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Hedge funds: More money, more problems
As hedge funds attract more capital next year, they'll attract more scrutiny.
December 20, 2005: 11:00 AM EST
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NEW YORK (CNNMoney.com) - What's in store for hedge funds in the coming year? How about more money ... and more scrutiny from regulators and investors.

Such funds -- private investment pools catering to wealthy investors and employing a variety of non-traditional investment strategies -- are coming off a so-so year. Nevertheless they remain attractive to investors and institutions looking for better returns amid the uninspiring investment landscape. And with those investors will come the feds.

"You are going to see a lot more SEC investigations of hedge funds and money management organizations in the upcoming year for trading improprieties and things that aren't kosher," said Daniel Strachman, principal of New York-based financial services firm Answers & Company Group and the author of "Getting Started in Hedge Funds."

Strachman believes that the frauds at Bayou Group, KL Financial and others as well as the newly imposed registration rule, set to take effect in February, will spur increased SEC investigative action. He also feels the SEC will commit a significant amount of resources to hedge funds in 2006 to prove a point to people who objected to registration on the grounds that the SEC doesn't have the manpower to enforce it.

The Securities and Exchange Commission filed more than 20 enforcement actions against hedge funds or purported hedge funds in 2005. In the most notable case, Bayou Group, investors lost $450 million to outright fraud.

Pension money to keep flowing in

More and more pension funds are finding it difficult to meet payout obligations as their traditional investments in stock and bond markets have disappointed. As a result these institutional investors have begun to turn to alternative asset classes, such as hedge funds, to boost their coffers. Such moves are likely to multiply in 2006.

"I just don't know what they are going to do otherwise to catch up. If people start to see how bad of shape they're in -- and you can't just invest in bonds to catch up -- investing in hedge funds (will be viewed) as a real strategy," said Randy Shain, executive vice president of investigative due diligence firm First Advantage CoreFacts, which publishes BackTrack Reports.

Fred Dopfel, managing director of the client advisory group at Barclays Global Investors, said his firm has seen a marked increase in pensions investing in hedge funds. He thinks pensions will keep investing in hedge funds to get performance above regular market returns.

Dopfel added that hedge funds have historically been financial products for the private wealth market, but as the number of institutional investors continues to climb, hedge funds will start looking and acting more like institutional-quality investments. This means increased attention to controlling risk, increased transparency about their trading strategies, and producing returns in excess of the average hedge fund.

Wave of consolidation

Many industry experts think that the industry will see consolidation in 2006 meaning that some existing funds will fold, and those assets will flow into others.

People in the business say one prime area for consolidation is the fund of funds segment. Funds of funds, in which a manager invests in hedge funds on behalf of clients and charges an additional layer of fees, have come under fire this year for underperforming, as the managers they invest in have also had a tough time putting up strong numbers.

There is hard evidence that the industry is taking a hit: A recent survey from Chicago hedge fund tracker Hedge Fund Research found that during the third quarter, funds of funds lost $1.2 billion in assets.

"It's an elegant concept, but it's not working," said Jim Melcher, founder and principal of Balestra Capital, a New York-based firm that operates both a hedge fund as well as a fund of funds. "It's tough when you layer a bunch of fees on top of a bunch of fees. You're basically strapping a car battery around your ankle when you try to go swimming."

Strachman of Answers & Company Group said tough times for funds of funds this year means that chances of survival lie with the largest, most established funds of funds, who already have access to the industry's top managers.

Regardless of whether consolidation takes place, Robert Schulman, chief executive officer of Tremont Capital Management, a hedge fund investment and advisory firm, said he thinks that the number of hedge fund start-ups will decline in 2006.

"There will be fewer hedge fund launches; it's much more expensive and requires more capital and infrastructure" than it used to, he said. "It's harder to wake up and say, 'I'm starting a hedge fund.'"

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Bill Gross sees lower returns all around:More here.

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