BULLS & BEARS: Hedge funds on hot seat as fourth quarter nears

As the third quarter winds to a close, investors find the stock market behaving much as it did last year. At this point in both 2004 and 2005, the S&P 500 index (with dividends reinvested) had risen about 2 percent.

Most Wall Street pundits are predicting the market will finish this year with a repeat of last year’s performance, when a post-election rally pushed the S&P 500 to a 10.9-percent return.

One group of investors is praying they are right: hedge fund managers. Money has cascaded into these investment vehicles in recent years based on a perceived ability to outperform the stock market.

Following the market bubble, hedge funds did turn in stellar results, as some of the savviest managers profited by short-selling overvalued growth stocks and buying underpriced value stocks.

Yet as the money flowed in and the number of new hedge funds exploded, pricing discrepancies in the stock market have dwindled. Since 2003, hedge funds in aggregate have actually underperformed an S&P 500 index fund.

Much is on the line for hedge fund managers. These “alternative” investment vehicles charge substantial fees for their oft-touted expertise. The standard hedge fund charges a 1-percent management fee and collects a performance fee of 20 percent of profits (some charge much more).

Moreover, many pension funds and institutions choose to invest in this category through a “fund of hedge funds,” thereby adding another layer of fees. Funds of hedge funds are firms that conduct due diligence on hedge funds, raise money from investors, then allocate funds to selected hedge fund managers. They, in turn, usually charge management fees of 1 percent, with some collecting an additional 10 percent of profits.

This largesse led Bill Miller, the respected mutual fund manager of the Legg Mason Value Trust, to comment: “Hedge funds are not an investment strategy; they are a compensation strategy.” There are also concerns that many hedge funds have borrowed too much money in an effort to boost their performance. While this leverage magnifies investment returns on the upside, it also amplifies losses on the downside.

Not all hedge fund managers invest in the stock and bond markets. Some hedge funds deal in esoteric securities such as derivatives and credit default swaps, where market regulation, liquidity and accurate pricing are sketchy.

All of which makes the rush into these investment vehicles a bit curious. Many institutions, after all, are fiduciaries to retirement plans that generally place a high value on conservatism.

In part, what is driving the herd into hedge funds is:

a dissatisfaction with stock market returns in the aftermath of the bubble

a stretch for higher investment returns

recommendations from consultants, who, by the way, also charge fees and advise institutions to move money into these “alternative” asset classes.

Of course, there are hedge funds that have equitable fee structures and are run by very bright people, using prudent investment strategies.

Needless to say, it will be interesting to see how the year ends.

It would also not be surprising to see some underperforming hedge funds shut down, since it is difficult to pay the mortgage on the summer home in the Hamptons without those hefty performance fees.