Old School Hedgies Stand Firm On High-Volatility Strategies

Feb 10 2006 | 10:38pm ET

The search for institutional dollars has caused a fundamental change in the way many hedge funds operate. While some hedge funds are morphing into something other than a high risk-reward vehicle for wealthy individuals and acting more like mutual funds, others are standing their ground by continuing to manage money for high flyers looking to take on more risk for the chance of achieving higher returns. 

"The moment pension funds enter into alternative investments is the moment you have two very different kinds of investors," said Anthony Santelli, portfolio manager of AES Capital Management, which he founded in 2001. "I think there is going to be somewhat of a split in the industry, between those [fund managers] who offer a lower volatility, lower return product and into which pension fund investments are made, and those who offer a higher return, higher volatility strategy that continue to cater predominantly to wealthy individuals." He added that the former would tend to be larger funds managing assets in excess of $1 billion, while the latter would be funds with more niche strategies managing assets between $100-500 million

Santelli, who manages $2 million in assets and has had a compound annual rate of return of 40% for the five years since his fund's inception, is aiming to attract more investors, including institutional money, but he is not willing to curtail his strategy in order to do so. 

"We recognize that 95% of the money invested in hedge funds has no interest in our highly volatile, high-return strategy, and that's fine with us," he said. "There is more than enough in the remaining 5%."

Scot Billington, a commodities trading advisor and partner at Covenant Capital Management, also sees a split in the industry.  He believes that the high-volatility strategy he and other CTAs employ is much more in line with the old school, macroeconomic George Soros' and Paul Jones' methods of investing.

"Most hedge funds are just dolled up mutual funds with higher fees," said Billington.  He said that since institutional investors are not usually remunerated to take risk, "they tend to be a herd, so it is very rare to see one of them do something that not everyone else is doing." He said for this reason, his clients tend to be more traditional, high-net-worth individuals who are willing to take risks for the chance at higher returns. 

Despite the two distinct paths that hedge funds are taking, there are some developments in the industry that are common to all types of hedge funds, namely, many are taking a more active, long-term interest in the companies in which they invest. 

"We are dealing with micro-cap firms that may or may not survive," said Santelli, explaining that his firm takes a venture capital-style approach to investing. 

If Santelli is planning to take a sizable position in a company, he always meets with management first. He also advises companies on changes, such as once when he recommended that a firm spin-off a piece of its business, which it did.

"Sometimes it is less radical advice than that. It may simply be trying to persuade them to spend their capital more efficiently," he said. 

Philip Summe, managing partner of Crossfields Capital Management, a hedge fund that invests in small-cap publicly traded companies undergoing operational challenges, has also noticed that hedge funds are using private equity tactics.

"There is clearly an increasing trend to blend the styles as both groups have something to learn from the other," Summe said. "One of the biggest challenges the blended groups face is cultural in nature. Can they effectively integrate the appropriate and different skill sets into a typically very strong investment culture?" 

While the verdict is still out on the hedge fund, private equity culture clash, one thing is certain: fund managers will continue to use their ingenuity to employ whatever tactics it takes to produce absolute returns, regardless of whether they are managing money for wealthy individuals or large institutions.

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