Three years ago Barton Biggs, the curmudgeonly chief global strategist of Morgan Stanley, said a hedge funds “mania” had gripped the United States and Europe and that a “bubble” was inflating. Biggs allowed that he didn't know when the hedge fund bubble would collapse, but he speculated that it would cause pain.

What's Biggs doing now? Why, he's a hedge fund manager, of course.

It seems everybody is doing hedge funds these days — a trend not lost on the SEC. Motivated in part by memories of the Long-Term Capital Management implosion, the SEC launched an investigation into the implications of hedge funds' rising popularity. In a report issued last September, the SEC recommended that hedge funds register under the Investment Advisers Act of 1940 to ensure they could be more carefully watched.

In February, in hearings to discuss mutual fund industry reforms, Congress also took up the issue of forcing hedge funds to register with the SEC. After all, the reasoning went, at the heart of some of the most abusive trading scandals was a hedge fund. (It should be noted that Fed Chairman Alan Greenspan in February stated that he was against proposals to regulate hedge funds.)

Under a Bushel

But what many may have missed in the SEC's report, Implications of Hedge Fund Growth, was the SEC's more nuanced view of the implications of hedge fund popularity.

“There was a broad feeling among many staff and Commission members that if hedging strategies are good enough for institutions and wealthy individuals, why aren't they good for average investors?” says Ron Lake, president of Lake Partners, investment consultants based in Greenwich, Conn. “The answer is: They are.”

Hedge funds and hedge funds of funds continue to grow in size and influence. The bear market helped investors see the beauty in absolute return strategies, such as long/short or market neutral. There are now an estimated 6,700 hedge funds, up from a mere 600 in 1990, that control around $750 billion in assets worldwide, according to TASS Research. Fund of funds (FOFs) have grown too: As of the end of 2003, there were an estimated 1,700, managing an estimated $200 billion in assets, according to TASS. That's up from 1,150 FOFs managing $70 billion of assets in 2002.

Foundations and endowments, large institutions and ultra-high-net-worth clients have long used hedge funds to round out their portfolios. But the past few years have seen the entrance of more conservative pension funds, which are coming to see hedge funds not as ticking time bombs but as true diversifiers against iffy capital markets. And the industry has been targeting the mass affluent market (those with $1 million to $5 million) with more accessible products such as FOFs and registered funds, including funds based on broad hedge fund indexes.

Johan Wong, CEO of HedgeWorld, the industry's main information provider, calls this process the “mainstreaming” of the industry. Hedge funds, once the exotic province of institutions and the super rich, are increasingly viewed as an asset class acceptable for all kinds of institutions and wealthy retail investors.

Thus, the SEC's interest is understandable, Wong says. “When assets are flowing into an area and there's a greater potential impact to the average investor, it becomes more important and the SEC starts looking into it,” Wong notes. It isn't clear if hedge funds and their sophisticated strategies will trickle down to the average retail investor. But, as its own report suggests, the SEC is considering allowing it. After all, mutual funds, with some restrictions, were freed up to mimic some hedging strategies for retail investors in the late 1990s (for a related story, see page 54).

Fourth Class Investment

In the past few years, such financial stalwarts as S&P, Dow Jones and Morgan Stanley Capital International (MSCI) have created indixes based on the different hedge fund investment styles. More recently, Morningstar, the mutual fund tracker, responded to marketplace demand for a hedge fund database. If these trends continue, hedge funds could soon become a fourth asset class, one that is essential to any well-balanced portfolio.

“In the not-too-distant future,” says John Kelly, president and CEO of Man Investment Inc., one of the largest multinational hedge fund companies, “a portfolio without hedge funds and alternative investments in them will appear Stone Age.”

While hedge funds may never trickle down to the average investor, reps who are targeting affluent investors (and who isn't?) need to learn the hedge fund basics even if they choose not to use them. “I think the use of hedge funds is increasing, and more and more clients are asking for them,” says Lynn Mathre, a CPA with Asset Management Advisors in Houston. “New clients may already have some hedge fund exposure when they come to you, so you have to get up to speed because you need to know what your clients own.”

Certainly many investors may still associate hedge funds with the 1998 blowup of Long-Term Capital Management and the dangers of derivatives. But as the legendary manager Michael Steinhardt once said, “Hedge funds use a speculative means for a conservative end.” Used properly, hedge funds can mitigate risk in a portfolio. Hedge fund managers use a variety of investment strategies (see style box on page 48) that can involve derivatives, shorts, leverage, managed futures and other tactics that are restricted in mutual funds. Some strategies may be risky because they involve a lot of leverage, for example, but others may be extremely cautious. Indeed, many reps use hedge funds in a portfolio as a kind of amped-up bond proxy rather than a source of dramatic upside returns.

“I'm not after equity-like returns. I want something that's higher than bonds in this interest-rate environment but that has bond-like volatility,” says Jonathan Bregman, investment manager at Hudson Palisades Asset Management in White Plains, N.Y. “The hedge fund I'm using has maximum drawdowns of 5 percent. If a hedge fund is up 20-30 percent, that means they can be down by that much, and that's not what I want. My dream hedge fund goes up 1 percent per month forever.”

