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Insights: Finance

A brief history of hedge funds, and how you can buy in
Mario J. Gabelli
From the Print Edition:
Dennis Hopper, Jan/Feb 01

(continued from page 1)

Unfortunately, many of the new hedge fund managers weren't really hedging at all. Shorting even a small percentage of a portfolio restrained performance in the go-go markets of the mid- to late 1960s, so most hedge fund managers simply stopped doing it. They were leveraged long -- particularly risky business in less accommodating markets. This produced some big hedge fund losses in 1969-'70 and major bloodletting in the savage 1973-'74 bear market. The more prudent hedge fund operators survived, but many more closed their doors. In 1984, when Sandra Manske formed Tremont Partners and began researching the hedge fund industry, she was able to identify only 68 funds.

The hedge fund industry limped along until the early 1990s, when the financial press again began trumpeting the returns achieved by hedge fund superstars Soros (Quantum Fund) and Robertson (Tiger Fund and its offshore sister, Jaguar Fund). Many hedge funds no longer resembled the classic long/short equities model developed by Jones. For example, Soros made his big killing in the currency markets and Robertson employed modern financial derivatives such as futures and options, which didn't exist when Jones started his fund. With lots of new hedging tools and a tide of favorable publicity, the hedge fund universe exploded. At the end of 1999, Tremont Partners estimated as many as 4,000 hedge funds of all shapes, sizes and investment disciplines existed, 2,400 of which were tracked in its database.

The Fund of Funds

A new hedge fund concept -- the fund of funds -- also evolved. As the name implies, limited investment partnerships are limited to a maximum number of partners. Hedge funds are also limited by the type of partners they can accept -- very-high-net-worth individuals and large institutional investors (pension plans and endowment funds). Consequently, hedge funds remained very exclusive clubs.

Then, innovative financial service companies such as Tremont Partners began opening doors in the early 1990s by introducing funds of funds -- limited partnerships pooling assets to secure partnership slots with one or more top performing hedge funds. This pooling of capital opened the hedge fund doors to people with more limited investment resources. Fund of funds minimums are still generally in excess of $1 million, but you no longer need to be on the Forbes 400 list to hire the impressive investment talent that has gravitated to the hedge fund industry. Also, funds of funds allow investors to diversify among several hedge funds.

Hedge Funds' Inherent Edge

At this juncture, I hope some of you are at least intrigued by the hedge fund concept and wondering whether you should seriously consider a fund of funds investment. You will have to look beyond the recent headlines that have given hedge funds a bad name and realize that hedge funds are as good or bad as the folks who are operating them. To paraphrase famed investment writer Gerald Loeb, the only priceless ingredient in a hedge fund is its management. However, Tremont Partners and its research arm, TASS Investment Research, have identified performance patterns that infer there are meaningful advantages to the hedge fund structure.

Tremont's research reveals that from 1990 to 1999, the top 25 percent of hedge funds outperformed the top quartile of more traditional fixed-fee-based investment managers. Interestingly, this top quartile of hedge funds outperformed in down markets as well as up markets, indicating the use of leverage in rising markets does not fully explain higher returns. Tremont believes two factors -- trading advantages and incentive-based compensation -- give well-managed hedge funds an edge.

Trading advantages include superior information, lower transaction costs, better market access, size advantages and structural inequities in the markets in which investors operate. So, what's new? These are the very same advantages that financial institutions, including mutual fund companies, have always enjoyed. But remember, most hedge funds have greater investment flexibility than regulated investment advisers. They can profit from leverage in up markets and varying forms of short selling in declining markets, whereas most mutual fund companies can't use leverage and their only defensive option is to raise cash.

Also, hedge funds tend to be focused on less efficient market sectors where the "first call" on new information can translate into an even bigger performance advantage. Size matters as well. The largest mutual fund dwarfs the largest hedge fund. In today's volatile markets, the small and swift often have a distinct edge over the big and unwieldy.

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