NEW YORK (CNN/Money) -
Hedge funds -- those famously publicity-shy investment pools targeted at wealthy individuals, institutions, and increasingly, public pension plans -- were the talk of Wall Street in the second quarter, when rumors of a major fund's collapse raced through financial markets.
The rumors of the mystery fund's demise were greatly exaggerated. But in the ensuing media feeding frenzy, a simple question went mostly overlooked: How are hedge funds doing?
Managers and investors say that despite the occasionally wild ride and a tough April, when the dust settles after June, hedge funds probably finished the quarter, and the first half, about flat. That's because June looks like it was a much better month than had been expected for many funds.
The June pickup is welcome news for an industry where business has gotten so tough that two big funds shut down in the first half of the year, and others are said to be considering cutting fees.
The real story now isn't when we might see a blowup, but how long can the industry endure its current lackluster returns.
With investors looking back wistfully to the double-digit average returns of the 1990s, and managers charging performance fees of 20 percent on top of 2 percent management fees, flat returns aren't good news, especially for fund managers who often live the "eat what you kill" rule and sink lots of their own money into their funds. Still, some observers think the current environment is being blown out of proportion. Some hedge fund investors point out that while hedge fund returns are indeed getting increasingly correlated to returns for traditional stock indexes, investors will still be willing to pay for hedge funds if they can get those returns with less risk.
"The historical performance of hedge funds indicates that they deserve a little more rope, after 14 years of being tracked by professionals, now that they have hit a soft spot in their track record," said Charles Gradante, managing principal of hedge fund tracker and consultant Hennessee Group.
The best performers so far this year are equity hedge funds, particularly those that trade growth stocks, such as in the technology sector. Funds investing in high-yield bonds and the debt of troubled companies are also expected to be up for June.
With June gains offsetting April's weakness, the quarter's returns appear to be actually better than some market watchers had forecast. Hedge funds had a tough May, when two big rating agencies cut the bonds of General Motors and Ford to "junk" status, just before Kirk Kerkorian's move to buy a large block of GM stock drove the stock sharply higher. A handful of hedge funds were said to have taken a double hit by being on the wrong side of both trades, holding the bonds and selling the stock short.
"Everyone was running around like chickens with their heads cut off thinking there was another Long Term Capital Management when the downgrades occurred but it just didn't materialize," says Jeff Maillet, who runs the multi-strategy hedge fund Noble Asset Management in Chicago.
Maillet was referring to the infamous 1998 collapse of LTCM, a highly leveraged hedge fund that blew up, sending shivers through financial markets worldwide. The New York Federal Reserve helped prevent a disaster when it organized a consortium of Wall Street firms to privately bail out the fund with a $3.5 billion cash infusion.
Since that debacle, hedge funds have scaled back on borrowing to make investments, and the industry has mushroomed, with assets estimated at $900 billion to $1 trillion – roughly the size of the entire mutual fund industry in 1990. That year, hedge funds had about $40 billion in total assets.
But hedge fund managers face a tough market now, with many stocks and bonds trading in tight bands, less volatility in general, and more competition.
"We are less concerned about hedge fund blow-ups. (But) in general, we expect the average hedge fund to underperform, on a risk adjusted basis, after fees," said Larry Kochard, chief investment officer of the $680 million Georgetown University endowment fund. "There's so much money and so many people competing with each other."
Kochard said he still wants to invest in hedge funds but will seek ones with niche strategies that stand apart from the pack.
Investors so far have proved patient in 2005. Almost every hedge fund strategy except for convertible arbitrage -- buying undervalued convertible bonds and selling the underlying stock short -- has seen assets stay where they were at the beginning of the year.
But some large hedge funds did shut their doors in the second quarter.
San Francisco-based convertible arbitrage fund Marin Capital shut its doors after six years in business, citing a lack of investment opportunities in the sector. Marin had about $2 billion in assets at its peak and had produced a 98 percent total return since inception, according to a letter it sent to investors.
Another San Francisco-based hedge fund firm, Creedon Keller & Partners, liquidated its flagship convertible arbitrage fund for the same reason.
Across the pond, London-based Bailey Coates Asset Management, which once had $1 billion in its flagship equity hedge fund, shut the fund after posting steep losses of nearly 20 percent for the first four months of the year.
Apart from these high-profile closures, though, most funds haven't taken a nosedive. According to the Credit Suisse First Boston/Tremont Hedge Fund index, which tracks the performance of 409 funds, the average hedge fund has a return of 0.03 percent through May 31, the latest data available.
Observers said some managers, cognizant that their hefty fees won't sit well with investors looking at low returns, may have to start scaling back on fees. But some managers, like superstar Jim Simons at East Setauket, N.Y.-based Renaissance Technology Corp. can keep fees high, people in the business said.
What's happening, according to Maillet at Noble Asset Management, is that some funds are getting more conservative as they seek to lure bigger pools of capital from pension funds and other more traditional investors.
He said lower returns are partly from more mediocre managers getting into the business, as well as some managers being too careful, over-promising and under-delivering.
"I like the way that (Julian) Robertson and (George) Soros operated – that's the way hedge funds are supposed to be," Maillet said, referring to the industry's most famous managers, who produced high-flying returns during their heydays in the 1990s.
"They're supposed to have hedge fund returns, not mutual fund returns with a big fee attached to it," he said. "If you don't want volatility, don't talk to me."
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