In a Favorable Light

While many in the industry were worried about increased oversight and regulation, the SEC took an unexpectedly favorable view of alternative investments that, in effect, they do act as hedges. In addition to recommending greater transparency in information about funds, risks and fees, the SEC report recommended that “retail investors could benefit from greater access to absolute return strategies and hedge fund investment techniques.” It also advised relaxing restrictions on the use of leverage and shorting in mutual funds as well as the restrictions on hedge funds' ability to advertise.

“The SEC likes the incentive compensation and the absolute return orientation,” says Greg Stitt, a spokesman for OppenheimerFunds, which, with its affiliate, Tremont Advisors, offers hedge funds. “The criticism is that sometimes the mutual fund industry is too benchmark-based.”

The industry is responding to demand with new products that make hedge funds more accessible, more transparent and, in some cases, more liquid. FOFs, for example, combine the strategies of many managers into one product overseen by a seasoned manager. This not only creates a more diversified asset but relieves reps of the onerous due diligence involved in choosing the underlying managers and singling out one strategy. “Brokers are comfortable with funds of funds because someone reputable is doing due diligence,” says Stitt.

Financial services companies have begun to offer more registered funds, which offer several advantages to investors over traditional hedge funds, which are offered as private placements. Registered funds disclose more information to investors and can have an unlimited number of investors, which allows them to offer considerably smaller investment minimums — some as low as $25,000. Lower minimums also make it easier for reps to offer hedge funds to their mass affluent clients. (The funds are still supposed to be restricted to “accredited investors,” those who have over $1 million in assets or earn at least $200,000 a year.)

Registering Your Vehicle

The registered vehicle is catching on. Registered single- and multiple-manager hedge funds grew from 38 in December of 2002 to 52 in the first half of 2003, according to HedgeWorld. “We're looking at registered hedge funds carefully,” says Bob Alderman, managing director of alternative investments at Merrill Lynch. “We don't have it on the calendar, but the idea is extremely important for the $1 million client and above.” Other major brokerages are also laying the groundwork to offer registered hedge funds.

Yet more evidence of the mainstreaming of hedge funds comes from a nascent trend in investable hedge fund indexes. In the past few years, MSCI, Dow Jones and S&P have joined the industry's CSFB Tremont index with hedge fund indexes of their own. Various companies now offer investable versions of these indexes, which give investors a fixed exposure to an asset that theoretically crosses all styles in a scientific manner. S&P's HFI for example, launched in October 2002, contains nine hedge fund strategies grouped into three broader style categories: arbitrage, event driven and directional/tactical. Rydex adapted S&P's HFI into the first registered investable index, called the Sphinx Fund last June. Since then it has gathered $50 million in assets and is available on a variety of platforms, such as through Schwab and Raymond James.

The venerable S&P brand can't be underestimated. It has attracted reps like Cameron Turner of Adams Hall Investment Management in Tulsa, Okla., into hedge funds for the first time. “Until the last six months, we felt there wasn't an alternate investing product that fit our clients,” Turner says. Uncomfortable picking one strategy or manager, the low minimums, diversity and transparency of the index were all appealing. “One of the biggest deciders was that we knew S&P and knew it wouldn't put its name on something that was going to potentially blow up,” says Turner.

Principal protected funds, also being trotted out to retail, ensure investors that after a period of years, they will get at least their original investment back. While they are new to U.S. retail, these products are hugely popular abroad.

Too Big a Stretch

While hedge funds are becoming more accessible, they haven't gone far enough for many reps. Relative to other investments, fees remain high, liquidity and transparency low. “We decided not to use hedge funds for a few reasons,” says Stewart Welch III, head of The Welch Group in Birmingham, Ala. “First is the lack of transparency. We understand why it can be a great idea, but the cost is way too high.” True enough: Hedge funds not only charge a management fee of 1 percent to 2 percent, but incentive compensation of around 20 percent — that is, the manager takes 20 percent of the profits in addition to the annual fee. FOFs add another layer of management fees (as well as incentive fees).

“Once you pay the underlying managers the annual management fees and profit participation and then the overall manager, and then you pass on your fee, you have to make sure the client is going to wind up with a good return,” says investment advisor Jonathan Bregman. “When managers are putting together top tier returns, it's worth it, but not every manager is going to be worth it.”

And while liquidity on newer products may allow investors to redeem or invest once a month, it's more common to have to lock up your investment for at least a year before redemptions kick in. Another mainstreaming trend is the growing use of third party administrators, commonly used by off-shore funds. While hedge fund managers traditionally valued their own assets for investors, TPMs, as an independent third party hold the promise of reporting disinterested returns.

It's safe to say that hedge funds are expanding at a rapid pace. And there are many compelling arguments for using them in most portfolios. Will the current enthusiasm for these assets turn into a passing fad or a popping bubble? It's more likely that the industry is still just growing up.

“The business is moving into its teen years,” says Jim McKee at Callan Associates, a consultant to pension funds. “It's adopting responsibility and transparency, but hasn't matured into a full-scale, institution-friendly industry.” Still, there remains a lot of work to do in terms of providing ever better products and educating reps and investors.