Can the new breed of hedge fund managers be trusted?

In the last six years, the hedge fund industry has been the most amazing gravy train for everyone involved. And now ordinary investors have the chance to joining as hedge funds join the City establishment. But if the returns on offer are so high, why are valuations so low?

The hedge-fund industry really has been the most amazing gravy train for pretty much everybody involved over the last six years. It was the dotcom boom for those who missed out on the chance to set up their own business the first time round. And appropriately enough, it was the collapse of the dotcom boom that gave the industry its greatest boost and ensured its pioneers made the eye-popping fortunes that their internet forebears were denied. As the stockmarket tanked, hedge funds offered investors an opportunity to make money by selling shares short or investing in bonds and other financial instruments whose performance was not linked to the stockmarket. And it afforded those who set up these funds the chance to charge lavish fees typically 2% of funds under management and 20% of profits made.

Since then, hundreds of hedge funds have been set up in London alone, managing billions of pounds. And besides the thousands the industry employs directly, it supports tens of thousands of others across the City, not least in the investment banks, for whom the hedge-fund industry has become one of the biggest sources of fees. The success of the industry has transformed the social geography of Britain. Fortunes have been created on a scale and in a timeframe that we have not witnessed for 100 years, if ever before. According to The Daily Telegraph, the average age of buyers of Old Rectories in Britain has fallen by ten years to people in their early thirties.

And now ordinary investors are being offered the chance to join in the fun. After years of jealously guarding their reputation as maverick outsiders, hedge funds are coming of age and looking to join the City establishment. Two hedge-fund managers have listed in London since the summer: Ashbourne, which runs emerging market debt funds, and BlueBay, a European fixed-income manager. They join Man Group and Rab Capital in what is sure to be a rapidly expanding quoted sector.

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On the face of it, these hedge-fund groups offer amazing value. Where else can you find companies that trade on price earnings multiples of 15, yet are growing earnings at 40%-plus per year? These are the kind of valuations enjoyed by the online gaming industry before it went belly-up. Yet nobody argues it is illegal to operate a hedge fund even if funds do tend to be based in the same exotic tax havens as online gaming groups. True, some sceptics still think hedge funds are a fad, but their number is dwindling as the industry starts to pull in money from institutional investors. UK institutions currently invest 2% of their assets in hedge funds. But that is forecast to rise to about 5% over the next few years.

So why are valuations apparently so low? The market is focused on two main risks. One is that it might only take one year or one quarter of poor performance for investors to lose faith and withdraw their money. Several funds planned to float before the market wobble in May and June, but had to postpone as investors got cold feet. The second is the reliance on performance fees, which are volatile, hard to value and certainly not worth as much as management fees. If you strip these out, Man Group's valuation, for example, rises closer to over 19 times 2007 earnings, putting them at small premium to the European asset manager sector which trades on around 18 times.

But both these fears are overblown. First, hedge funds are designed to deliver absolute returns, regardless of whether markets are up or down. Historically, they have done this pretty well, which is why money is flowing into the industry. True, many funds were caught out by the volatility earlier this year, but most have bounced back. Second, management and performance fees are more closely linked than many investors realise. Nobody is going to leave money sitting in a fund that fails to deliver on its promises. So if performance fees fall, management fees are likely to fall too.

So what investors should really be asking is can the fund continue to perform, and thus grow fees? That will largely depend on whether it can lure and hang on to the most talented fund managers. This gets harder as the industry evolves from start-up mode into something that can be trusted with institutional money. Funds are having to become more institutionalised, processes are becoming more bureaucratic, and in the industry's Mayfair heartland, people are starting to don suits again. But if the culture changes, will that make star performers more reluctant to quit big investment banks? And as the industry matures, will equity in a hedge-fund manager become less enticing, since the founders will already have made the big winnings?

That's not to suggest investors should steer clear of the new breed of listed hedge-funds. Far from it. Firms like BlueBay and Ashmore are impressive outfits, with highly rated management, and they are exposed to some strong market trends. But don't lose sight of the fact these are still young businesses with all the risks that entails.

Simon Nixon is executive editor of Breakingviews.com

Simon Nixon

Simon is the chief leader writer and columnist at The Times and previous to that, he was at The Wall Street Journal for 9 years as the chief European commentator. Simon also wrote for Reuters Breakingviews as the Executive Editor earlier in his career. Simon covers personal finance topics such as property, the economy and other areas for example stockmarkets and funds.