By Tom Bradley

The Globe and Mail, Report on Business
Published October 13, 2007

The first column I wrote for The Globe and Mail was on hedge funds. As a guest columnist, I innocently poked my head up and declared that their fees were too high and could not be sustained. I also suggested that returns would come down to earth in the years ahead because the available investment opportunities were being swamped with new money flowing in and because everyone and his dog was trying to get in on the action.

Now a year and a half later, money from individual and institutional investors continues to move to hedge funds, but my sense is that the bloom is off the proverbial rose. I say that for a couple of reasons.

First of all, hedge funds on average have been lagging behind conventional equity and balanced funds for a few years now. Strong equity markets helped boost hedge fund returns, but hindered the firms' competitive position relative to other asset managers.

Second, hedge funds did not perform well during this summer's turbulent markets. The median hedge fund experienced negative returns and there were a number of firms that literally blew up. To my way of thinking, this should have been a period when "alternative strategies" (as opposed to a good ole' portfolio of stocks and bonds) went to the top of the industry standings.

I'm revisiting the topic of hedge funds because this rapidly changing industry is moving into a new phase. We are now seeing an increasing number of firms selling out to larger financial institutions.

A couple of weeks ago, Xerion, a manager of $400-million (U.S.), sold itself to Perella Weinberg Partners LP, a New York-based investment bank. The rationale behind this deal, and most others I've seen, is that the hedge fund industry is becoming a place for the big boys. It is getting difficult for a small firm to thrive. Daniel Arbess, the founder of Xerion, was quoted as saying "the hedge fund industry is becoming winner-take-all, with the vast majority of capital going to the largest, most institutionalized firms."

He is alluding to the fact that large pension and endowment funds want to invest $50-million or more in a fund, which is more than small and mid-sized firms can handle. Merging into a bigger entity becomes a strategic imperative for a small firm.

But hold on a minute. Does this trend make any sense? And is it a good thing for investors?

Weren't hedge fund promoters ridiculing the large pension and mutual fund managers for being slow, bulky and more focused on gathering assets than adding value? Weren't they portraying themselves as quick, nimble and totally focused on generating alpha (returns in excess of the market indexes).

And don't hedge funds charge a premium fee so they can make a living (gulp) without bulking up on assets. Because they are geared toward performance fees, superior returns are more important to a firm's bottom line than asset size.

Are we seeing an industry trend developing whereby the ruthless pursuers of alpha will start to look like the pension and mutual fund managers they once ridiculed?

So far the number of transactions is relatively small, but given that there are 10,000 hedge funds in the world, we are likely to see an increasing flow in the coming years.

When reading about these transactions, I would suggest you ignore the rationale given in the press release. Successful managers don't need to worry about access to larger clients or new distribution channels. If they are an attractive acquisition for a big firm, then they no doubt have a great track record and solid reputation. Firms like that will never run short of assets to manage.

In reality, there is a very short list of reasons why an asset manager is selling, merging or going public, and none of them are good for the clients. Transactions happen because the founders are getting ready to retire and want to take some money out of the business (we can hardly blame them for that). Or deals are driven by employee shareholders who want to cash out at the peak and move on to something else (ironically, they often want to start small and do it all over again).

When I suggest that it's bad for investors, I'm generalizing of course. But often, size in the asset management business is a bad thing, given that returns tend to be negatively correlated with assets under management.

It's also not great when the founders are winding down and/or losing interest. And ownership changes bring upheaval - office moves, new bosses or partners, shareholder meetings, more funds to manage - in a business that doesn't deal with change or distraction very well.

I haven't altered my view that hedge fund fees are too high and returns are coming down. Indeed, with assets moving into the hands of large institutions, I'm more confident of that view. The alpha hunters are becoming asset gatherers.