F

or the last several years there has been a

widely observed trend in the traditional invest-
ment industry. Many of the largest firms have
launched, or are preparing to launch, their
own hedge funds. This is evident in both the US and
Europe, but the trend appears to be stronger among
European-based firms.
The reasons for this are evident. Not only is nega-
tive sentiment toward hedge funds decreasing, but
there is increasing recognition that they can effec-
tively diversify portfolios. Clients of traditional firms
are asking, sometimes insistently, for access to
hedge funds. And the financial incentives within
investment firms to provide them can be powerful.
Hedge fund fees, as everyone knows by now, are
sharply higher than traditional fees, and star man-
agers can be tempted to walk away from their firms
unless given the freedom to manage a hedge fund.
There have been high profile defections, both in the
US and Europe. The main issues seem to be rev-
enues, and, importantly, the retention of talent.
A recent survey by Golin/Harris Ludgate clearly
shows growing interest in hedge funds among
clients of traditional firms, spurred by weakness in
equity markets worldwide. In a survey of 100 major
European institutional investors, Golin/Harris
discovered a high level of interest in hedge funds.
They report that 36% of institutions currently invest
in hedge funds, double the number of one year ago,
and that a further 28% intend to do so in the
foreseeable future.
The traditional firms that have begun offering
hedge funds or fund of funds include some of the most
recognisable names in the investment world. The
Golin/Harris survey results are consistent with the
hedge fund-related activities of the firms discussed in
the box on page 22. The survey showed that for the 36
firms that reported investing in hedge funds, the most
popular choice was the internal hedge fund. When
asked about future hedge fund investing plans, again,
the most popular route was the internal hedge fund.
Transition
Traditional managers who start hedge funds, tend to
gravitate to the equity long/short strategy. There has
been a flood of long/short managers over the last
several years, especially in Europe, many of them
coming from traditional firms.
Kevin Coldiron, who heads BGIs alternative
investment business in Europe, says, Weve seen a
strong demand for long/short strategies from our
clients and we believe this approach holds great
merit. He believes that the firms interest in develop-
ing hedge funds is a natural progression for them, in
view of their quantitative approach to investment
management. We feel very comfortable in the
long/short conceptual framework because, even in
our traditional strategies, we start our research
process by thinking from a long/short point of view.
We feel that if a process or a trade cant hold up in
that context and to that kind of analysis, it wont work
in a long-only framework either. Our real learning
Mainstream managers
APRIL 2001 RISK & REWARD
A mutually
rewarding
enterprise?
Randy Warsager examines the
treasures and the pitfalls awaiting
those who make the transition from
traditional to hedge fund manager
curve has been on the operational side, rather than
on the trading side.
Coldiron adds, Rather than rely on any particular
star manager, BGI integrates its research and port-
folio management teams in a manner that is quantita-
tive and process-oriented. This way the process can
continue if any member of the team departs the firm.
Making the transition from long-only to long/short
is extremely challenging under the best of conditions.
In difficult markets, it can be an impossible task for all
but the most talented managers. Charles Gradante,
president and CEO of consultants The Hennessee
Group in New York, agrees. For hedge fund man-
agers, downside risk management is the road to
good performance, while on the traditional side its
stock selection. These are two fundamentally differ-
ent approaches, totally different mental sets, and its
a difficult gap to bridge, he says, adding, Generally
speaking, traditional managers have a benchmark-
ing orientation, so they tend to buy and hold, rather
than trade actively in the way many hedge fund
strategies do. Because they do not trade as much
around their positions they tend to sit on a portfolio
that will float with the broad index, generally leading
to the benchmark return plus or minus 10%.
As a consulting firm, Hennessee gets a lot of man-
agers fresh out of the traditional world
looking for support as they try to raise
assets for their own hedge funds.
However, he says, Only a small per-
centage of them make it past the first
level of the due diligence process.
People have to realise that Jeff Vinik
was an exception. Many mutual fund
managers find the transition very diffi-
cult, and ultimately insurmountable. In
effect, its a cultural and a process
problem.
Gradante points out that going
short in this context is far more com-
plex than might be anticipated by a
long-only manager with no shorting experience.
