Familiarity and deep pockets provide an edge

Big, traditional money management firms are offering more hedge-fund-related products, prompting some to ask: Can these firms succeed as the hedge fund world evolves?

The answer seems to be a qualified yes.

The reason seems to be that growing interest in hedge funds among institutional investors will create enough demand that everyone gets a slice of the pie – at least in theory.

Numbers provide some proof.

According to Chicago-based Hedge Fund Research Inc., after growing steadily but moderately in eight of the previous 11 years, estimated assets in hedge funds of funds doubled between the end of 2001 and the end of 2002. An estimated $103 billion flowed into fund-of-funds strategies in 2002, more than five times the amount of assets that went into funds of funds in 2001, according to HFR.

Similarly, the number of funds of funds grew to 781 last year, from 550 in 2001, HFR estimates.

About half that growth is attributed to new firms, HFR president Josh Rosenberg says. The other half is new funds of funds opened by established firms.

Some observers say that in the short term, the big firms will win their share of pension fund business, mainly from plan sponsors more comfortable with a name they recognize that also has the deep-pocketed support of a large firm. Specialized hedge fund operations will hold their own by attracting institutional investors favoring companies that have specialized in hedge funds for years.

Down the road, the big firms will have built up their own experience and track records, which will level the playing field. But that could lead to the departure of the management teams that built those records.

Leaving Lazard

That already is happening at some firms.

Lazard Asset Management, which itself lifted a team of fund-of-funds managers from another big New York firm, J.P. Morgan Fleming Asset Management, recently saw some of its highest-profile hedge fund managers leave.

One manager who left Lazard, William von Mueffling, plans to start his own hedge fund company. Others, including Robert Cope, Thomas Ellis and Ben Guest, haven’t commented publicly on their plans.

Philippe Bonnefoy, head of alternative-investment strategies at Commerzbank Securities in New York, says he suspects that the hedge fund managers who left were unhappy with Lazard’s compensation package. Mr. Bonnefoy says compensation will be a critical issue for big firms that are getting into hedge funds.

“In many cases, Lazard did everything right,” he says.

“They created the hedge fund group, they allowed the star culture, and they did spectacularly well,” Mr. Bonnefoy adds. “But ultimately, you have these shops that can offer all these products but still can’t work out compensation packages for the guys who are there.”

Some big firms have acquired hedge fund expertise through mergers.

Citigroup Alternative Investments, part of Citigroup Asset Management in Stamford, Conn., has hedge fund roots dating to the 1980s, thanks to Citibank, Salomon Brothers, Smith Barney and Travelers. All those firms offered alternatives prior to the series of mergers and acquisitions that created Citigroup Inc. in New York.

The number of big firms that offer hedge fund products has grown in recent years. They include The Bank of New York Co. Inc., Credit Suisse Asset Management, Deutsche Asset Management and Goldman Sachs Group Inc., all in New York, as well as Massachusetts Mutual Life Insurance Co. in Springfield.

Dozens of large financial services firms have delved into hedge funds by offering individual hedge funds, funds of funds or both, or by buying or investing in independent firms.

Citigroup’s alternatives arm is making headway convincing pension fund clients on the traditional-asset side that its hedge funds and funds of funds are good investments, says Patrick McNelis, head of Citigroup Alternative Investments’ institutional advisory services for the Americas.

“We’re banking that a large number of institutions will choose to make their alternative investments through a large institution such as us, with a long list of traditional investments,” Mr. McNelis says.

He acknowledges, however, that Citigroup must overcome the perception among consultants that so-called boutique firms are the best way for pension funds to get started.

“In the long term, we see the competition pendulum swinging toward firms that see it our way – J.P. Morgan, Goldman, larger financial service firms,” Mr. McNelis says.

Jim McKee, vice president for capital markets research at consultant Callan Associates Inc. in San Francisco, says that as a consultant, he prefers recommending established hedge fund players to his institutional clients. Mr. McKee concedes, however, that that leaves out some of the big institutional players, which have only recently entered the hedge fund arena.

“I’m the first to admit I look for some funds-of-funds players who lived through 1998,” he says. “It’s a reasonable gripe [among the big institutional firms] that people prefer those veterans with that experience.”

Marc Cohen, managing director of Fimat Group’s New York-based financial services group, sees room for both boutiques and large firms in the future. The latter group advises investors on alternative investments and provides services to hedge funds and funds of funds.