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Hedge Funds Adopting New Strategies To Deal With Asset Growth

by Carla Johnson, Investors Offshore, London

19 December 2001

Faced with record inflows of capital, many of the best hedge funds have closed to new investors, fearful that their strategies, which have generated returns of 15% to 30%, are not scalable beyond current levels of capital. This is true for convertible bond arbitrage, for example, in which funds have recently been very successful, but are dependent on the supply of suitable bonds.

There are some obvious reasons why a very large hedge fund can outgrow its own strength, such as the loss of flexibility, liquidity and response time and the danger that the fund will itself drive the market it seeks to manipulate. Both Julian Robertson and George Soros gave size as one of the reasons for their exit from the hedge funds they ran.

While some managers seek safety by limiting their growth, others have developed ways of expanding their markets while keeping their value-creating strategies intact. Recent instances have been the Maverick Capital swap into a three-year lock-up share class and fee increases by Renaissance Technologies.

"We're seeing two things," said Michael Waldron, a partner with Cadogan Partners, a New York manager of hedge funds of funds, to the Financial Times. "We're seeing people change their terms via liquidity or, more commonly, through fees. We're also seeing more new managers coming out with higher fee products."

Historically, hedge fund managers got by on basic fees of 1% annually and a 20% incentive fee, but it's now not uncommon to find basic fees up to 2% with incentives of 25%.

Apart from possibly limiting capital inflow, higher fees allow fund managers to employ more expensive help in order to extract the very best results from market strategies. This is exemplified by Citadel, the convertible bond arbitrage firm founded by Ken Griffin, which spares no expense to build a high-margin business. Expenses are passed through to investors, sometimes totalling up to 7% annually - but this appears justified by the extremely high returns Citadel achieves. Citadel's chief operating officer was the head of Andersen's North American practice, while its head of strategy was the leader of Boston Consulting Group's financial services practice.

The idea is to build a business for the long term, rather than just to run a hedge fund. Industry professionals may be good at fund management, but they seldom have the skills to address the managerial problems that come with increasing company size - another reason for staying small!

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