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Private investors are being squeezed out of the industry, which is now dominated by institutions.

The world’s super-rich will soon become marginal financiers in the hedge fund industry as the business they invented is increasingly dominated by large institutional investors, fund managers say.

Billionaires and other individuals rich enough to spend most of their time nurturing their bank accounts are still pouring more money into the industry, which uses sophisticated financial strategies to aim for high and sustained returns.

But inflows from pension funds, endowments and companies are rising faster, reducing private investors to a minority now that the industry, at an estimated $1 trillion of assets, has become sizable enough to swallow institutional investments.

Just five years ago, the overwhelming majority of the then-$500 million of assets managed by hedge funds were from wealthy individuals, said Tanya Styblo Beder, who runs a hedge fund called Tribeca Global Management LLC.

“If we go forward to the year 2010, it’s estimated that 80 percent of the assets under management in the hedge fund will be from institutions. So it’s a big switch that’s happening,” she said. Tribeca manages $1.5 billion for Citigroup.

Hedge funds first became popular as early as the 1960’s, when wealthy individuals used innovative financial tactics like short-selling and leverage to create returns they could not match in conventional trading.

Research confirms that such investors are no longer in the majority, with data provided by IFS, a U.K. financial lobby, showing 44 percent of the assets in the industry came from wealthy people in 2004, down from more than 60 percent in 1996.

The difference is even more telling when looking at inflows into hedge funds—a more precise measure of investor appetite. In 2004, institutions signed up for roughly 30 percent of inlows, a number expected to rise to 50 percent by 2008.

Bull market blues
Less sophisticated private investors may have lost interest in hedge funds, however, as the sector has shown meager returns in the last two years, with bullish equity markets pre-empting the need to hedge against bear markets.

Such high net worth individuals typically still have millions to look after and were often lured into buying alternative investment products by their banks in the heyday of the industry just a few years ago.

“You’ve seen some sub-optimal returns in 2004, some hiccups in 2005. Those clients are now thinking, hold on, that’s not what I was told about hedge funds,” said Jonathan Wauton, who leads Liberty Ermitage, a New Jersey-based hedge fund.

Private investors are typically more fickle than institutions, fund managers say, shifting assets rapidly in search of higher returns.

“Interest in hedge funds certainly from a private client perspective is waning, because they see that there are again decent returns to be made in equity markets,” says Stan Beckers, a hedge fund manager at Barclays Global Investors.

October was the worst month for hedge fund performance since August 1998, Eurohedge said recently, and analysts say funds’ returns in the first half of the year were nearly flat. Last year, the industry failed to match 2003’s solid returns.

Hedge funds ask for hefty fees in return for beating stock market indices on a sustained basis, often charging 2 percent of assets under management a year plus 20 percent of the actual investment result. Sometimes they ask for more.

Institutions will use their financial clout to strong-arm fund managers into charging lower prices, but private investors may well choose to return to equity markets instead, where returns may be similar and fees are much lower.

Hong Kong’s first property investment fund, which was nearly scuppered by a legal action from a pensioner, has gained on its first day of trading.
Shares in the Link REIT, or Real Estate Investment Trust, rose as much as 15% to 11.80 Hong Kong dollars ($1.5).

The fund will buy real estate such as car parks from the government and pay investors a fixed return from rents.

However, the scheme was delayed by a legal case that complained it would push up rents and grocery prices.

The case was dismissed earlier this year and demand for Link REIT has been strong because the returns it offers are better than those available in bonds.

That is especially the case now that the US Federal Reserve has hinted that it will stop raising interest rates in the world’s largest economy, prompting many investors to look elsewhere for opportunities.

“In the long-term, I think there is quite a lot of institutional money that might just want to simply have a yield, a relatively high yield, with perhaps a little bit of growth potential in it,” said Howard Gorges of South China Brokerage.

“If the expectation is that interest rates are near their peak, then it would be quite tempting to lock this in,” he explained.

The sale of shares in the Link REIT was the world’s largest initial public offering (IPO) of a property trust.

It was delayed after 67-year-old pensioner Lo Siu-lan applied for a judicial review.

She argued that the sale of property to Link REIT would push rents higher, not only for public housing tenants like herself but also for the shops where she buys fish and vegetables.

Those prices would then have to rise as a result, creating a situation where she and others like her were subsidising the profits of Link REIT.

Ms Lo also alleged that the portfolio of property being sold to the Link REIT was undervalued.

The case went all the way to the territory’s highest court, which found against Ms Lo in July.

