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How hedge funds make money now
With some strategies tapped out, managers are getting ever more creative in the search for returns.
August 4, 2005: 12:04 PM EDT
By Amanda Cantrell, CNN/Money staff writer

NEW YORK (CNN/Money) - Where do you put your money when the stock market stagnates?

If you're a hedge fund manager, the answer is wherever the heck you want, or so the conventional wisdom goes. Give a loan to a struggling retailer? Sure. Buy government bonds in Turkey? Why not?

But even broad investment mandates and large pools of capital don't make it easy to find lucrative investments when the stock market's stuck in a rut and competition for new ideas is fierce. As Fed Chairman Alan Greenspan has noted, a lot of low-hanging fruit has already been plucked as money managers profit from inefficiencies in the markets.

"At this point, there isn't an obvious place to park money," said Andrew Lo, a partner at hedge fund Alpha Simplex Group and director of the financial engineering laboratory at MIT. "A number of strategies that produced good returns in the past are no longer profitable. A lot of the smart money is sitting on the sidelines right now just waiting for the direction to change."

But hedge fund managers are known for creativity, for better or worse. And some are finding ways to generate returns outside the realm of traditional hedge fund strategies.

This is because markets that were hot a year ago, such as credit, are less attractive now, and managers are being forced to come up with increasingly esoteric ways to make money.

"There are still no fat pitches, and it sounds like where really smart guys are finding opportunity is by and large hidden in the corner where the light isn't shining -- small strategies that are typically longer term in nature," said Mike Hennessy, managing director at North Carolina-based fund-of-funds shop Morgan Creek Capital Management.

For example, Hennessy says, some hedge fund managers are hedging slices of collateralized debt obligations, which are investment-grade securities backed by pools of bonds, loans or other assets. It's a complex transaction that usually involves selling credit protection in the CDO market while simultaneously buying protection from CDO investors. Hennessy points out this strategy is both fairly illiquid and difficult to price.

"We've really seen managers sort of turning over all sorts of stones" searching for bigger returns, said Robert Leonard, a managing director at Credit Suisse First Boston who works with hedge funds. "We've had hedge fund clients come to us and, from a financing standpoint, ask us to consider doing a lot of things that would be considered 'out of the box' things like aircraft leasing, bank loans, financing in the area of utilities. We're seeing managers increasingly looking to go away from the pack."

Another area in which credit hedge funds are finding opportunities is in direct lending. These loans can range from secured loans to "second-lien" loans, or loans that are second in repayment priority.

A handful of "hybrid" funds are popping up that blur the distinction between hedge funds and private equity funds, which invest mostly in closely held companies. In these funds, the investment horizon is more long-term than that of a typical long-short equity hedge fund manager who is actively trading all day.

With hybrid funds, managers can accumulate big positions with a view toward influencing the company's management to unlock value over time.

New entrants to this strategy include $4.7 billion Dallas-based hedge fund Carlson Capital, which is said to be launching the Black Diamond Hybrid fund. And some of the highest profile launches of the last year are in the gray area between hedge funds and private equity.

These include former Goldman Sachs whiz kid Eric Mindich's Eton Park, which launched last year with $3 billion, and fellow Goldman prodigy Dinakar Singh's $2.9 billion TPG-Axon fund, co-managed with private equity firm Texas Pacific Group.

Hard times breed creativity

Hunt Taylor, director of investments of Hartz Trading, the investment arm of the Hartz Group, said the potential for solid returns has been squeezed out of some of the mainstay strategies of traditional hedge fund investing, leading some managers to drift away from the fund's original mandate.

"You are seeing hedge funds push the envelope of businesses they need to get into to maintain their returns," said Taylor. "Everybody's looking for their secret fishing hole and they don't want to tell everybody where it is."

He noted that hedge fund managers are making pitches with a wide amount of leeway, "basically saying you can put 10 percent of your money in a back-alley dice game" if investors are comfortable with the risk-level of the investment.

Hedge fund investors often decry "style drift," industry jargon for when a manager strays from his originally stated investment style, but it can be unavoidable when a manager's style is out of favor and the fund is suffering.

"Do you expect your manager to deviate from what he said he was going to do and go find you a return, or stick to his knitting and do what he said he was going to do even though opportunities are not there?" asked Taylor.

Some managers are handling this issue by moving some of their portfolios to cash, to avoid putting investor capital at risk. While most investors won't stand for managers doing this for too long -- no one wants to pay hedge fund fees for money that's not making returns -- it is one short-term option when managers see few good opportunities.

As for what's hot now, industry observers say hedge funds that follow booming strategies like energy may have a tough time maintaining those gains, and financial services funds may also face difficulties as interest rates rise.

But healthcare funds, after being out of favor for some time, are starting to gain traction again. And more traditional, liquid markets such as debt and equities had a strong July, while a spate of recent mergers and spin offs has also drawn some new money.


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