Hedge funds now run in the trillions

Wednesday, June 29, 2005 at 1:00am

When the words "hedge" and "fund" come together, they elicit a lot of different reactions from financial investors. Some are positive and some are negative, but most everyone assumes hedge funds originate out of mega-cities in the Northeast.

The majority of investors in Nashville would probably be surprised to find a significant amount of hedge-fund activity right here in their own metro area.

There are not only funds based in the Nashville area, but also fund managers and even one of the best-known hedge-fund research and index firms in the world.

The word hedge refers to playing both ways in a game to reduce potential losses. When combined with the word fund, it usually means buying a stock or other equity with the expectation that the equity will go up in price - referred to as going long. At the same time, an equity (possibly the same equity or possibly another) is sold short - meaning the investor makes money if the stock goes down. The process thereby hedges the bet by ensuring returns whether the equities go up or down.

Hedge funds often use a balance of investments weighed more in one direction, such as having more positions going long than going short.

Hedge funds don't have to invest in only stocks. Depending on their investment strategy, they can deal with bonds, commodities, currencies or other instruments. They can be quite specific, concentrating on energy, real estate or some investment sector that is unique.

One local hedge fund that in the last several years has had tremendous success is the MidSouth Investor Fund. Buzz Heidtke is a general partner and a portfolio manager for the fund.

"We focus on micro-cap value stocks, meaning companies with $200 million or less in market capitalization," Heidtke said. "We are pretty much on the longs, but do a small amount of shorting."

MidSouth started out in 1993 and primarily invested in companies in the Southeast, but because of the growth of the fund, there eventually were not enough potential stocks in the region. So Heidtke decided to go to the national scene and eventually international.

The fund now has 200 diversified holdings with 15 percent outside the United States.

MidSouth's success was recognized in May of this year by the MARHedge Annual U.S. Performance Awards in New York. The fund was picked as the No. 1 fund in its category of Long/Short Equities. There were eight other hedge funds receiving awards that were based on their gains over several years.

MidSouth had gains of 35 percent in 2004, 65 percent in 2003, and was down only 1 percent in 2002, the year the bubble burst. A down year in the market is when short selling really pays off.

Heidtke said he looks at approximately 8,000 companies a quarter to find a few potential winners and moves fast to buy at the right time. Out of the few acquired winners, a very few turn out to be really outstanding, increasing in value many times over.

He cautions, however, that the market is cyclical and the micro-cap stocks he favors may not continue with the great returns he has experienced recently.

MidSouth has become so popular that the fund has had to turn down some world-class investors such as Goldman Sachs and Merrill Lynch.

"We are very selective in [the investors] we pick now and don't want to become too big," Heidtke said.

The minimum investment required is now up to $500,000 from an original $50,000.

Jefferies and Co., a New York-based investment bank, has two hedge funds managed out of Nashville.

"Most of our clients are institutional investors that are investing money fund to fund," said Elliot Lawrence, portfolio manager of the Jefferies RTS Fund.

Lawrence's fund invests in the retail/consumer segment employing a long-short strategy. His fund favors long, however.

The firm's other locally run fund, Jefferies HC Fund LP, which was only recently started, is managed by Andy May.

Other funds located in the Nashville area are Jet Stream Capital, Courage Capital and Teleion Fund, whose managers declined to speak for publication.

Also based in Nashville, Van Hedge Fund Advisors International LLC evaluates hedge funds and has developed an index to track them.

George Van is the board chairman and founder of the company. Prior to starting the advisory firm in the early '90s, he had been the president of Hospital Affiliates International and of Health Group Inc., the latter of which he founded.

He became interested in investing, particularly with hedge funds, he said, after leaving Health Group and receiving significant assets to put to work.

"I became fascinated by what the big fund managers at the time such as George Soros, Julian Robertson and Michael Steinhardt were doing," Van said.

Unable to find any in-depth information on hedge funds, he decided to set up his own research and database group to track the various instruments.

The company is now a U.S. Securities and Exchange Commission Registered Advisor and is registered with the Commodity Futures Trading Commission. His clients are provided up-to-date information on funds and the strategies with the best returns.

Van said that today the industry has grown to more than 8,000 funds managing nearly $1 trillion.

One of the trends his firm has noticed is that hedge funds tend to provide their best returns when they first go into business. A major reason for this phenomenon is that smaller amounts are easier to work with, Van said.

When funds become larger it is harder for them to find good investments, he added.

Van's company just released its periodic index indicating which hedge-fund strategies are performing best this year.

In the months through May, the best performing fund strategies were short selling, emerging markets, and statistical arbitrage market securities. The worst performing strategies were aggressive growth and vertical arbitrage.

Overall, Van's analysis shows hedge funds to have the best returns of all investment groups. Using a statistical sample of the funds in his index, Van indicates that from January 1988 through the middle of 2004, the average hedge fund had a total return of 1,175 percent.

This compares to a return of 367 percent for the average equity mutual fund and 579 percent for the Standard & Poor's 500 Index. These numbers correspond to compounded annual returns of 16.7 percent, 9.8 percent and 12.3 percent, respectively.

"It is difficult to measure returns of hedge funds," said Hans Stoll, professor of finance at Vanderbilt University and director of the university's Finance and Markets Research Center. "The ones that have gone out of business are not [typically] factored in to overall returns."

Stoll points out that a number of funds have recently ceased operating for various reasons.

Acknowledging the risk, another Van company runs a "fund of funds" that is composed of multiple hedge funds, allowing investors to spread the risk and reduce volatility.

Hedge funds are not for everyone. Once your money is in place in a fund, you can't just take it out. Most funds require the money be left untouched for months or a year at a time.

The average fund requires $250,000 from an investor and typically charges a 2 percent management fee and a 20 percent fee on returns.

And despite the returns, hedge funds are considered riskier than many other investment products such as mutual funds or bonds, partly because the Securities and Exchange Commission (SEC) does not heavily regulate them.

The SEC does have certain requirements for hedge funds and has defined two basic types. One type limits the number of investors to 99. An investor in this fund must have a net worth of $1 million. The other type places the limit on investors at 500 and requires each investor to have $5 million in investment assets.

But despite the potential risk and the SEC restrictions, Van predicts hedge funds will grow to $2 trillion in managed assets by 2010, $3 trillion in 2013 and $5 trillion by 2015.

"People didn't believe me when I predicted that hedge funds would grow to $1 trillion by 2005," Van said.

They do now.

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