Palo Alto, California-headquartered Technology Crossover Ventures has closed its latest venture capital fund, TCV VI, on $1.4bn. Investors in the new fund include public and private pension funds from North America and Europe, university endowments, financial institutions, family offices and technology entrepreneurs.

Jay Hoag, a founding partner of TCV, said, ‘We are very pleased to have received such a strong response to TCV VI from existing and new limited partners.’

‘We believe this response was a direct reflection of the great companies and entrepreneurs we have backed throughout our ten-year history,’ Hoag continued.

Rick Kimball, also a founding partner of TCV, added, ‘We appreciate the overwhelming support of our limited partners and look forward to continuing to work with great management teams to help them achieve their full potential.’

TCV VI will be invested by TCV’s team of 23 investment professionals, which includes ten partners. The new fund brings the firm’s total capital under management to $4.7bn.

The predecessor fund, TCV V, closed on $900m in 2004.

TCV is a provider of growth capital to technology companies. Its crossover investment model combines venture capital with public market investing and enables TCV to continue to invest in its portfolio companies at the IPO and beyond.

The firm’s investments include Actuate, CNET, Expedia, Liquidnet, Netflix, Redback Networks, Webroot and Xylan.

What may appear to be cash hoarding doesn’t translate to expectations of a crash in the property sector, according to these fund managers

With the wisdom of hindsight, many investors are vigilantly watching for signs of the next technology-like market crash in the real estate sector. After Morgan Stanley’s (MWD ) MSCI US REIT index reached an all-time peak of 885 on Aug. 2, stock prices seesawed mostly down, hitting a low of 783 on Oct. 13. Advertisement

During this time, Standard & Poor’s noticed that three real estate mutual funds had reported cash levels above 10% as of Aug. 31, based on the latest figures available in our database for 234 funds. Because mutual funds typically aim to be fully invested, we asked several managers if these cash hoards were defensive plays against an expected future crash. Or, more optimistically, were the managers building arsenals for use in a buying opportunity?

In this case, holding a lot of cash did not mean that these portfolio managers were expecting a bust. Michael Winer, manager of the Third Avenue Real Estate Value Fund (TAREX ), says the 12.79% cash level in his fund in late August was not unusually high. Last June, cash had represented 28% of assets. “We consider ourselves fully invested when under 10%, but we have been over that because of growth of the fund,” he says. “It’s a function of our ability to put money to work as fast as it was coming in.”

INTERNATIONAL DIVERSIFICATION. Due to rapid inflows of new cash, the $2.86 billion deep-value fund was closed to new investors on July 1, though it might be reopened if cash levels again drop below 10%.

Winer said he was avoiding stocks of companies building condominiums, especially in overheated markets like South Florida and Las Vegas. But the other income-producing, largely commercial sectors in which his fund invests—multifamily housing, office buildings, industrial, and hotels—look “very solid,” he says. Winer described the pullback in real estate investment trust (REIT) stock prices that began in August as a “great opportunity to add to holdings.”

A year ago, he began buying British property companies and, more recently, Hong Kong businesses. About 13% of the fund’s assets are now invested in real estate companies outside North America. In terms of diversification, this move makes sense to Standard & Poor’s, which finds that property stocks are less correlated internationally than traditional equities or bonds in general.

TAKING PROFITS. Alex Peters, portfolio manager of the $760 million Franklin Real Estate Securities Fund/A (FREEX ), admits that the fund’s 16.5% cash level in August was higher than normal. “I was having trouble finding opportunities at that point,” he says. Peters stressed that this position was due more to his bottom-up investment style than to any macroeconomic call. The fund doesn’t have a targeted cash level.

Peters says he’s somewhat wary of apartment REITs at present, because they “have held up the best and have the furthest to fall” in the event of a downturn. But he feels that retail and mall stocks, which represent his fund’s largest holdings, could best weather such a turn.

Although the $640.3 million Alpine Realty Income & Growth Fund/Y (AIGYX ) had 10.46% cash in late August and nearly 12% in late July, the fund “basically doesn’t have a cash position” at present, says manager Robert Gadsden. During the summer, the fund took some profits by trimming back health-care and other REITs. “We weren’t eager to invest it at that point because we didn’t like the valuations,” Gadsden says. Since then, customer redemptions—and new stock purchases by the fund as shares dropped further—have dissipated the cash hoard.

INTEREST RATE “WILD CARD”. Though Gadsden sees improving fundamentals in all property types, he’s particularly bullish on lodging, apartment, and office REITs. Higher end hotels are seeing little additional inventory and are able to raise prices, he says. Office REITs are a “mixed bag,” due to leases signed after the commercial market passed its 1998-2000 highs, Gadsden says. But he expects the coastal regions in which his fund’s office REITs are concentrated, specifically Southern California, New York, and Washington, D.C., to enjoy rising rents of potentially 10%.

