AFTER STRONG YEAR FOR HEDGE FUNDS, INVESTORS RETURN

THE NEW YORK TIMES, SATURDAY, APRIL 17, 2010After Strong Year for Hedge Funds, Investors ReturnBy PAUL SULLIVANWHILE the stock market was surging back last year, so, too,were hedge funds.This recovery may anger the average investor who equateshedge funds with the bad deeds of Wall Street. And the funds’quick return may surprise sophisticated investors who are stillsmarting from the money they lost in their rush to move theirportfolios to cash.But in its most recent report, BarclayHedge, which tracksthe flow through hedge funds, said 2009 was the best yearfor the industry’s performance against the Standard & Poor’s500-stock index since the company started tracking this in2000.As a result, money has started to return to hedge funds,particularly into those focused on distressed debt, fixed-income and so-called event-driven strategies where a managertakes a position in a company because he believes its situationis about to change. In February, investors put $16.6 billioninto hedge funds, according to BarclayHedge. Assets in theindustry as of the end of February stand at a 16-month highof $1.5 trillion.”After it’s all said and done, hedge funds did outperform thebroader stock indices in 2008,” said Sol Waksman, presidentof BarclayHedge. “As bad as the losses were, they were muchworse in the broader stock markets.”An even more optimistic prediction by Deutsche Bank’sAlternative Investment Survey estimated that $222 billionwould be invested in hedge funds this year. Mr. Waksmansaid he believed this was overly rosy. “It’s a record-settingnumber,” he said. “I hope they’re right.”Even if Deutsche is wrong, the point is that interest inhedge funds appears to be picking up again. So will this timebe different? Are investors who are returning now chasingsomething that has already passed? Here are some of thecrucial points to consider:WAS IT REALLY LIQUIDITY?At the nadir of the credit crash, the rap against hedge fundswas that they used their gating provisions to prevent investorsfrom pulling their money out. In some cases, this increasedinvestors’ losses, because they ended up selling other securitiesto get cash.In reality, provisions surrounding when and how investorscould withdraw their money had been clearly stated in hedgefund documents. The hasty sales were driven by the fear thatthe entire system was going to collapse. What happened 18 months ago is not going to change howtop managers allow their investors to pull out their money,advisers say. Hedge funds will continue to require investmentsto be locked up, particularly the top-performing funds. Thatmeans people need to accept quarterly, semiannual or yearlonglockups.”If you want to invest with the best managers, you have to livewith their rules,” said Martin Gross, president of SandalwoodSecurities, a fund that invests in hedge funds focused on debt. “Some people get this and want to be invested with that greatmanager. Others are very nervous about locking their moneyup.”He pointed out that a lack of liquidity forces people to stickwith their investment strategy. The bad news is that those whofiled forms to redeem their money at the end of March 2009missed out on the rally.A liquidity budget may be the better option. This isessentially an assessment of how much money you can standto have out of reach and how much money you need to keepliquid. Investors with those budgets would have been able toset aside a safe amount of money and allow the hedge fundstrategies to play out.NOTHING GOES UP FOREVEROn the whole, hedge funds were down 18 to 19 percent atthe end of 2008. This shook up some people, even though thebroader market indexes were down as much as 40 percent.”Clients fall into two groups,” said David Bailin, globalhead of managed investments at Citi Private Bank. “The oneswho believed in absolute returns – that hedge funds willnever go down – are shell-shocked and gone. The secondgroup did the tough analysis.”By this he means they looked at hedge funds for theirrelative returns. And those who stuck with that strategy havebeen rewarded. Mr. Bailin said 75 percent of the funds hisgroup worked with were at or above their Jan. 1, 2008, high-water marks.A DEEPER DIVEHindsight may be 20/20, but there is something to belearned from how managers positioned their portfolios inthe downturn. David Donabedian, chief investment officer atAtlantic Trust, which manages $16 billion, said the downturnhad allowed him to differentiate between hedge funds withsolid strategies and those driven by the momentum of the bullmarket.”There is now a track record for how the industry performedfrom October 2007 to March 2009,” he said. “You can lookat how they protected assets: were they market-timing or didthey do it through security selection?”It is also worthwhile to do due diligence – the buzz phrasesince Bernard L. Madoff’s Ponzi scheme was revealed. Whileall investors want to understand how the hedge fund intends to make money, the savvier ones are performing what RobertFrey, a former managing director at Renaissance Technologies,one of the top hedge funds, called “operational due diligence.”In addition to asking how the black box investing strategyworks, investors should also want to know how the firm doesbusiness.”People didn’t ask about it before,” Mr. Frey said. “Now theywant to know the process. They want to see the details. Theywant to know how to avoid the next Madoff.”WHAT NEXT?But human nature being what it is, investors also wantto know the next hot areas. Three strategies appear to beparticularly popular.The first is long-short equity, which allows a manager tobet against a stock he does not like. “Good companies and badcompanies have come back together,” Mr. Bailin said. “Weneed someone who is going to do fundamental analysis.”The second area is emerging markets, because investorswant to have more options than simply purchasing stocks andbonds in a particular region. The third is distressed debt, whichgained added relevance after the credit squeeze. Mr. Bailinsaid it could provide as much as a 20 percent annual return forthe next few years.Yet beyond finding the next hot strategy, there has also beena move to rethink what a hedge fund should be used for: Is itto get outsize returns, or to preserve capital regardless of whathappens in the broader markets?Mr. Frey said he had preservation of capital in mind whenhe started the Frey Multi-Strategy Fund in February. “I’mnot worried about a double-dip recession, but a low-growthworld,” he said. And in that world, the more circumspectstrategy may suit investors who were burned.Michael Sonnenfeldt, who made his money as a real estatedeveloper and investor, said he had maintained his allocationsin hedge funds, but he had become choosier.”If you’re in an elevator and it drops 20 floors and yousurvive, you’ll never get into an elevator again withoutremembering that,” Mr. Sonnenfeldt said. He is the presidentof Tiger 21, a learning group for high-net-worth investors.”Our members suffered unexpected, unpredicted losses thattheir economic life couldn’t prepare them for. They’re pawingtheir way back into risky investments.”