NEW YORK (CNN/Money) -
What goes up must come down ... but some hedge fund investors have forgotten that.
Though returns are improving, especially after July's gains, many indexes that track hedge funds are still hovering in the 2-3 percent range per year. Some investors are growing impatient, particularly in light of the fees they're paying, and are starting to demand that managers take on a little more risk to boost their returns.
Some managers, particularly those who run smaller funds, are beginning to field requests from investors for more concentrated portfolios, which are riskier by nature because they are less diversified, and for more leverage, or borrowing money to invest.
But that has managers worried. As one industry vet pointed out, investors who want their managers to take on more risk are obviously looking for bigger gains and are not thinking about the losses they could incur.
"There is a huge set of investors out there that think that hedge funds' return patterns will skew to the positive, regardless of volatility, and that's just not the case," said a hedge fund professional who asked not to be identified. "The other reason is, there are a lot of investors who think that under all circumstances, higher risk equals higher return, and that's not always the case."
The person added that because many hedge fund investors cannot use leverage themselves, they are asking their managers to do it for them.
Interestingly, the clamoring for more dramatic returns, and the attendant increase in risk that is an inevitable byproduct, is a reversal of what managers have heard for years. Many investors have worshipped at the altar of low volatility, to the chagrin of other long-time investors and managers, who say this led to an environment of too little risk taking – and mediocre returns.
The current return environment has made higher-risk strategies more attractive to investors hungry for returns.
"It's driven by a difficult period where returns are hard to come by but there are not a lot of blowups," said Philip Broenniman, managing partner of New York-based hedge fund Cadence Investment Partners, LLC. "If this were 2002 (when equity market returns were much worse and more volatile), no one would be asking for more leverage or a more concentrated portfolio. What we have is low volatility and a paucity of returns."
Bradley Ziff, a director in the commercial and investment banking practice at Mercer Oliver Wyman, said the pressure is more likely to come from high-net-worth individuals, as opposed to institutional investors, because these investors tend to move their money around more quickly than institutional investors.
"2005 is not the first time, and won't be last time, hedge funds have an average year and hit cyclical bumps. And it's not uncommon that when that happens, some investors begin to wonder what they can do," said Ziff. "But this is not an institutional response."
Ziff said he has not seen large hedge funds ramping up leverage to boost returns, but he has seen some explore other ways to make money, most commonly by diversifying strategies within their own funds. For example, if a manager wants exposure to Asian equities, the firm will hire a trader or portfolio manager with expertise in that area and allocate money to him internally. If the portfolio manager does well, the firm could launch the portfolio as a separate fund with outside investors.
Finding the right risk balance to keep managers comfortable and investors satisfied is incredibly difficult. Managers say one way to handle such requests is to make sure they've got the right investors in the first place.
"You need the right investor constituency; that is the most important thing," said Cadence Partners' Broenniman.
Ziff added this is important for investors to remember as well, so that they don't get shut out of top-performing funds in the future.
"Hedge funds, like elephants, have long memories, and when you yank money from managers at a time like this with the belief you can go back in at another point in time, they will remember you," he said. "This is supposed to be a long-term, institutional market ... not a skittish, uneducated, fast money market."
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