But they are attracting closer scrutiny, SIA conference attendees learn.

    As fast as Alice tumbled down the rabbit hole, the demand-driven hedge fund industry continues its explosive growth. This year alone, some 500 new funds are being rolled out globally. In a lackluster market, brokerage houses, investment firms, mutual fund companies, pension funds and endowments, even banks, all are eyeing the potential for higher returns in these investment vehicles, which so far have attracted $1 trillion in assets. Hedge funds also are open to individual investors with as little as $25,000 to invest.
    At the Security Industry Association's (SIA) mid-September Hedge Funds and Alternative Investment conference in New York City, industry insiders offered different perspectives. Many warned about substantial risks in a rapid-growth industry that lacks transparency and is seen by some as operating, at least on the margins, like the Wild West. Regulatory officials in attendance made plain that the SEC and other regulators will enforce all regulations and continue their scrutiny of the industry in the wake of recent blowups.
    Despite the wave of new offerings entering the market this year, "no more than a handful are expected to survive as sustainable businesses," Philip N. Duff, chairman and CEO of FrontPoint Partners LLC, a hedge fund in Greenwich, Conn., with approximately $6 billion under management, told attendees.
    In his keynote address, Duff gave a brief historical overview and presented his view of some of the industry's challenges and shortcomings. He noted that hedge funds today are still in their adolescent phase and have experienced tremendous change. In the 1980s and 1990s, the principal buyers of hedge funds were high-net-worth individuals "who were not particularly tax-sensitive," said Duff.
    Today, while that constituency is still the predominant holder of hedge funds, the marginal buyer, representing the bulk of new money coming into the industry, is the institutional buyer-public and private pension funds, insurance companies, endowments of universities and foundations. Those businesses have different wants and needs than high-net-worth buyers, Duff said.
Right now, the sector is experiencing growing pains and a high mortality rate, Duff said. Current demand exceeds capacity. The medium-sized hedge fund is still slightly larger than $100 million in assets, with an average life span of just three and one-half years. Of the 400 hedge funds launched last year, FrontPoint Partners estimates roughly 20% won't make it through 2005. Only seven of those launches were in excess of $500 million in assets, he noted; the median launch was $11 million in assets.
    Duff expressed concern that, in his opinion, too many hedge funds today are being run largely for the managers' personal gain rather than investors' benefits. While there are many hedge funds that may prove to be attractive investments, in Duff's view, there are very few sustainable hedge fund organizations.
"Most hedge fund organizations today are, quite literally, three guys with a Bloomberg (terminal) in a garage" out to increase their own net worth, he contended. "The statistics are a real impediment to a large asset owner."
Duff indicated that investors and financial advisors seeking higher returns for their clients in alternative investments will have to undergo significant investor education to more efficiently incorporate such investments into their portfolios. On the industry side, he urged hedge fund organizations and service providers, such as securities firms, to provide the inputs to create standards, benchmarks and a more robust infrastructure to support the hedge fund industry.

