Who will benefit from the new breed of hedge funds?

There's little doubt that the next big thing in hedge funds, the 130/30 funds, will make a fortune, but for whom? Simon Nixon reports on the latest developments in the industry.

People sometimes liken the current hedge-fund stampede to the 1990s dotcom mania. Certainly, I detected echoes of the internet boom at the hedge-fund conference I've been at in New York this week. Hundreds of hopefuls had gathered to hear advice on how to get started, network with potential investors and listen to pitches from various IT and other service providers. There was a buzz about the event from the start, thanks to an article on the front page of that day's New York Times, which claimed the top 25 hedge-fund managers earned at least $240m each last year, double the amount in 2005. The top spot went to James Simons of Renaissance Technologies, who earned a mind-blowing $1.7bn last year. Two others also earned more than $1bn. With that kind of money around, who wouldn't want a bit of the action?

But like the dotcom crowd, I fear most of these wannabe entrepreneurs are doomed to fail. For every one that makes it into the James Simons league, hundreds will fall by the wayside. That's because, these days, almost anyone with any credibility can start a hedge fund. The investment banks will do much of the work for you. They'll find you offices, sort out all the boring legal stuff, get you the IT and introduce you to hundreds of potential investors. But that's the easy bit. Unless you already have such a huge reputation you can raise many hundreds of millions of dollars on day one, it soon becomes hard work.

In the early days of hedge funds, almost all the money came from very rich people who were happy not to ask too many questions, providing they got their returns each month. Costs were low and the rookie hedge-fund manager could expect to make money when his fund hit $50m. These days, most of the money comes from funds of hedge funds, which invest money on behalf of institutional investors like pensions funds. These investors won't even look at a start-up unless it's run by someone with a track record. What's more, they don't like to invest small amounts or own more than 10% of any one fund. So to have a chance with these investors, the fund needs to have at least $100m in it already a very tall order for most start-ups.

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Instead, most hedge fund start-ups will be forced to fall back on specialist providers of seed capital, who might hand it out in dollops of $20m or so. But these demand huge rebates on fees and often a share of the firm's profits for several years, which means that until you build enough of a track record to tap new investors, you won't make any money. Worse, hedge-funds investors these days demand the same kind of processes and controls you would expect from a traditional fund manager. So the talented trader who wants to leave his investment bank to focus on doing what he does best will soon find he's spending half his time on expensive, time-consuming management functions. The result is that you now need to be managing about $200m before you start making real money.

Suddenly, starting your own fund doesn't look so much fun. The likelihood is that it will involve years of paying yourself very little, while trying to juggle the competing demands of managing the funds, managing the business and enduring endless, mostly fruitless meetings with potential investors. One hedge-fund founder told me she had met 200 investors to raise her first $50m. And even then, it only takes one quarter's bad performance and you are back to the beginning again. Not surprisingly, huge numbers of start-ups fail and their founders drift quietly back to the banks.

There was a delicious moment at the conference that really summed up for me what this industry is about. We'd been listening to a panel of bankers explain the delights of so-called 130/30 funds, which they said were the next big thing. These are essentially the poor man's hedge fund a bog standard mutual fund that is allowed to run a limited number of short positions equivalent to 30% of the fund. Not much here for a hedge-fund manager to get excited about, you might think. After all, they can already go short as they like.

But then somebody pointed out the true potential of these funds. Because, like hedge funds, these products can sell short, they should always beat the index. That would justify a performance fee. But because, like mutual funds, they're primarily long investors, their performance will also largely track the market. Suddenly, the penny dropped. "You mean we can still charge a performance fee even if we lose clients' money?" asked an incredulous hedge-fund manager. "Correct," came the reply. There was silence as the room drank in this news. Until now, hedge funds could only get paid if they made money, even if the markets fell 20%. Now they were being told that, providing they only lost 19%, they could still charge a performance fee. Better still, you could sell these funds to ordinary retail investors who are usually off-limit to hedge funds. Expect to see lots of hedge funds launch 130/30 funds in the year ahead.

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.