Banks' love affair with hedge funds
Large banks are eager to manage their own hedge funds, despite recent blowups like Amaranth.
NEW YORK (CNNMoney.com) -- Hedge funds have come under fire in recent days, owing in part to the recent $6 billion Amaranth debacle. But the regulatory run-ins aren't scaring off large banks, which increasingly are turning to hedge funds as a way to create serious growth.
As increased competition for deposit growth and a flattening yield curve continues to put pressure on profits, banks are eager to attract high net-worth clients and diversify their profit stream.
And while banks like Goldman Sachs (Charts) and Morgan Stanley (Charts) have had success in their prime brokerage units, which cater in part to servicing hedge funds, analysts say the big bucks lie in the management of actual hedge fund assets.
Just look at the numbers: Hedge fund managers collect 2 percent of the assets under management regardless of the fund's profitability. If a fund shows a profit, its managers receive an additional 20 percent as a performance fee.
For the banking industry, which is concerned about dwindling profits and higher interest rates, that type of fee structure is particularly appealing, analysts said.
A no-brainer for banks
High net-worth investors continue to demand hedge-fund products, making it a no-brainer for banks to enter the business and meet that demand, said Dick Bove, analyst at Punk Ziegel & Co. Hedge funds are notoriously high risk but offer potentially high returns to investors - thus their appeal to wealthy bank customers.
According to Hedge Fund Intelligence, the U.S. hedge fund industry grew to $984 billion in assets in July - a 32 percent jump from last year.
Industry tracker Hedge Fund Research estimates that the size of the hedge fund industry globally is $1.225 trillion.
"The banking industry is in the business of gathering money wherever it may exist," said Bove. "If the money now exists in hedge funds, it's incumbent on the banking industry to get into that business."
But banks are doing more than just getting in to the business. They're now becoming leaders within the hedge fund industry.
Banking titans Goldman Sachs and JPMorgan (Charts) Asset Management - through JPMorgan's majority stake in Highbridge Capital Management - are currently the largest hedge fund firms in the United States, according to a recent survey by industry magazine Absolute Return.
Goldman Sachs leads the pack with $29.5 billion in assets, while JPMorgan ranks a close second with $28.8 billion. Barclays ranks sixth with $17 billion in assets under management.
It marks an impressive leap for both Goldman and JPMorgan in just one year. In 2005, Goldman Sachs ranked third with $15.3 billion, while JPMorgan wasn't even in the top ten.
As hedge funds aren't required by any regulation to disclose their monthly returns, they're notoriously tight-lipped about their performance, and it's unclear what the banks' profits - if any - are on those assets.
But given the growth in assets under management at Goldman Sachs and JPMorgan, its little wonder other banks are looking to enter the hedge fund arena as well. Morgan Stanley, most notably, has been the subject of Wall Street rumors to the effect that the bank is in talks to acquire a hedge fund. The buzz is that such a buy would fulfill part of CEO John Mack's vision of expanding the company's alternative investments business, which includes private equity.
Still, Wall Street has long had a love-hate relationship with hedge funds. Investors love the promise of high returns, and managers love the heady fees associated with running the alternative investments.
But when a large-scale meltdown occurs - such as Amaranth's roughly $6 billion loss attributable to bad natural gas bets or, worse, the implosion of Long-Term Capital Management in 1998 - the closely guarded hedge fund world suddenly becomes enemy number No. 1, raising fears of litigation and huge losses to investors.
A risky business
Indeed, banks eager to profit from hedge funds may open themselves up to increased legal risks, warned Christopher Whalen, managing director of Institutional Risk Analytics, a financial analysis and valuation firm.
"These things are highly speculative and we're likely going to see a lot more [Amaranths] coming out of the closet," he said. "If a bank-owned hedge fund blows up, the liability trial attorneys will have a field day."
And there are no guarantees that a fund will be profitable for investors or the banks that offer them. Citigroup (Charts), for instance, has been struggling with its in-house hedge fund unit. The company invested about $1.5 billion in Tribeca Global Management and currently has about $2 billion in assets. Citigroup Alternative Investment, which includes Tribeca Global Management, has total assets of about $7.5 billion, according to Absolute Return.
But the unit lost its chief executive, Tanya Styblo Beder, after months of relatively poor returns to investors and high expenses.
There is also concern that, after years of stellar growth, hedge funds may be in for a slowdown that could lead to consolidation. That could spell bad news for banks that enter the business now.
After starting the year with a 3.5 percent gain, the HFRI Fund Weighted Composite Index - a broad industry measure of hedge fund performance - ran into a rough patch in May, June and July. The index showed losses for those three months before rebounding modestly with a 1 percent gain in August.
The number of new funds launched has dropped, but liquidations declined apace. In the first half of 2006, 549 funds were launched and 223 liquidated. Over the same period, there were 1,211 launches and 428 liquidations.
But critics shouldn't be too quick to predict a decline in the hedge fund industry, said Josh Rosenberg, president of Hedge Fund Research. For one thing, the HFRI index is still up almost 7 percent year to date as compared to a 5.8 percent gain on the S&P 500.
Record inflows into hedge funds
And while fund launches fell from last year, the hedge fund industry is in for a record year of inflows.
Through the first half of the year, the hedge fund industry saw inflows of $66.1 billion, with the second quarter accounting for $42.1 billion of those flows - a record for a single quarter. And inflows in the first half of the year beat the $42.1 billion in inflows that the industry recorded for the full year of 2005.
"There's been quite a bit of fluctuation in performance during the course of this year but money still continues to flow into hedge funds," Rosenberg said.
And as money keeps flowing in, banks will continue to have an even stronger incentive to get in on the action.
"I don't know if banks will ever own the entire market," said Denise Valentine, senior analyst at independent consulting and research firm Celent LLC. "But it's a major trend that will continue because banks have tremendous resources both in technology and money to buy these firms."
Correction: CNNMoney.com incorrectly identified Hedge Fund Intelligence as Hedge Fund Research. We regret the error.