Hedge funds look set to take off as investors, scarred by recent losses, demand more rigorous management of their capital – and as regulatory changes make the previously clubby and secretive world of hedge funds available to a broader group of investors.

Hedge funds always used to be seen as the bad boys of the financial community. Today, their image is not quite as bad as it once was.

In part, that is because they have been eclipsed by mutual funds, who were supposed to be looking after mom and pops’ savings, but were actually stealing from them – and by the big banks and securities firms, who told lies about the value of internet stocks and tangled themselves up in conflicts of interest.

Admittedly, hedge funds have not come out of the recent spate of financial scandals completely untarnished. One fund, Canary Capital, was fined for its role in the mutual fund timing scandal, and more hedge funds will no doubt be implicated as the net widens.

But Eliot Spitzer, the high-profile New York attorney general, has done the hedge fund industry a huge favour by showing that hedge funds are no worse than any other financial activity.

This may not seem like much of an accolade, but it is an improvement on the low position that hedge funds once held in the public esteem. When this improvement in the image of the industry is combined with solid performance by many hedge funds during the recent equities bear market, the scene is set for a period of impressive growth that will accompany the steady democratization of the industry.

The main drivers of this process that will take hedge funds from the wood-panelled offices of private Swiss banks to the shelves of the financial supermarket will be US regulators and the investment banks.

Regulators at the Securities & Exchange Commission are considering forcing all hedge funds to register. At the same time, the investment banks want to sell these high fee products to their clients.

What seems certain is that nothing will stop the hedge fund juggernaut. The spectacular collapse of Long-Term Capital Management in 1998 slowed the flow of assets into hedge funds for just one quarter.

Thereafter, the relentless march upwards continued with Europe emerging as the fastest growing hedge fund market. Assets in Europe have surged from $17 billion in 1999 to close to $130 billion at the start of 2004.

The only question now is about the pace of growth. Will it continue at its current breakneck speed or will it slow as the weight of assets impacts on performance? Much will depend on performance and on the outcome of the SEC’s deliberations over regulation.

If the SEC forces mandatory registration and if performance continues to be good, then a new army of investors will discover hedge funds. If, on the other hand, either the industry performs moderately or if mandatory registration is not introduced this year, then the pace of democratization will slow.

The old guard, who violently oppose any regulation and want the industry to stay the way it is – a cosy and secretive club of wealthy individuals and big institutions – realize that the best way to slow democratization is to get the SEC to change its mind. On the other hand, those calling for modernization know that registration must be implemented to maintain the momentum.

This battle between the old-timers and the modernizers only affects the US, which accounts for $600-$700 billion of global hedge fund assets. In Europe and Asia the forces of modernization are already firmly in control.

Even the conservative regulators in Germany are willing to change the rules to allow hedge funds to prosper, but in the US the outcome of the regulatory debate is far from certain.

The older, established US funds argue that registration will provide no tangible benefit to investors. They say that once the process of regulation starts it will go further and further in a process they call “regulatory creep”.

But what the big, established players hate above all is the threat to their cherished secrecy as registration will create a vast directory of hedge funds on the SEC website.

Such is their loathing for this proposal, and such is the level of emotion the debate generates, that one of their supporters recently said: “It will mean that hedge fund managers [will be] rounded up and led naked into the square.”

Arrayed against the old guard are many investors, particularly in the fund of funds community, which now accounts for 50% of the assets flowing into hedge funds.

They, in particular, see merit in the second half of the SEC’s proposal, which is actually far more significant than mandatory registration as it will allow hedge funds to advertize and tell potential clients about their funds.

Currently, under US private placement rules, hedge funds aren’t allowed to say anything about their funds in case the “mom and pop” market of US retail investors overhears and invests with the fund.

Under the proposed SEC rule changes, hedge funds will be allowed to tell anyone about their funds, but they won’t be allowed to take money from anyone but qualified or accredited investors.

This subtle change means that hedge funds will no longer be breaking the rules if they simply talk about their fund. They will only break the rules if they allow “unsuitable” people to invest.

The modernizers have the two Democratic Party commissioners of the SEC, backed by the SEC staffers, on their side. For the time being, William Donaldson, the Republican chairman of the SEC, also appears to favour registration.

