It may pay to seek out risk takers.

    Hedge funds have been looking a little ragged lately. The downturn in performance began in 2003 and accelerated last year. Returns slumped, inflows into the funds slowed and the industry entered a bleak period. Those seemingly invincible funds, into which so many had poured so much money, suddenly hit the skids.
    In 2003, the HFRX Global Hedge Fund Index rose 13.4% even as the Russell 3000 Index, a broad measure of stock market performance, was gaining 31%. Hedge fund performance fell to 2.69% in 2004 as the Russell 3000 rose 11.98%. In the period from January to May 2005 hedge funds lost 2.7%, whereas the Russell 3000 slid only 0.7%.
    The downturn sprang from a variety of sources, but it affected funds across the board. Diversification among hedge funds, therefore, was no solace for investors.
    Many had second thoughts about investing in hedge funds. Asset inflows fell by almost half, from a high of $43.3 billion in the second quarter of 2004, to reach $24.6 billion by the first quarter of 2005, according Tremont Capital Management Inc.'s TASS Research.
    The result: The hottest segment in the investment industry froze over. Now some say hedge funds, which sprang into prominence and popularity in the wake of the 2000 stock market crash, are on the decline. But before we doom the entire hedge-fund industry, we need to examine what has gone awry and assess whether there is hope for the future.
    For starters, the hedge funds have reduced their appetite for risk and in some ways the industry has become almost respectable. That's a problem. Originally, those who invested in hedge funds were risk takers. Although not always justified, the industry had an image of high risk in which superlative returns were accompanied by spectacular failures. To have a chance at high returns, you simply had to accept that you were taking a high risk.
    As the industry matured, however, that image began to change. Suddenly, in investors' eyes, hedge funds went from being high-risk ventures to less-risky investments. Some investors began to see them as even less risky than equities.
    At the same time, some managers became nervous as their managed assets grew and they became less inclined to take major risks. Investors thought along similar lines. As foundations and endowments-and even some pension funds-poured money into hedge funds, some fund administrators imposed limits on investing and set conditions on how the money should be invested. They demanded, too, that the managers spend less time on investing and more on reporting. None of these conditions was conducive to risk-taking, yet some managers felt obliged to honor them because of the large amount of money coming their way.
    Yet hedge funds are all about taking risks-so much so that managers should take compensated risks in all environments. Underperforming hedge fund managers might have lost their edge, taking on too much money or becoming asset guardians rather than opportunity seekers.
    Without risk, the potential gains may be lessened until, if fees are taken into account, at some stage they become little more advantageous than investing in the money market-or worse. The result is that today it has become a challenge to find a manager who is prepared to take the level of risk that many investors require if hedge funds are to distinguish themselves from other forms of investment.
    But it was not only the influx of large sums of money and the resulting reduced appetite for risk that hit hedge funds. Several other factors also played a role in the downturn.
    Less market volatility meant fewer opportunities to exploit price differences. Many hedge fund managers seek to make money by taking advantage of the ups and downs of the market. They try to buy in the downturns and sell when the stock turns up. The more volatility that occurs, therefore, the more opportunities become available for such trading.
Volatility is important, too, to those long/short managers who, although they seek protection from downturns through shorting, benefit immensely from up markets. Many of these funds require stocks that vary markedly from the general market trend to make money.
But the past year or so has seen volatility at its lowest level in a decade. The result not only is a lack of opportunity. It also makes it tougher to choose between managers because the opportunities for one to outperform the other are reduced. The distinction between good managers and less effective managers is harder to make.
    Narrowing spreads have made it tougher for managers to exploit the fixed-income markets. Credit plays were a free lunch for some time when the gap between short- and long-term rates was wide. Toward the end of 2004 and into 2005, the gap became as narrow as it had ever been and exploiting the differences became challenging, especially in higher-rated securities. Fixed-income arbitrage managers and convertible managers simply had nowhere to go in their search for opportunities for arbitrage.
    In addition to narrower spreads, interest rates began rising. Higher short-term interest rates mean it is more expensive to borrow. To boost profit, a manager has to buy more of a trade in order to leverage the investments, but doing so costs more. As a result, the profits resulting from the trade are reduced.
    Increased assets under management have hurt managers. As more money pours into a fund, managers are hit in three ways. First, the more money that is chasing existing strategies, the tougher it becomes to find opportunities to make money using those strategies. Second, as more managers seek to sell stocks short to cover themselves, the more difficult access to the short positions becomes. Third, the increased activity in shorting stocks might improve efficiency. With improved efficiency, the fewer the opportunities to exploit inefficiencies becomes. Increased regulatory scrutiny also may improve short-side efficiency.
    Does this mean that the end is near for hedge funds? We do not think so. At least a few of the chilling factors noted above have a sunnier side.
    First, recent months have shown an increase in volatility. Also, it is possible to find hedge fund managers who are still willing to ski the double-black-diamond slopes. Those who have left for safer ground might return.
    Another potentially positive factor is that, should long-term rates start rising, it may improve the amount of money to be made on "carry trades"-those that exploit the gap between lower and higher rates to realize an arbitrage profit. Rising interest rates also improve short rebates.
    If your managers are tired, perhaps it is time to find those with different habitats and strategies. If the U.S. market is becoming too efficient, what about Europe, Japan or the emerging markets?
    New strategies are also on the horizon as managers become more and more creative. To survive the hedge fund winter, the investor must keep a positive outlook and constantly seek out opportunities to take rewarded risks.
    Look for managers doing something innovative. Look for those who are reinventing hedge funds.
    Somewhere out there may be someone who does not want to settle for the comfortable, but aims at stirring up the hedge fund industry to enable it to produce stellar returns once more. When you find them you may want to keep the knowledge to yourself, because we have seen what popularity can do.

Leola Ross is a senior research analyst for Russell Investment Group responsible for conducting capital markets research and offering advice to the hedge fund and Australasia-Japan teams.