NEW YORK (CNNfn) - It's been nearly a year since the hedge fund industry captured headlines with the high-profile bailout of Long-Term Capital Management, the take-no-prisoners hedge fund founded by former Salomon Brothers trading legend John Meriwether.
The fund's staggering losses, triggered by sky-high leverage levels and the default of Russia's debt, sent shock waves through the markets when first reported last August.
And since then, industry insiders have been struggling to convince gun-shy investors (not to mention concerned regulators) that LTCM was an aberration -- that the vast majority of hedge funds take a more conservative investment approach that strives for steady returns.
They did a good job.
Today, profits in the hedge fund industry are going strong, most investors have put LTCM behind them, and those following the industry say there now are better internal controls in place to ensure such a crisis never happens again.
Banks reign in lending
"I think the silver lining in the cloud is that in the LTCM crisis it was the banks that really got the fingers pointed at them, because without banks and lenders (that provide funds with liquidity), the hedge funds can't make investments," said Steven Lonsdorf, president of VAN Hedge Fund Advisors International in Nashville, Tenn., an investment advisory firm specializing in hedge funds.
"As a result, we are seeing much better oversight and better internal controls on the part of the banks with respect to their lending policies to hedge funds," he said.
He noted most investment houses that lend to hedge funds "are just a lot more conservative now in how much money they are willing to spend."
That's good for the industry, Lonsdorf said, because it has forced fund managers to keep leverage levels under control and to hedge their bets a lot more carefully.
"This year, hedge funds are using what appears to be a lot less leverage than last year and they are also much better hedged," he observed.
Hunt Taylor, senior vice president for Tremont Advisers, a hedge fund consulting firm in Rye, N.Y., agrees.
"One of the things you are seeing in this industry now that you can trace back to LTCM is a rather pronounced lack of liquidity," he said. "We are seeing substantially less leverage both from lenders [and the hedge funds themselves.]"
Time to dive in?
Now, those keeping a finger on the pulse of the industry say some hedge funds -- many of which already are reporting returns back up to pre-LTCM levels -- are poised for additional gains in the months to come.
That's especially true for those involved in bond arbitrage.
That's because the spread between the price for corporate bonds and government bonds (on which many hedge funds base their bets) has widened to levels not seen since last October.
Lonsdorf said that represents a potential buying opportunity -- for those who can afford it.
"Last year, when the spread widened out in October, a lot of people [cashed out of hedge funds] but really, that's the time they should have been buying," he said, noting there's always a buying opportunity when there's a "serious price dislocation"
Lonsdorf acknowledged the wise investor should still exercise caution when considering hedge funds. But he said, they should keep the sector on their financial radar screen.
"If history repeats itself, and it often does in this business, then over the next 6 to 8 months these spreads will start to come back in again, which will produce better than average performances for these types of arbitrage strategies [used by some hedge funds]," he said.
"Most managers I'm talking to are excited," he said. "They say they are very hedged, not highly leveraged and once we get through this wide spread situation, they say they are getting set for what we hope will be a better than average run of the market over the next 6 to 8 months."
Although he wouldn't disclose the names of hedge funds he recommends, he did say investors also should keep their eyes on funds that play the spread between U.S. government securities and the bonds offered by other countries.
"Another one that could benefit [from the existing wide spread] is the funds that play mortgage backed securities," Lonsdorf said.
These funds take bundles of home mortgages, package them together and sell them as securities. Then, they play the spread between those mortgages and government bonds.
"It's the same as last fall, when the spread widened," he said. "The difference is that this time, fund managers are better prepared for this situation and consequently they are using much less leverage, so there's less risk."
According to VAN Hedge Fund Advisors, the average U.S. hedge fund outperformed the S&P 500 index with dividend reinvestment, the Average Equity Mutual Fund and the World Equity Index in the second quarter. It also outpaced those indexes for the first half of the year.
The average U.S. hedge fund returned 10 percent in the second quarter, while the S&P 500 returned 7 percent, the average equity mutual fund returned 9.7 percent, and the World Equity Index returned just 4.5 percent, according to its data.
At the same time, the industry's year-to-date performance is at least two percentage points greater than any of those indices.
(And by the way, LTCM is reportedly doing better as well, with plans to pay back its original investors by year's end.)
"We had, obviously, the apocalypse in the third quarter of last year and since that time the industry has pretty quickly returned to profitability," Taylor said.
According to David Friedland, head of Magnum U.S. Investment in Miami, the funds that have performed the strongest so far this year have been those that invest in Asian equities and those that employ a merger or risk arbitrage strategy. Long-short equity funds also have done well.
Funds that play the credit spread have struggled, he said.
By definition, hedge funds are private investment partnerships that invest primarily in public securities and financial derivatives.
The term "hedge" implies that fund manages take a long position, or buy, securities the hedge fund manager believes are heading up. At the same time, they go short, or sell, securities they believe are poised to drop in value.
Such a strategy of arbitrage is designed to position hedge funds to profit in both up and down markets.
In the case of LTCM, the Greenwich, Conn.-based money-management firm went short on U.S. Treasury bond futures -- meaning borrowed securities were sold in hopes that they could be bought back at a lower prices later on.
At the same time, the hedge fund invested in higher yielding (and higher risk) mortgage-backed or corporate debt securities.
The strategy -- known as playing a credit spread -- generates huge profits so long as Treasury bond prices remain stable or drop. Needless to say, they didn't.
In the end, the highly leveraged hedge fund was bailed out by a consortium of 14 banks and brokerages that pulled together a $3.6 billion rescue package. The move was made last September at the behest of the New York Federal Reserve
Since the hedge fund industry is largely viewed as high-risk, the Securities and Exchange Commission requires that the bulk of investors be accredited, meaning individuals must have a net worth of at least $1 million or an annual income of at least $200,000 for the last two years.
Increasingly, deep pocket pension funds, foundations and university endowments are adding hedge funds to their investment portfolios as well.
Since the industry is largely unregulated, its exact size is difficult to nail down.
But insiders estimate there are 5,000 hedge funds worldwide managing some $325 billion in assets, almost exactly where asset levels stood just before the LTCM collapse last summer, Taylor said.
The Securities and Exchange Commission does place certain restrictions on the type of marketing and promotion tactics hedge funds can use, an effort to keep what is viewed as a high-risk investment tool at a safe distance from the general public.
But Taylor said that's largely the reason the industry is so misunderstood.
"The reason for the public perception [that hedge funds are high-risk] is that there is a negative selection process for learning about them," he said. "They aren't allowed to put out press releases saying they've done great. All their marketing is done by word of mouth."
The only time hedge fund news gets picked up by the press, he said, is when there's been a major disaster, as in the case of LTCM.