That leaves two Republican commissioners on the side of the old guard. Both Paul Atkins and Cynthia Glassman have publicly opposed the proposal for mandatory registration.

As the battle over mandatory registration goes down to the wire, the big investment banks are simultaneously gearing up to sell hedge funds to their institutional and private banking clientele.

These banks, led by Merrill Lynch, UBS and CSFB, have got over their coyness about being associated with the one-time villains of the financial services industry and are planning a series of initiatives to market hedge funds.

The most eye-catching example of this is the return of Merrill Lynch, CSFB and UBS to the business of selling hedge funds, something none of them has dared to do since the Long-Term Capital debacle.

Ironically, they were willing to sell internet stocks or obscure mining companies to their customers, but they weren’t willing to sell them the best performing asset class in the world over the past three years. Before long they will be back selling established managers for a one-off placement fee on one to three-year lock-up terms.

The next phase, many people believe, will be the securitization of hedge funds, where hedge funds will be bought and sold through banks with daily liquidity.

Even if it doesn’t go this far, the very act of marketing funds to banking clients will bring in a different set of investors – the “sticky” institutional investors – so-called because they won’t give money to the industry unless they are satisfied that they are getting enough transparency.

Other banks, like UBS, are in the process of constructing platforms that will allow their private banking customers greater access to hedge funds. These platforms are likely to offer clients a choice of single managers, funds of funds and a new concept of “baskets” – consisting of a limited number of strategy-specific single-manager funds – in a move to increase dramatically the allocation of their customers to hedge funds.

The factor that could slow this aspect of the democratization process is performance. While hedge funds have performed well over the past three years, the case for hedge funds is a subtle one that may not translate well in the hands of salesmen at bulge-bracket Wall Street firms.

This is because if we cast a superficial glance at the recent performance of hedge funds it doesn’t look that impressive. Furthermore, there are fears that the growth of the industry could have a negative impact on performance.

From the early 1990s when the bull market got underway, to March 2000 when the internet bubble finally started to bust, hedge funds – as measured by the CSFB Tremont Index – lagged the S&P; 500 by 90%.

There should be no surprise in this underperformance – although it does seem pretty large – it is what the textbooks tell us should happen. Hedge funds are buying insurance with their short positions, which inevitably means that they lag a raging bull market.

But what happens next, in the bear phase of the market from the peak in August 2000 to the summer of 2003 does not conform to the orthodoxy of the textbooks. According to the theory, hedge funds should have marched on at a rate of 10%-15% a year irrespective of the severity of the bear market.

They didn’t. In fact, many critics rather unkindly referred to hedge funds throughout this period as products that delivered “cash minus fees”.

However, they didn’t lose any money, which is crucial in the next part of the story, and they outperformed the S&P; 500 index by an impressive 50% over the three-year bear market.

When the equity market started to recover after the fall of Baghdad, hedge funds started compounding again from a higher level than US equities, which had a mountain to climb before they get back to their all-time high.

Over the full cycle, from the start of the bull market, through the bear market and out the other side again in the second half of 2003, hedge funds outperformed the S&P; 500 by an astonishing 53%.

A pretty impressive story, but nonetheless a complicated one, and one that has not satisfied the majority of hedge fund investors, who think they should have done better.

Many are now fretting about performance and looking at ways of improving returns by building more volatility – hopefully upside volatility – into their portfolios, and by looking at ways of levering up their fund of funds portfolios.

What concerns them is that performance hasn’t been stellar, while hedge fund assets have been relatively small. All of which begs the question: what will happen when the industry ‘democratizes’ and assets double or treble?

The answer is that the opportunity set in hedge funds is very diverse with strategies ranging from merger arbitrage to macro and specialist equity, which can blow hot and cold depending on market conditions.

This will always be the case. Sometimes the poor performance will be rightly blamed on capacity issues, but more often than not it will be down to other factors. That is the nature of this fascinating and fast-moving business.

Iain Jenkins
Iain Jenkins is the founder of HedgeFund Intelligence (www.hedgefundintelligence.com) and managing editor of EuroHedge, AsiaHedge, InvestHedge and Absolute Return. Before launching HedgeFund Intelligence in January 1998, he was investment editor of Sunday Business, European business editor of the Sunday Times and investment writer for the International Herald Tribune.