    Lori Crosley, a principal at Greenwich Associates, gave an overview of the state of the hedge fund industry. She made the following points:
    Within the U.S., hedge fund investing is become a more important part of the institutional marketplace, with U. S. endowments continuing to have the largest allocations. Globally, continental Europe and Japan are leading the pack, while Canada and the United Kingdom have been slower to adopt.
    As a percentage of total institutional assets, hedge funds remain only a small proportion despite steady growth. But Greenwich Research sees an increasing number of public pension plans starting to test the water. Meanwhile, foreign plans are doing more investing in the U.S.
    One-third of funds expect to make a significant asset allocation change over the next three years. Among these, the most common expected moves are to increase alternative asset categories, as well as active international allocations.
    Risk control, research and due diligence processes rank highest when evaluating a fund of funds manager's capabilities. "Funds of funds" are funds that invest in multiple hedge funds, and are becoming more popular as they have separate accounts allowing for more transparency.
    One drawback, however, is high fees. From a fee perspective, Crosley said funds of funds often charge a fee, which gets layered on top of the underlying fee somewhat like a ticket broker. "You can go to the box office and buy a ticket directly or you can go to a broker or intermediary and pay a premium on top of the fee for the ticket."
    On the point of fees, David A. Vaughan, a lawyer with Dechert LLP in Washington, D.C., said he has not seen pressure brought on hedge funds to lower fees. In some cases, he said, "Hedge funds are able to raise fees, depending on how well they're perceived in the marketplace."
    At a luncheon meeting, the keynote speaker was SEC Commissioner Roel C. Campos. He began on saying the decision to require hedge funds to register with the SEC was a hard one. But ultimately the SEC decided in favor of regulations because it felt there was too much opaqueness in the industry and were a fraud to occur without SEC oversight in view, investors would lose confidence.
    He called for more transparency, saying the gap in available data on hedge funds makes it hard to properly evaluate them. "No one, neither the regulators, industry groups, competing hedge fund groups, investment banks nor investors themselves, has a complete picture of the industry," he said. "Even the experts question the value of available information in the hedge fund industry." 
    "That is why transparency is vital, and the need to analyze the risks inherent in the industry, and to protect the overwhelmingly honest hedge fund operators."
    Campos noted the rapid expansion of hedge funds, now totaling 8,000, has come at some costs. Part of the growth has come from the expansion of hedge funds into other business activities, pitting them against banks, mutual funds and other financial sectors competing for investor dollars. Some hedge funds, he said, have become clients of big corporations. Others have entered the money lending business offering quicker access to funds than investment banks.
    Still others recently "have focused on relative value trades in which long-term stock positions are balanced by negative debt on different companies in the same sector, either at home or abroad," Campos said. "There's no question that hedge funds have piled into the futures market, causing it to triple its size over the past five years, while the supply of available funds to fulfill these contracts has dwindled."
    Campos said that so far this year, the SEC has brought 11 cases against hedge funds directly, including Bayou Management LLC, and four cases against broker-dealers. In a press briefing following his speech, he said most of the enforcements today stem from investor complaints. "We think that by being there and providing examinations, the industry will tighten up and not be blamed [for] the actions of one or two players."
    The SEC planned a careful approach toward implementing regulations and would keep an open dialogue with the industry and other regulators, said Campos. "The agency is looking to implement the rules in a wise, practical manner that will allow business to go on as usual. We're not looking to get into the business of your business," he told attendees.
    There was a good deal of discussion at the conference on new rules and regulations regarding hedge funds. The rules now require hedge funds with more than $25 million in assets and more than 15 outside investors to register with the SEC by February 2006. Many advisors are expected to register, even those exempt from the requirement because of two-year lock ups, which prevent investment withdrawals during that period, Lindi L. Beaudreault, a Washington attorney, told attendees in a panel.
    Hedge funds that trade futures must also register with the Commodities Futures Trading Commission (CFTC) and the National Futures Association (NFA).
    Beaudreault pointed out that all registered advisors to hedge funds are required to have written policies and procedures in place, as well as a Code of Ethics, and are subject to annual compliance reviews. Funds must also appoint a chief compliance officer.
    Beaudreault reviewed some hot-button hedge fund enforcement issues that have surfaced recently, including gifts, insider trading, short-selling, misappropriation of customer funds and unregistered offerings. The gifts issue in particular, she said, is a big concern in the industry. As a result, many hedge fund advisors have tightened their procedures.
    Gary L. Goldsholle, associate vice president and associate general counsel in charge of regulatory policy and oversight at the NASD, noted that many funds of funds are showing more direct investment by retail investors, with minimums as low as $25,000. He cautioned that funds might be tempted, when their strategies don't yield high enough returns, to go after new money, meaning retail investors, and lower minimum levels just to increase their revenues.
    Goldsholle touched on the Bayou scandal, saying it was not clear to him what an examination of Bayou would have revealed. He noted that the accounting firm that Bayou's broker-dealer used was an independent firm.
    He was pleased, he said, that the due diligence some investors performed on Bayou had kept them away from the fund. "I thought it was impressive that people would actually stay away from a fund because they thought the returns were too high, given the returns of their peers," Goldsholle said.
    He said some in the press had "mischaracterized" NASD's ability to examine the books and records of Bayou. "That's simply not true," Goldsholle contended. "Just because we regulate broker-dealers doesn't give us the right to look at the books of the hedge fund."
    Duff said the major challenge hedge funds face today is building capacity to meet growing demand for higher returns from institutions and high-net-worth individuals. The way to accomplish this, he said, is to train and develop more people and allow them the autonomy that comes from being able to manage money in an environment that takes advantage of the benefits of size, scale and flexibility. In turn, this will enable them to produce the results their clients expect.

Bruce W. Fraser, a freelance financial writer, has written for many publications. Visit his Web site at www.bwfraser.com.