenging.

A study by Citigroup Asset Management suggests that as the number of hedge funds has
expanded, the quality of the average manager has fallen. The study
examined funds practicing 12 common strategies during two periods, 1990
to 1997 and 1998 to 2002.

For 11 of the strategies, the study found a “significant reduction”
from one period to the next in the funds’ “alpha.” That is a
statistician’s term for the component of performance attributable to
the managers’ skill rather than market-related factors.

The study’s authors said that while the managers’ ability to
generate gains had shrunk, there was no way to tell whether that
erosion would continue.

“Hedge funds remain an attractive addition to a portfolio,” they
said. “However, incorporating them requires a nuanced and careful
approach to portfolio construction.”

There are plenty of building blocks for constructing a portfolio of
hedge funds, although the size of the industry is impossible to know
with precision because many funds are unregulated.

Philippe Bonnefoy, an adviser on hedge funds at Commerzbank
Securities in London, estimates that there are 7,000 managers worldwide
controlling $850 billion. Many managers, like many of their investors,
are arrivistes fleeing conventional asset classes like stocks and bonds.

“As long-only markets have had flat-to-negative returns in the last
three years, fund managers are looking for ways to reinvent
themselves,” Mr. Bonnefoy said. “There’s a lot of experimentation going
on.”

One reason the average hedge fund manager has been adding less
value, he speculated, is that many of the fledgling managers are
devoting too much time to raising money, not managing it. More than
three-fourths of hedge funds have less than $50 million in assets, he
said. In contrast, “a tiny percentage are starting with a ton of
money,” Mr. Bonnefoy said. “They’re well resourced and well
capitalized. They’re going to be successful.”

So successful that they probably are not interested in having you as
an investor. “Some of the people to whom you would want to give money
open with $3 billion on Day 1,” he said.

Large capital inflows can hurt performance because many strategies
seek to take advantage of small discrepancies in asset valuations. If
too much money is committed to this task, the discrepancies vanish.
“The increase in supply has eaten away at some of the arbitrage
opportunities,” said Chris Woods, the chief investment officer for
hedge fund strategies at State Street Global Advisors in London. As
more hedge funds try to exploit security mispricings, he said, “it
becomes harder to achieve.”

He said hedge fund investors should expect average annual returns of
6 to 8 percent - less than the 20 percent recorded in some years, but
still respectable.

BUT any decline in hedge fund performance is amplified by their
fees. A portfolio of funds typically adds about one percentage point a
year to the fees of the individual funds. These amount to about 2
percent of assets plus a performance fee, often 20 percent of any gain.

If a portfolio of funds is up 20 percent in one year before fees,
investors are likely to receive 13 percent or so. If the gain the
following year is 10 percent before fees, the net return will be about
5 percent.

Mr. Woods also warned that investors should expect the unexpected.
“Once every few years a really nasty event comes along,” he said.
“Hedge funds fall out of bed at the same time, and everyone heads for
the exits at the same time.”

That is why Bill Blevins, managing director of Blevins Franks
International, a large firm of financial advisers in London, avoids
putting his clients’ money into hedge funds.

“I personally do not like hedge funds,” he said. “They are an
accident waiting to happen in many cases. I suspect that in the
fullness of time, there will be much closer international regulatory
requirements for such funds, but probably not until we go through
another L.T.C.M.” He was referring to Long-Term Capital Management, a
huge hedge fund that incurred billions of dollars in losses in 1998.

Because hedge funds tend to be accident-prone, Mr. Woods said,
“diversification across many funds and many strategies is vital.” A
separate industry, including bankers, fund managers and financial
advisers, exists to try to achieve the ideal blend of hedge funds. This
involves interviewing managers to learn about their investment styles,
track records, discipline, risk control methods and other factors.

Then the firms build portfolios of funds that employ strategies
whose returns tend to be independent of one another. The portfolios are
intended to be independent of movements in stock and bond markets.

FUNDS of hedge funds, as the portfolios are called, are usually sold
through brokers or other third parties, rarely directly to the public.
The minimum investment is typically $50,000 or more.

With minimums set so high, these hedge funds are not being marketed
to small investors, but they are no longer the reserve of the ultrarich
either. Susan Hirshman, a wealth strategist at J. P. Morgan Fleming
Asset Management in New York, said that funds of hedge funds put
moderately well-off investors on roughly the same footing as very
wealthy ones.

The diversification they provide is a strong selling point, Ms.
Hirshman said. In addition, she said, the firms that build portfolios
“are doing all the due diligence, meeting managers, following up.”

Hedge fund managers are notorious for providing as little
information as possible about their activities, even to their
investors, but a good fund packager “can see into their funds,” Ms.
Hirshman said. “They don’t know everything, but it’s getting more
transparent.” Having more information helps control risk, she said.

Bob Worthington, a hedge fund specialist and a colleague of Ms.
Hirshman’s at Morgan, said that investors might consider Rydex SPhinX,
a fund of funds that tracks a Standard & Poor’s index of hedge
funds.

He also recommended funds in the Oppenheimer Tremont range, run by
Tremont Capital Management, an affiliate of the Oppenheimer mutual fund
provider.

Mr. Bonnefoy, at Commerzbank, agreed with Ms. Hirshman that an
important benefit of funds of hedge funds was risk control through
diversification. Succinctly alluding to the potential dangers of hedge
funds when they were not purchased this way, he said, “You’re not
taking single-strategy risk, so the chances of an unmitigated disaster
are quite minimal.”