Identity Crisis

As the line blurs between hedge funds and banks, a bit of mystique goes missing.

People have trouble defining the term hedge fund. For some it simply conveys an aura of big money tinged with a dashing hint of menace. But within a few years the term may be even more meaningless than it is now, because hedge funds are rapidly becoming indistinguishable from the rest of the financial-services industry.

D.E. Shaw, an American group, is a case in point. It started as a “quantitative” manager, using sophisticated computer models to pick stocks and, with $26 billion under management at the end of 2006, was ranked as one of the four largest fund groups in the world.

But hedge funds were only the beginning; there is barely a financial activity in which D.E. Shaw is not now involved. In early June it announced a bid for James River, an insurance firm. The group already has an arm, Laminar Direct Capital, that makes direct loans to firms. It has considered moving into private equity and owns FAO Schwarz, a big toy store. As well as running hedge funds, it operates a “long-only” business, which buys assets in the hope they rise in price.

As hedge funds like D.E. Shaw move in one direction, investment banks and conventional fund managers are shifting in the other. Many have bought hedge-fund groups outright (such as JPMorgan Chase’s purchase of Highbridge Capital Management) or have taken minority stakes in them (Lehman Brothers bought 20% of D.E. Shaw in March). Others either operate funds-of-hedge-funds (Goldman Sachs) or have set up separate hedge-fund arms (Gartmore and—less successfully of late—Bear Stearns).

There also seems to be a growing belief that there is more to investment than long-only management. The latest fashion is 130/30 funds, which use borrowed money to combine 130% long positions with 30% short (betting on falling prices). According to this philosophy, stopping fund managers from shorting stocks is like preventing Tiger Woods from using all the clubs in his bag; smart investors should be able to spot overpriced stocks as well as underpriced stocks. Such products, which have been dubbed “hedge funds lite”, allow investors such as pension funds to take their first steps into the world of “absolute return” investing.

It is not too difficult to work out why banks and traditional fund-management firms should want to be more like hedge funds. For a start, the annual management fees are a lot higher. Second, as the flotations of Fortress and Blackstone, two large and varied alternative-investment firms, have shown, the stockmarket is willing to pay a very high multiple for companies that earn performance fees.

But why do hedge-fund groups want to move the other way? Part of the reason is the Darwinian environment in which they operate. They are constantly on the lookout for markets that are inefficient or areas that offer excess returns. In banking and insurance, for example, hedge funds may benefit because they lack either the costly infrastructure or regulatory burdens that impede the traditional operators; borrowers say hedge funds are much quicker than banks at deciding whether to make a loan.

For the individual hedge-fund manager, diversifying makes sense. Some strategies may be profitable for a while, but then have bad years, as convertible-arbitrage managers found out in 2005. If returns are bad enough, the business can disappear overnight. But that is far less likely to happen with a range of strategies.

There is a further level of protection if the manager raises “permanent capital” by issuing shares. Hedge-fund investors have the right to withdraw their capital, subject to lengthy notice periods. But if the manager is running a listed fund, investors can redeem their holdings only by selling them on the open market; the annual management fee is unaffected.

Permanent capital can also be raised in a different way if the hedge fund issues bonds (as Citadel did last year) or floats shares of the management company (this week London-based GLG Partners became the latest to aim for a New York listing). Such capital-raising exercises allow founders to cash in their holdings and also give the hedge funds some independence from their prime brokers, on whom they depend heavily when borrowing money.

But flotations also force hedge-fund managers to be more transparent, diluting the mystique on which their high fees partly depend. And they accelerate the process by which boutiques turn into broadly based financial groups, with all the bureaucracy that implies (bureaucracy that many managers went into the business to escape). Hedge funds may be gaining fame and fortune as they expand, but they may be losing part of their soul.

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