Gadsden also confesses to lowered expectations. “We’re expecting returns in the real estate and REIT groups to be more in keeping with traditional real estate returns, not in the 30% rate you’ve seen over the last couple of years,” he says. “There’s a tension between rising interest rates but improving cash flow.”

While these portfolio managers aren’t expecting an imminent crisis in commercial real estate, a caveat mentioned by Gadsden is that interest rates are the wild card. “As long as interest rates don’t accelerate significantly, we think the improvements in the economy ought to benefit real estate companies, speaking broadly,” Gadsden says. If financing becomes more expensive and other investment alternatives more attractive, less money will flow into real estate. As of Nov. 11, the Morgan Stanley REIT index had recovered to 845.

GREATER TRANSPARENCY. Raymond Mathis, an equity analyst covering REITs for Standard & Poor’s, is generally bullish on the sector. He points out that REIT stocks typically have lower volatility than those in a broader index because their dividend yield can never be negative. By law, REITs must pay at least 90% of their earnings as a dividend.

“Over time, those dividends accumulate until you’ve been paid back,” Mathis says. “Even if a company is insolvent, it’s unlikely to implode because the shares represent claims on hard assets.”

In an October, 2005, study, “Listed Property and REITs—A Compelling Case for Popularity,” Standard & Poor’s found that from 1994 to 2004, more than two-thirds of the growth in the property sector came from REITs. In general, property stocks—defined as those held in companies deriving more than 60% of revenue from real estate development, management, rental, and/or direct investment in physical property—offer greater liquidity and transparency than directly owned real estate.

LIMIT SECTOR FUNDS. These stocks also reduce volatility in an investment portfolio. This asset class offers the potential capital gains of equities, along with a steady income stream similar to that of bonds. Nonetheless, like all sector funds, those dedicated to real estate are mandated to invest in a specific area of the market, whether it outperforms or sputters. As Winer puts it, “The market could be overvalued, but we invest in companies we think are undervalued.”

In addition, investors should consider how much exposure they already have to a given sector in core, broad-based funds. Notwithstanding careful stock picking, Standard & Poor’s generally recommends limiting sector funds to no more than 5% to 10% of an overall fund allocation.

Some investors and managers worry that funds are making ever-bigger, unhedged bets on stocks.
November 15, 2005: 4:06 PM EST
By Amanda Cantrell, CNN/Money staff writer

NEW YORK (CNN/Money) – Hedge funds, which have had a tough year so far and a particularly nasty October, could be headed for a spectacular fall.

People in the business say traditional stock hedge funds are looking more and more like plain old stock funds these days, since they’re buying more stocks outright rather than hedging their positions.

If hedge funds keep dialing up their exposure to stocks and don’t make adjustments, some fund managers and investors say, the funds could be in for a very unpleasant surprise the next time the market produces a year like 2002, when the S&P 500 tumbled 23.4 percent.

That year, hedge funds were far less correlated to the stock market, and ended up rising 3.04 percent, according to the CSFB/Tremont hedge fund index, which tracks the performance of 400 funds.

In October, the average equity hedge fund lost 1.55 percent, according to Chicago-based hedge fund tracker Hedge Fund Research, while the S&P 500 declined 1.78 percent.

Investors and fund managers note, of course, that it’s impossible to say when stocks will have a big down year.

But growing signs that managers are just aping the performance of the broader market are disturbing to some in the business, who note that investors are paying eye-popping fees for the expertise of hedge fund managers.

“Investors will recognize that when a manager isn’t adding value and doing their job it’s not worth the fees that they are paying them and they will move on,” said Russell Lundeberg, the chief investment officer of Barrett Capital Management, a fund that invests in hedge funds.

Hedge funds were originally designed to produce positive results in up or down markets—in large part by using investments to offset risk, or hedge, against market declines.

The theory was that when stocks rose, so-called absolute return funds would rise, but not as much as the broader market. And when stocks sank, the funds would fall less.

Analysts noted several factors that have pushed hedge funds away from their original direction.

Investors are demanding bigger returns, a “gold rush” mentality has led less experienced managers into the business, and more managers have come from mutual funds where a classic hedging technique, short-selling, or betting against certain stocks, is less widely used.

“It’s a result of investor demand and the type of managers coming into long/short and where they cut their teeth,” said Justin Dew, senior hedge fund analyst at Standard & Poor’s, referring to the traditional stock hedge funds that both buy (go long) and bet against (go short) certain stocks or sectors.