Managers who come out of a long-only environment
tend to have a fundamental approach to picking
stocks and they tend to apply the fundamental
approach to the short side, where it is much less
appropriate... Good short sellers look for a catalyst
that will expose the poor fundamentals of the com-
pany... The rule of thumb should be, Never short
stocks on fundamentals alone. The dot-com phe-
nomenon in 1999 is a good example of a situation in
which many managers who sold companies because
of their poor fundamentals got badly hurt.
Fabio Savoldelli of Merrill Lynch takes a slightly
softer approach to the differences between managers
of a traditional background and independent hedge
fund managers. Depending on the investment style,
there is often not necessarily a huge difference
between these groups, other things being equal, but...
During the due diligence process on all hedge funds,
its important to drill down and find out what the source
of alpha has been, so you can distinguish true hedge
fund managers from those who have ridden the tradi-
tional long side approach during a bull market, he
warns. During the last year the market itself has
somewhat harshly fleshed out those who have made
money on beta, rather than really adding alpha.
Mainstream managers
RISK & REWARD APRIL 2001
The traditional focus means
managers are concerned with
failing to compete, to match or
exceed the benchmark, rather
than real investment issues
Ralph Yearwood
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Markets
More Posit ive
More Negat ive
Unchanged
Changes in attitudes by institutional investors since 2000
Source: Golin Harris Ludgate, 2000
This is something the managers themselves are
acutely aware of. Developing and constantly sharp-
ening our shorting skills is a prerequisite to running a
long/short strategy, said Lee Lowenstein, managing
director at Jundt Associates, Inc. He adds, During
this evolutionary learning process, we found that
futures tend to be efficient hedging tools because the
instruments do not raise many borrowing or liquidity
issues. He says the firm eventually grew more com-
fortable with shorting stocks directly, and integrated a
complementary shorting strategy into its portfolios.
The firm is especially systematic on the short side,
and employs stop loss limits and individual security
concentration restrictions. He adds, The firm hedges
actively, not only to preserve and protect, but also in
an attempt to make money.
Thames River Capital, based in London,
launched a European long/short equity fund,
Thames River Kingsway Fund, in March 1999. Tony
Zucker, who heads the portfolio management team,
had a long and very strong track record at Friends
Provident (now Friends Ivory Sime) managing long-
only European equity portfolios. The fund, in its Euro
class, returned 67.8% in 1999, 34.8% in 2000, and
is down slightly (7%) through February this year.
Jonathan Hughes-Morgan, Chairman of Thames
River, says of the transition to long/short investing:
Making this move is not easy. Shorting is one more
dimension to get wrong. Unless a manager is very tal-
ented to begin with, in whatever strategy he is accus-
tomed to, taking on this new dimension can be diffi-
cult. Shorting calls for a different set of skills. Its much
more event-driven in nature than being on the long
side. Theres more inefficiency on the short side, and
less coverage by analysts. Furthermore, you have to
move very quickly. If you get in after too many others
have, you increase the risk of exposing yourself to a
short squeeze.
Hughes-Morgan adds, It can take time for long-
only managers to make the transition to long/short,
and they should approach it step by step. Our team
approached shorting carefully, initially using a mix-
ture of short equity positions and derivatives. The
derivative positions were phased out over time and
the team has only used short equity positions in the
portfolio over the last eighteen months.
He emphasises that, Investors, for their part,
should remind themselves that hedge funds are only
vehicles. They do not provide any magic formula for
success. The manager has to have considerable tal-
ent to begin with to exploit the greater freedom they
will enjoy within a hedge fund structure.
Tom Hoffman of the Managers Fund says some
investors seem to have a curious take on the growing
hedge fund industry. At the same
time that our interest in hedge funds
grows, he says, We have noticed
that investors are giving mixed sig-
nals. They sometimes complain
about management fees in mutual
funds, while on the other hand they
are enamoured with the concept of
hedge funds. They can have access
to the long-only managers they really
like for 30 to 90 basis points a year,
depending on the asset class, but
they seem willing to pay 100-200
basis points plus 20% of profits for, in
Mainstream managers
APRIL 2001 RISK & REWARD
Our real learning curve has
been on the operational
side, rather than on the
trading side
Kevin Coldiron, BGI
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Market
Yes
No
Potential for conflicts running both
long & hedge funds in-house
Source: Golin Harris Ludgate, 2000
Kevin Coldiron
some cases, the very same managers when they
start a hedge fund.
