For hedge funds, nowhere to go but up

December 28, 2010: 12:07 PM ET

With regulatory and political landscapes evolving, change is afoot for hedge funds. But will their performance change for the better?

This has been a relatively blah year for hedge funds. Sure there have been pockets of excitement -- there was Timberwolf, the so-called "shitty deal" brought to us by Goldman Sachs (GS), there was the story of the hedge fund wife's inspirational piano playing pig, and of course, there's the ongoing insider trading probe. But no single trend has defined the industry.

If 2007 was the year of the Big Short, 2008 that of the Great Liquidation, and 2009 the Performance Comeback, then 2010 might best be described as the Year of Muddling Along.

At the beginning of December, the industry's average year-to-date return was about 7%, versus 6% for the S&P 500, according to Hedge Fund Research. Gold made managers tidy sums, but not the vast fortunes reaped from previous bets against subprime mortgages or trades on government largesse. Investors cautiously came back to hedge funds, but with SWAT teams of due diligence pros and determined to drive down fees. And new managers launched without much fanfare.

It seemed that most funds lurched from flash crash to sovereign debt scare, trying to understand the changing regulatory, political, and economic landscapes, and laboring to make money along the way.

"We just went through a make no waves period," says Ron Geffner, a partner at Sadis & Goldberg who structures and advises hedge funds. "It was a time when you didn't pull your head out of the sand, lest it be lopped off. But I'm optimistic going into next year. Next year the industry will grow."

Geffner is not the only optimist. Managers and analysts predict that money will start flowing more quickly to hedge funds, and that the cash will go to strategies that were recently eclipsed by a mania for credit, event, and distressed investments. They also say that some trends that put down roots in '09 and '10 will finally bloom next year, and that hedge funds will look more than ever like their tamer mutual fund cousins.

From performance to fees to scandals, here's what to watch for in the hedge fund industry next year:

Strategies go macro

Event-driven strategies will remain popular next year, but limited partners are also interested in global macro and long/short equity strategies, according to reports from Lipper and Bank of America Merrill Lynch (BAC).

"A lot of things are now macro driven, including economic and regulatory policy, and potential wars," says Sam Hocking, global head of prime broker sales at BNP Paribas, who adds that equities will likely stage a comeback.

Volatility in commodities will make managed futures funds popular, too. Crowded trades, like gold, could hurt latecomers. And the biggest funds are moving to Asia and the Pacific Rim, where managers benefit from relatively fast growth and where Hocking says some are looking for the next big, headline-making, payday trade.

Bigger is better

Hedge funds are in the "early stages of a massive reallocation of capital, one that is occurring on a scale that could redefine the competitive landscape," says recent report from JP Morgan's capital introduction group.

This is a fancy way of saying that big, established funds are getting a disproportionate amount of the money that is coming back to the hedge fund industry. About 75% of third quarter inflows went to the handful of funds with over $5 billion in assets under management, according to Hedge Fund Research.

The move toward bigger and more institutional is being driven by investor desire -- limited partners are no longer willing to invest in anything that seems at risk of collapse. It is also driven by increased regulation, including new SEC registration requirements. The requisite legal and compliance departments are expensive, and the world is becoming more standardized and regulated.

But there's still room for the right small funds. Hedge fund launches with $1 billion haven't been the norm since '07, and that's not a trend coming back soon. But things like banks scaling back prop trading and this year's relatively (very relative) crappy pay day will drive people to start their own funds. BNP's Hocking says that the trend of managers launching on seeding platforms will continue, and that we can expect to see smaller players merge or, if very small, fade away.

Performance rebound

Thanks to inflows and the prospect of rising equities and commodities markets, many people think that hedge fund indexes could rise more significantly than they did in 2010. While that's great for some, it does create the rising tide that could lift all boats, even the very worst funds. Let's hope that good performance doesn't lull LPs into doing less due diligence.

Falling fees

While Greenwich hasn't hit upon Detroit-like hard times, fees for hedge funds continue to fall. Christian Picot, the chief investment officer at hedge fund Odyssey Investment, points out that fee structures could also change.

"Our fee structure could look more like a private equity structure, whereby you don't get paid until the investment is fully realized," Picot says. "You're starting to see this request come from institutions and insurance companies with managed accounts."

The scandal factor

No one knows how the government's latest broad insider trading investigation will play out, but everyone knows it's certain to exacerbate the move toward institutionalization. "When Putnam was caught up in the market timing scandals, it didn't sink the company because it's an established institution. It's thought of in a different way," says Picot.

But hedge funds tainted by scandal tend to eventually go under. "It's like pulling a thread and unraveling a suit," says Geffner, of Sadis & Goldberg.

And that thread has only begun to be pulled. So far, the arrests have been centered on research analysts and corporate executives, but with witnesses cooperating in the probe, there will almost certainly be more perp walks by hedge fund managers in the coming weeks and months.

Also on Fortune.com:

Is the SEC fighting last year's war?

The big hubbub over St. Joe Company

Icahn's no good, very bad Dynegy deal

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About This Author
Katie Benner
Katie Benner
Writer, Fortune

Katie Benner joined Fortune in October 2006. As a writer for the magazine and the website, she focuses on Wall Street and the economy. Prior to joining Fortune, Benner worked at TheStreet.com, CNNMoney, and as a freelancer in Beijing for China International Business, the South China Morning Post, and as a columnist for Beijing Review. She has a B.A. in English from Bowdoin College.

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