Mutual Funds Attack Hedge Funds As June Fallback Prompts Investor Fears

by Carla Johnson, Investors Offshore, London

10 July 2002

With preliminary results from hedge-fund indices for June showing net losses for most styles of investing for the first time for years, the herd of eager retail investors and their institutions that has been pouring money into the sector in recent months has taken fright. Do these results mean that hedge funds' day in the sun is over? Has too much money swamped the ability of managers to make money through contrarian tactics?

Well, hold on now, hedge funds have had their bad moments before, the last time being in 1998, but these have been just blips in a twenty-year success story. On the other hand, there's no doubt that severe bear market conditions and prevailing low interest rates put pressure on hedge fund managers, many of whom are new to the business and have no experience of investing in such conditions.

A recent research report from UBS Warburg's Alexander Ineichen addresses these issues. Entitled "Hedge Fund Performance: Is There Reason for Disappointment?", the report argues that, based on historical patterns and current interest rates, investors should not expect better than single digit annual returns during the current market phase. The report calculates that last year's mediocre returns were showed a standard deviation of only one percentage point from the expected mean return, giving no evidence that any factor is at work other than poor market conditions.

Hedge funds still represent less than 2% of global investible wealth, and seem unlikely on that basis to be muscle-bound. Not that this stops the established mutual fund sector from being frightened of them. The main weapon being deployed against them is likely to be regulation: as inventive bankers and lawyers find more and more ways around current prohibitions against hedge fund marketing both in the US and Europe, regulatory authorities are sitting up and taking notice, although at this stage they are far from framing sets of rules to curb what they see as the excesses of hedge fund managers.

Meanwhile, conventional fund managers use other methods to try to fend off the incursions of hedge funds onto their territory. Last Sunday the UK's Sunday Times carried an article in which David Prosser, chief executive of Legal & General, one of Britain’s biggest life and pension funds, called for a regulatory review of the way hedge funds are influencing stock markets, saying that a new tax should be introduced to make it less attractive for hedge funds to sell stocks short.

He said: “We need more grit in the system, but one that does not penalise what is good for long-term investment. Hedge funds have crept up on us and the authorities don’t have much leverage over them. They operate in a fairly opaque way and some of them operate from tax havens.”

Prosser claims that hedge funds have been a big contributory factor to some of the wild gyrations in the stock market, particularly among life-assurance companies, in recent days. But there are plenty of other reasons for the 'wild gyrations', particularly the FSA's dramatic loosening of prudential ratios; the activity of hedge funds, like the activity of currency market speculators, is far more likely to have a smoothing effect on markets than the reverse. Even Prosser had to admit that the evidence against hedge funds was 'anecdotal'.

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