In dealing with the issue of long-only managers
making the transition to a long/short strategy,
Gartmores Phipps noted the companys policy of
seeking capital for a managed account in order to
build experience and a track record. He says, Our
long/short managers continue to manage long-only
portfolios as well. We believe this offers advantages
in both directions. For long-only portfolios, the
manager is better attuned to opportunities, particu-
larly short-term ones, he may otherwise not have
discovered. Long/short managers remain
integrated within regional teams, which helps
encourage an interactive idea-generation process.
Some investors have strong views on the impor-
tance of managers effectively making the transi-
tion. They are well aware of the differences in phi-
losophy, as well as in strategies and tactics,
between a typical long-only portfolio manager and
managers who cut their teeth in an active,
long/short environment.
At the same time, they are aware that there are
cases in which this transition has been achieved with
spectacular success. The challenge is in identifying
those who have the potential to adapt to a new envi-
ronment and methodologies. In the mind of some
investors, hedge fund managers who have experi-
ence only with long-only strategies have to overcome
some initial doubts about whether they can success-
fully make the change. This is not, by any means, to
say that these doubts cannot be overcome. The stel-
lar records of some former long-only managers have
demonstrated that it can indeed happen.
Shorting stocks takes a different set of skills,
said Mark Anson, senior investment officer for global
equity at the California Public Employees Retirement
System, the largest pension fund in the US, with
assets of about $170 billion. He adds, I always ask
a new hedge fund manager where he or she learned
to short stocks. Managing margin calls, hard to bor-
row stocks that may be called away, and short rebate
takes a different set of skills than long-only manage-
ment. Bottom line: I do not let a hedge fund manager
learn to short with my money.
He continues, Traditional shops do not understand
the risk profile that hedge funds can produce. And
they need to understand this for risk management pur-
poses, for disclosure purposes, and to set reasonable
expectations for risk and return, not only for their own
profits, but for that of their investors. Anson recently
gave a talk on this issue at a hedge fund conference,
because it is of concern to investors.
An investment official with a major US university
endowment, who prefers not to be identified, says,
More and more, we are only looking at managers
with hedge fund experience. But I can understand
that traditional firms might try to keep their talented
long-only managers by giving them the option of
running a hedge fund.
Pros and cons
Hedge fund managers have typically been entrepre-
neurial types who flourish in the open environment
characteristic of hedge funds. Some investors won-
der whether, on balance, large firms can effectively
nurture the kind of non-linear, flexible thinking
required of many hedge funds strategies. CalPERS
Anson says, This is an age old question: How does
one maintain an entrepreneurial environment in a
long-only shop? Compensation schemes will have to
change and this may create friction between the
haves and have-nots. Also, once a long-only man-
ager gets a taste of the unregulated environment of
the hedge fund world, it can be hard to go back to
long-only investing.
Others believe that the disadvantages of the less
entrepreneurial environment may be offset by the
advantages in infrastructure that a large, established
firm can offer.
State Street Global Advisors has offered a
long/short market neutral US equity strategy since
Mainstream managers
RISK & REWARD APRIL 2001
Jeff Vinik was an exception.
Many mutual fund managers
find the transition very difficult,
and ultimately insurmountable
Charles Gradante
Mainstream managers
APRIL 2001 RISK & REWARD
1990. The fund, which has been actively marketed
only in the past three years, currently has about
$450 million in assets. In addition, SSgA launched a
European long/short fund in mid-2000. Jane Tisdale,
a principal at the firm, observes that, The resources
that a large firm can bring to the development of
hedge funds are considerable, including accom-
plished investment strategists and a well-developed
investment infrastructure. She adds that hedge
funds are a natural way for firms to diversify their
revenue streams.
Antoine Josserand, a director at London office of
AXA Investment Managers GS, notes that it has been
helpful in developing and running hedge funds that
AXA IM has significant investment expertise in-house
and a strong quantitative department to draw upon.