What it means to you
Why would a rough year for hedge funds matter to the average investor?

The hedge fund industry has doubled in size since 2001, according to Tremont Capital Management, and these funds now manage an estimated $1.3 trillion worldwide and can have a big effect on some markets.

Perhaps more important is that more average Americans are exposed to hedge funds than ever before through their pension plans. After years such as 2002, when hedge funds dramatically outperformed the broader stock market, pensions began investing in hedge funds to boost their performance.

Shortly after the Sept. 11 attacks, many long/short equity hedge funds stepped up their hedging to reduce their exposure to the stock market.

But in the intervening years, from 2003 to 2005, these funds appear to have drifted away from more aggressively hedging their portfolios. From 2003 to today, hedge funds have doubled their net long exposure, according to research prepared for CNN/Money by Markov Processes, a New York-based financial services consulting firm.

Markov CEO and founder Michael Markov analyzed the returns for long/short hedge funds using both the CSFB/Tremont index and Hedge Fund Research’s index and compared them to returns from the S&P 500. The research found that the levels of net long exposure in the funds studied are now back to pre-Sept. 11 levels.

“One may conclude that it took about two years of solid market gains for hedge fund managers to become more optimistic and increase their net exposure in 2004-2005,” Markov wrote.

Why are managers dialing up their exposure to the market?

Barrett Capital’s Lundeberg believes that the explosion in the number of hedge funds worldwide in recent years has created a surfeit of new managers who aren’t experienced and don’t know how to hedge effectively.

“With all the new entrants into the hedge fund world, there are a lot of people that are coming … that unfortunately are no more than mutual funds with hedge fund fees,” he said.

Do your homework
And one investor noted that long/short managers are not as contrarian as they used to be and often just follow the herd, and end up owning many of the same stocks.

This investor noted that it’s getting harder and more expensive to short stocks, and that many long/short equity managers are gaining short exposure not through stocks but through derivatives. A typical example is a hedge fund that takes long positions in stocks but shorts ETFs, this person said.

Dew said he believes that rising net exposures in long/short equity funds are not necessarily a bad thing—as long as these managers apprise their investors of the types of risks their investment style carries.

“As long as managers do what they say and say what they do, I don’t think it’s an issue. If the manager deviates from that, that’s when you get into style drift, and that’s a big problem,” he said, referring to managers who deviate from their stated strategy.

“If I were invested with a manager and all of a sudden the market was down 20 percent and my manager was only down 2 percent, I’d question that,” Dew said.

“No matter what the direction of the inconsistency, it should be questioned,” he added, because it could indicate that the manager took on bigger risks than advertised.

The Hedge Fund Services business of UBS Global Asset Management has reached the milestone of $100bn of assets under administration.
With offices in Grand Cayman and Dublin, the business, with a professional staff of 140, holds a leading position in hedge fund administration services and benefits from a significant ongoing investment in state-of-the-art technology. The business provides a complete range of services including accounting, NAV computation, shareholder services, banking and credit facilities. Hedge Fund Services administers over 700 funds with assets balanced between single funds and funds of funds.

The business has a specialised team to service the unique needs of both sets of clients. Its offering to fund of funds sponsors includes specially tailored services such as global custody and settlement services, credit facilities and foreign exchange hedging. For single manager funds, the business offers considerable expertise in valuing complex instruments, and a global platform with connectivity to all the major prime brokers. All valuations are conducted independently from the fund’s own prime broker.

Commenting on the latest news, Sean Flynn, head of Hedge Fund Services, said:

“We are very pleased to have reached this milestone. It illustrates the confidence that our clients have placed in the business. Clients – both private and institutional – expect full service capability from day one. To continually meet their needs in this competitive industry, you need the experience to understand their requirements and the scale to deliver. We are continually investing in people and infrastructure: by hiring and training qualified, experienced staff; and ensuring we have accurate, timely reporting and robust systems.”

One of the world’s top ten hedge fund administrators, UBS has administration offices in the Cayman Islands and Dublin. Clients include asset managers, institutional investors and family offices.
The business expects to expand this network with offices in North America and Asia in 2006 to better meet the needs of clients in their own time zones.

With fewer investors and low returns, the $1.1 trillion behemoth needs a new direction.
November 14, 2005: 12:52 PM EST
By David Stires, FORTUNE writer

NEW YORK (FORTUNE) – Fidelity is in a funk, and it is finally making some dramatic moves to shake things up.

The stage was set back in May, when Stephen Jonas replaced Abigail Johnson, the daughter of chief executive Edward “Ned” Johnson III and long considered his potential successor, as head of Fidelity’s core money-management unit. Now Jonas is on a mission to improve the firm’s mediocre results by revamping the firm’s research operation.

