Big Banks, Like J.P. Morgan Chase & Co., Look to Hedge Funds for Growth, and Vice Versa

Date: Friday, October 8, 2004

By MICHAEL J. MARTINEZ - NEW YORK (AP) - What's a major investment company to do when its ultra-high-worth clients _ the high rollers whose portfolios can rival the size of small mutual funds _ want to take their money away and put it in a hedge fund? If you're J.P. Morgan Chase & Co., you buy your own hedge fund. And not just any fund, but Highbridge Capital Management, considered one of the best around, with an average 20 percent annual return for investors for the last 10 years, before fees, and $7 billion under management. If you're any one of the other big Wall Street firms, you sit up and take notice. Once derided as shadowy investment vehicles only for people with massive amounts of money, hedge funds are lowering their net worth requirements _ which typically range from $100,000 to over $1 million _ so that the mere well-to-do can participate. Like mutual funds, hedge funds pool investors' money to try to earn the highest return possible. But, under law, hedge funds can use techniques that are off-limits to mutual fund managers, such as betting that stocks will decline in price and using derivatives and other complex financial instruments to hedge against risk. That allowed many of them to post profits through even the worst market declines. Because of the higher risks involved, government regulators require that hedge funds be limited to high net-worth individuals with ample investment experience. They also limited the number of investors a fund could attract to usually 100 or less, though current regulations are vague and this number has been relaxed over the past few years. In turn, hedge funds operate with far less government scrutiny _ which can be attractive for wealthy investors hoping to make their money quietly. J.P. Morgan Chase's Sept. 27 acquisition of a majority stake in Highbridge was valued at around $1 billion. Highbridge, founded by Glen Dubin and Henry Swieca, has not stated publicly who will get the payout from J.P. Morgan's investment. While still a fraction of the size of the $7.5 trillion mutual fund industry, the amount of money invested in hedge funds has risen from $76 billion in 1995 to $795 billion at the beginning of this year. "If you're a big investment bank and you don't have a hedge fund, then you're not playing with a full deck," said David Beim, professor of finance and economics at the Columbia University Graduate School of Business. "Every major bank will be driven in this direction." The number of hedge funds surged from 2,080 in 1995 to 7,000 at the start of 2004, in part because anybody who can attract investors can set up a hedge fund. That, of course, has led to concerns about how these funds are regulated. "The barrier to entry in the hedge fund business is zero, but the barrier to success is high," said Bob Sloan, founder of S3 Asset Management. Sloan's firm helps small hedge funds with administration and trade execution by pooling their resources _ much like a group of small businesses might pool their resources to bring health insurance costs down. "If you add the potential costs of regulation, then that barrier to entry rises," he said. According to the Securities Industry Association, 42 percent of hedge funds operating in the United States are not registered with any regulatory agency. Thirty-nine percent of fund companies are registered as investment advisers, 9 percent are registered as commodity pool operators and just 1 percent are registered broker-dealers. Nine percent are registered as two or more of the above. In July, the Securities and Exchange Commission approved a proposed new rule ordering most hedge fund managers to register with the agency. If formally adopted after a public comment period that ended Sept. 15, the rule would open the funds' books to SEC examiners and make them subject to an array of regulations including accounting and disclosure requirements. Those requirements could end up cutting into many funds' profits, forcing them to either absorb the higher costs of regulatory compliance to remain attractive to investors or increase their base fees to make up for it. Those base fees, while low, are in addition to performance fees that customarily total 15 percent to 20 percent of investors' returns after the funds meet predetermined minimum target returns. There is a great deal of debate on regulating hedge funds. SEC chairman William Donaldson is an advocate of increased scrutiny, citing the 46 cases brought by the SEC against hedge funds in the last five years that the commission claims defrauded investors of more than $1 billion. The SEC filed a civil suit in August against hedge fund operator Sterling Watters Group and one of its executives, alleging that the executive and the fund raised $27 million by lying to investors about the fund's performance when the fund was allegedly worthless. The fund has vowed to fight the charges. However, experts note that as a whole, the number of funds involved is on par with the larger mutual fund industry, and that most funds operate legally and ethically. "These funds are not some kind of scam city," said Michael Udoff, vice president and associate general counsel for the Washington-based SIA. "Yes, there have been some problems, but these funds have significant benefits as well." Hedge fund supporters, most notably Federal Reserve chairman Alan Greenspan, have said hedge funds are beneficial because their active trading strategies provide liquidity in the markets when volume would otherwise be low. And they argue that the SEC already has the regulatory oversight needed to pursue fraud claims under current regulations. In the end, observers believe the SEC will succeed in increasing its hedge fund oversight. And that may lead to consolidation within the hedge fund industry, more efforts like Sloan's to help funds overcome their higher costs, or more partnerships like the one between J.P. Morgan Chase and Highbridge. "Hedge funds have to come into the mainstream at some point," Beim said. "And Wall Street will see an opportunity there."