Leadership Spotlight

Industry insiders agree that hedge funds are the victims of their own success, with good opportunities likely to be spotted by more funds and exhausted more quickly. “It’s harder; it’s more competitive,” says Karen Finerman, W’87, president of Metropolitan Capital Advisors in New York City.

Michael Steinhardt, W’60, managing member of Steinhardt Management LLC and a hedge fund manager from the early days of such enterprises in 1967 until 1995, agrees that this is probably the case. But he also doesn’t think today’s investors push their fund managers hard enough.

“[Some funds] could not exist without the softness, the weak nature, of so many of their institutional clients,” he says. “I say that because they are sheep-like in their choices. They are not demanding enough in terms of return expectations, particularly [with] hedge funds and private equity.”

His comment goes partly to what investors, and fund managers, have come to see as normal. “In those days, when the egregious 1-and-20 I was making was truly a rarity, I felt this extraordinary compulsion to be the best performing person in the world,” he says. But he feels it’s a different business now. “I think it’s now a superior method of compensation for anyone who can do it—without much pretense even of achieving rates of return that remotely, in my mind, justify the kind of compensation that hedge funds charge.”

If returns do come under pressure across the board, investors may eventually force fees down. But average hedge fund fees have been remarkably stable for years. Some observers suggest this is partly because better performing funds keep charging their 2-and-20 or more, while those that don’t deliver good enough net returns quietly close up shop.

Investor be Wary

With so many funds to choose from, picking the winners is becoming all the more challenging. Aside from achieving good enough returns, avoiding fund blow-ups—the inevitable occasional consequence of risk-taking by hedge funds—is a key objective of many investors, especially as more endowments and pension funds with responsibilities to their beneficiaries move into hedge fund investing.

In the mutual fund world, a single percentage point divergence from a benchmark annual return—say the S&P 500 stock index—is considered relatively large. In hedge funds, and even among funds that claim to pursue a similar strategy, the return difference between a fund that does well and one that does poorly can be 10 or 15 percentage points or even more.

That’s why investors queue up to get into funds with track records like Steven Cohen’s at SAC. But it’s also why Marston says hedge fund investments are not for everybody. “Somebody with one or two million dollars ought to think twice before they get into this business,” he says.

Gaine at the MFA also emphasizes that investors should be wary. His organization doesn’t view hedge funds as a retail product. He cautions that smaller institutional investors, too, need to do plenty of research to assess hedge funds before they invest.

One way to do so is by entrusting money to funds of funds, through which HFR reckons more than 40% of hedge fund investments have been made. In exchange for more fees— themselves sometimes a target of criticism—these groups screen individual funds and help investors select and gain access to a portfolio of funds that suits them.

Even after careful selection, investors shouldn’t expect too much, Marston says. He notes that with about $20 billion in assets, Yale’s endowment—headed by chief investment officer David Swensen, who has pioneered alternative investments with great success—has the scale and experience to have a reasonable chance of picking winners. Yet according to its 2006 update, the Yale endowment expects just a 6% annual return after inflation on hedge fund investments, or less than 10% in absolute terms.

“That ought to be an eye-opener for investors,” says Marston. “They’re going to earn something between fixed income and domestic equity … [with returns] not correlated with domestic long-only equity.” In other words, that non- correlation, which applies most of the time, should be as much of an attraction as the size of the expected returns.