He adds, The infrastructure with which investors,
especially institutions, are comfortable already exists
at a firm like this.
Gartmore also sells the advantages flowing from
having a large, well-established traditional firm
behind a hedge fund. In particular, says Phipps, a
hedge fund manager can benefit from being able to
draw upon a large, diverse research and opera-
tional infrastructure. Gartmore has 13 pan-European
sector analysts with whom a manager can
exchange ideas. Further, a large firm often has
strong relationships with senior management of
companies that the hedge fund managers might
wish to evaluate, and the manager may be able to
leverage these relationships into a higher quality of
information flow.
The endowment official quoted earlier also adds,
From a managers perspective, staying with their
large firm can offer back office and analytical sup-
port so the manager can focus exclusively on
investing.
Side by side?
When Merrill Lynch introduced its long/short
European equity hedge fund in February, it said the
managers would continue to handle long-only portfo-
lios for the firm, and would, in doing so, leverage the
research of the Merrill analysts team.
Gartmores Phipps adds that as weel as having
long/short managers continue managing long-only
portfolios, We also have the long/short managers
physically located near long-only managers. We find
this helps encourage an interactive idea-generation
process.
Lowenstein of Jundt Associates provides an inter-
esting example of how a manager running both a
small cap growth mutual fund and a hedge fund can
respond differently to the same information, given the
mandates of the respective funds. The
firm manages a family of mutual funds
with approximately $500 million in assets
as well as two long/short growth equity
hedge funds, one onshore and one off-
shore, with total assets of just under $300
million.
In spring 1998, just before the financial
market turmoil, says Lowenstein, The
firm got a strong sense that market liquid-
ity was drying up. While running our small
cap growth mutual fund, we discovered
that small companies, in particular, were
experiencing tremendous difficulty bor-
Bottom line: I do not let a
hedge fund manager learn
to short with my money
Mark Anson, CalPERS
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Yes
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Maybe
Role of the small investor
Source: Golin Harris Ludgate, 2000
Michael Phipps
Mainstream managers
RISK & REWARD APRIL 2001
rowing any money. We further noticed that small-cap
prices were behaving in strange ways. This erratic
behaviour, we believed, was an indication of trouble
ahead. In response, we protected our mutual fund as
much as possible within its mandate. Using the same
information, we were also able to protect the hedge
fund to an even greater degree, given that industrys
more flexible regulatory regime.
Other firms have a different view. Alliance Capital
Management has assigned its hedge fund and
mutual fund areas to separate business units, and
has physically separated managers and analysts
from the two areas.
The endowment official observed that, Running a
hedge fund alongside a mutual fund or long-only
separate accounts can raise potential issues of con-
flict that investors find unsettling. How does an
investor on the mutual fund side, for example, know
that the best ideas are not all being funnelled to the
hedge fund side, with its significantly higher fees?
This touches on an issue of concern to the US
Securities & Exchange Commission, in fact, which is
investigating the issue of money managers who
offer both mutual funds and hedge funds. SEC offi-
cial Paul Roye is director of the regulators division
of investment management. In a recent speech at a
mutual fund conference he said: We have
observed that more and more mutual fund man-
agers are sponsoring and advising hedge funds
and other alternative investments...The conflicts in
these arrangements result from the differing fee
structures of hedge funds and mutual funds, and
the fact that greater profits can be earned by the
adviser from the performance based compensation
of a hedge fund. The differing fee structures create
a real risk of favouring a hedge fund over a mutual
fund when allocating trades.
He continued: Conflicts can also arise when a
hedge fund effects short sales of securities, if such
securities are held long by mutual funds managed by
the same advisory firm. Such trades could adversely
affect long positions held by mutual funds. Or mutual
trades could be used to benefit a hedge fund, when
mutual fund long positions are sold after the hedge
fund sells the same security short. We expect firms to
have compliance procedures in place to address
these concerns.
Relative performance
The percentage of total hedge fund assets in the
hands of managers who either emerged from, or are
still operating within, a traditional environment is hard
to determine. One keen observer of the industry feels
that the number in the US is quite low, around 5%.
