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Hedge fund bubble?

Hedge fund bubble? Just when it seems Businessweek magazine "gets it" with a cover story on applying mathematics in the real world (of which quantitative trading - ie many of the better hedge funds - is a prime example), they run this piece on the hedge fund industry implying the growth story is basically over!

The "leak" is that net capital inflows to hedge funds have temporarily slowed. Just because investors have got excited and distracted by several current bull markets - Japan, emerging markets, private equity LBOs - hedge fund inflows did indeed slow a tad. So? Those investors will be back soon enough, likely after learning yet another expensive lesson from long only euphoria.

Hedge fund performance was NOT lousy last year and was exactly as desired. Returns across investment choices can only be compared after adjusting for the risk taken to generate those returns. Sure "indices" for the industry in AGGREGATE will always have their numbers dragged down by the many unskilled managers. Most hedge fund managers that I follow were all well into double figures. Fees are not high; they simply reflect the demand from investors for products that offer reliable returns with capital preservation.

Bona fide hedge funds occupy the risk continuum BETWEEN bonds and stocks and offer essential portfolio diversification. They are not a "laggard", they are a new source of return. There are always other investments that look "juicier" as they take much higher risk. Buy lottery tickets, go to Las Vegas, put all your money into Iraqi Dinars or Zimbabwe equities. You might win.

As a long only, highly leveraged asset class, private equity is almost GUARANTEED to outperform in a bull market. Adjusting for RISK however, private equity returns have mostly been abysmal compared to hedge fund returns over the long term. Hedge fund managers are a paragon of virtue compared to the games many private equity firms play with IRRs, carry, "advisory" fees, "special" dividends and portfolio "valuation". I wonder what the media would write about a fund manager who attempted to include only winning trades in their numbers(!) or calculated performance from the day they "say" the money was put to work, rather than from when the investor committed capital.

So what if new investment inflows into hedge funds have slowed a tad. Nothing grows in a straight line. Doubling in size since 2000, wow! $500 billion grows to $1 trillion at just 12% in that time with ZERO new cash inflows. A decade or so from now the industry will be managing many more trillions as pensions, retirees and anyone with investable assets belatedly realize a well-managed hedge fund most closely matches their conservative risk tolerance.

Every year, lots of hedge funds start up and lots close down. In its early days a hedge fund is an entrepreneurial small business. Just like ALL other industries there will be a high attrition rate. Some funds shut down or return external client cash because of SUCCESS. A fund that ceases functioning did not necessarily lose all or even any of the money.

Lock-ups. Aren't we all supposed to be long term investors? With the time and costs of due diligence, once you commit to a fund, you should actually COMMIT. If you can't stomach a 2 year lockup, keep your money under the mattress.

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