It’s about time. Fidelity has taken in just $3.4 billion in new money since Jan. 1, according to Financial Research Corp. That’s down 80 percent from the same period a year ago. American Funds has inhaled $61.2 billion this year, while Vanguard has collected $34.9 billion. Many of Fidelity’s signature large-company stock funds—including Magellan, Dividend Growth, and Growth & Income—rank in the lowest quartiles of their categories based on three-year performance.

Jonas’s mission is to improve those mediocre results. Soon after he took over, he and his team began scrutinizing the company’s funds.

“Domestic equity was a mixed bag,” Jonas said during a recent interview. While half of Fidelity’s $500 billion in domestic stock funds were “doing extremely well,” he says, half were “not meeting our performance expectations.”

And that’s not acceptable for the Boston fund behemoth. Unlike Vanguard, which is famous for its low fees and index funds, or the broker-sold American Funds, which excels at delivering reliable returns, Fidelity relies on hot funds to attract investors.

“Fidelity is a performance shop,” says Jonas, who wants all his funds to beat at least two-thirds of their competitors on a three-year basis, and for longer periods as well. “We will have good performance across all our asset classes.”

To reach that goal, Jonas will spend $100 million to double the number of U.S. equity analysts to 150 by next summer. And no longer will Fidelity hire all its analysts straight out of business school and groom them to become portfolio managers. Now the firm is bringing in experienced analysts and allowing them to follow companies for years.

The research staff will also be organized differently. To augment Fidelity’s analyst pool, Jonas is creating a series of small teams of two to 20 to work closely with specific fund managers. Fidelity first started using this system in the mid-1990s in its bond division and generally liked the results. The teams will sort through research from the central pool of analysts and do intensive work on the most promising stocks.

“The idea is to get a large organization to feel and play small,” says Jonas. “We’re trying to get the best of both worlds.”

Magellan will be the big test for the new system. In many ways the fortunes of the fund mirror those of the company. Ned Johnson was the fund’s first manager, serving from 1963 to 1971. But it was Peter Lynch’s dazzling results—annualized gains of 29 percent for 13 years—that made the fund an enormously powerful marketing tool; long after Lynch left, the Magellan name helped persuade big companies to pick Fidelity to run their 401(k) plans.

At its peak in 2000, the fund was the largest on earth, with $102 billion in assets, and delivered an estimated $500 million in annual fees to the parent company. Since 2000, a combination of market losses and shareholder defections has cut Magellan’s assets to $52 billion.

Now it’s up to Harry Lange, a stock picker known for an aggressive style, to turn the ship around. Lange, 53, first joined Fidelity as an industrial and machinery-stock analyst in 1987; he took over Fidelity Capital Appreciation in 1996. There, he displayed some of Lynch’s gunslinging style. When the market plunged after the terrorist attacks on Sept. 11, 2001, for example, Lange doubled his technology-stock holdings to 30 percent of the fund’s assets. As a result, the fund roared back as the market recovered.

“This is good news for shareholders,” says Eric Kobren, executive editor of Fidelity Insight, an independent newsletter based in Wellesley, Mass. “Lange will make Magellan a more aggressive, go-anywhere fund, as it was under Peter Lynch.”

“I’m going to make it a go-for-it kind of fund,” Lange says. “I really want to shoot the lights out.”

Energy Investors Funds, a private equity fund manager that invests in the US energy and electric power sector, has closed its sixth institutional fund, the United States Power Fund II, with $750m in commitments. The original target was $500m.

Investors in US Power Fund II - the firm’s largest fund to date – include the California Public Employees’ Retirement System, Howard Hughes Medical Institute, John Hancock Life Insurance Company, Kauffman Foundation, MIT, Pacific Life, UnionBanCal Equities, and University of North Carolina, in addition to other corporate and public pension funds, funds of funds, endowments and foundations, insurance companies, banks and financial institutions. The global investor base represents the US, Canada, Europe and Australia, with 31 investors in total and 85 per cent returning, Energy Investors Funds said in a statement.

‘Investor response to US Power Fund II was extremely positive, resulting in a greater diversity in our limited partner base for this fund,’ said John Buehler, Energy Investors Funds managing partner. ‘There is ongoing interest in our investment strategy in the power and energy market, and we have been able to attract an array of investors as a result of our 18-year track record as the pioneer private equity investor in this sector.’

US Power Fund II has already made three investments: Glen Park Hydroelectric Project, Neptune Regional Transmission System, and a New York-based transmission project.

Energy Investors Funds was founded in 1987.