Others suggest slightly higher estimates of 10-20%.
But in terms of European managers, observers com-
monly give a much higher number, suggesting that
as much as half of hedge fund assets fall into this cat-
egory, partly because there is a less developed
indigenous hedge fund industry.
Many of the large firms rolling out hedge funds
have huge capital-raising networks and will doubt-
less find substantial capital for their funds, assuming
that performance is at least reasonably good. They
have an advantage in marketing over many inde-
pendent managers. Other things being equal
(though they almost never are), the funds in this cat-
egory, as a percentage of total hedge fund assets,
could increase substantially in coming years.
At this stage it is too early to say how the overall
performance of former traditional managers who
have migrated to, or expanded into, the hedge fund
arena compare to independent hedge funds. Some,
including several who were interviewed for this arti-
cle, have excelled by any standards, rising to the top
of the rankings. If current market conditions persist,
the weeding out process will certainly show who can
really find the alpha.
Randy Warsager is director of Education at the Center
for International Securities & Derivatives Markets,
University of Massachusetts, Amherst
There is a real risk of favouring
a hedge fund over a mutual fund
when allocating trades... We
expect firms to have procedures
in place to address these
concerns Paul Roye, SEC
Mainstream managers
Who does what
Randy Warsager offers a flavour of traditional managers hedge fund activity
Barclays Global Investors entered the hedge fund business in Europe in October 2000, having had a large cap
equity long/short fund in the US for several years. The newer fund is a long/short UK equity market neutral strat-
egy, with about $25 million in assets. BGI is developing funds along the same strategy lines in the Japanese,
Australian, and Canadian markets. Performance in the UK fund has got off to a good start, with the exception of
a tough month in February.
Henderson Global Investors offered its first hedge fund the Henderson Global Technology Absolute Return
Fund in mid-1999. Two of its most prominent internal technology managers were tapped to manage the fund.
Hendersons long/short Japanese fund, launched in July 2000, has also performed strongly in difficult markets,
with returns of over 20%. A long/short Asia-Pacific fund, launched in November 2000, has also shown promise.
Henderson has taken a soft approach to hedge funds, according to Stuart MacDonald, Divisional Director of
Alternative Investments, though they are now planning to increase their profile.
Henderson recently introduced a tax-efficient retail product. The Henderson Absolute Return Portfolio, a closed
ended fund of hedge funds, focused on long/short strategies, vehicle listed on the London Stock Exchange, cor-
responds to the maximum annual investment UK tax rules allow in an Individual Savings Account (ISA).
Gartmore, a traditional investment management firm based in London, has made a conspicuously successful
entry into the hedge fund arena. Gartmore fund manager Roger Guy ran a long/short strategy in a managed
account as a precursor to the launch of hedge fund AlphaGen Capella. The fund itself was launched in
November 1999 and has assets of about $1 billion. Hedge fund assets total $1.7 billion, including Japanese,
emerging markets, small/mid cap Europe and fixed income strategies. In sixteen months of performance the
Capella fund has not had a down month and correlations with traditional markets have been low. The firm will be
launching several other equity long/short funds this year, focusing on various geographic regions.
Goldman Sachs European product manager for hedge funds, David Burnside, says Goldman had long been a
believer in the value that hedge fund strategies can add to a portfolio. In 1997 Goldman acquired Commodities
Corp LLC, which has a history in the alternative investment business, dating back to 1969. Commodities Corp
focused mainly on managed futures and macro managers until the early-90s, since when it has invested in the
full range of hedge funds strategies.
Abbey National, the UK mortgage bank, will be formally asking the March board meeting to consider approving
a foray into hedge funds. Ahead of that meeting the bank would not comment, beyond referring inquirers to a
Reuters story printed in January, which said Abbey is contemplating launching the following hedge funds: a Pan-
European long/short equity fund, a dedicated currency fund, and a global macro fund. Abbeys head of strategy,
Scott Jamieson, is quoted as saying, This has the status of a project and is being assessed according to a
whole range of criteria, and analysis is not complete.
AXA Investment Managers runs several fund of hedge funds from its New York office. A diversified fund, AXA New
Horizons Select Dollar Fund, was launched in late 1998 and currently has about $140 million in assets. The fund
has returned an annualised 15% since inception. In addition, AXA IM has offered a managed futures program
since July 2000 and has recently launched a convertible arbitrage fund. Other products are being considered.
Pioneer Alternative Investments, based in Dublin, has 300 million under management. Pioneer is the hedge
fund arm of Pioneer Investments, which was acquired by the Italian bank UniCredito.
Pioneer Alternative Investments offers three hedge funds, said Paolo di Montorio-Veronese, chief marketing offi-
cer. The first, the Pioneer Global Opportunity Relative Value Fund, was launched in April 1999. Earlier this year
APRIL 2001 RISK & REWARD
Mainstream managers
the firm opened a global macro fund and an equity arbitrage fund. They plan to launch a convertible arbitrage
and long/short equity fund around mid-year. In response to client interest at the retail level, the firm will launch a
principal protected note in April, tied to the performance of a multi-manager fund.
UBS Paine Webber recently announced that it would issue a EUR 200 million note intended to enable European
investors to participate in a fund of funds. The product has a minimum investment of EUR 50,000. This is the
third tranche for the firms Euro S.T.A.R. (Strategically Targeted Absolute Return) product.
Deutsche Banc Alex Brown, Inc, which manages over $3 billion globally in fund of funds, runs a variety of these
products, including several that are exchange-listed. A Deutsche Asset Management team based in New York
oversees the funds.
Merrill Lynch has offered alternative investments in a multi-manager context to its clients since 1978, beginning
with managed futures and later hedge funds. Fabio Savoldelli, managing director at Merrill Lynch Investment
Managers says, Client demand has been strong and has been the force behind Merrill developing and offering
various hedge fund products. He anticipates continued strong demand, especially from institutional investors.
Putnam Investments, headquartered in Boston, is exploring the idea of launching hedge funds, either internally
or with its partner in the alternative investment area, TH Lee, Putnam Capital. A decision has yet to be made.
The Managers Fund, based in Norwalk, CT, is a traditional mutual fund manager seriously considering develop-
ing a multi-manager alternative investment fund, according to Ralph Yearwood, director of marketing and sales,
and Tom Hoffman, director of research. The trend of traditional firms offering hedge funds is extremely interest-
ing to us, said Hoffman. One of the reasons we are interested in hedge funds, said Yearwood, is that in tradi-
tional funds the focus is on a benchmark. So managers are concerned mainly with the business risk of failing to
compete, to match or exceed the benchmark, rather than the real investment issues that a hedge fund in an
absolute return strategy is able to focus on.
Montgomery Funds, a mutual fund company based in San Francisco, started a global long/short equity mutual fund
in January 1998. Montgomery has no immediate plans to launch more of a kind. The fund has assets of about $170
million and requires a minimum investment of $1,000. It has returned an annualised 39.6% since inception.
Invesco offers a long/short strategy, which it launched in mid-2000. The fund, called the Invesco Advantage
Fund, currently has about $75 million in assets. Like the Montgomery Funds global long/short equity product, it
is not actually a hedge fund, but is intended to offer individual investors access to a hedge fund-like strategy.
The Invesco product is available only through financial advisors.
American Express Asset Management Group Inc. has four hedge fund products with a total of $2 billion in
assets. The firm has been running a US equity long/short hedge fund since January 1997. Our flagship US
equity fund has exceeded both its risk and return targets since inception. said Leroy Cody, senior vice president
at the firm. He added, We recently expanded our hedge fund offerings. We launched a European equity
long/short fund in October 2000 and in March this year started a fixed income arbitrage fund.
As a traditional investment management firm, Cody continued, we were aware of the need, when we launched
our first long/short fund, to develop a focused approach to the short side. We added a dedicated short side ana-
lyst to the team initially, and then added another later, because we believe you cant survive the down markets by
using shorts just to hedge. You have to add alpha.
Fidelity, the mutual fund giant, says it has no plans to offer a hedge fund product.
COPYRIGHT NOTICE: Reproduced from Risk & Reward, April 2001
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