A closer look at our recently produced directory showed that more than 1 in 10 of the funds covered were actually hedge fund offspring of traditional long only houses. Looking into the pipeline of hedge funds, we were surprised to see that this figure actually rises to around 1 in 7, although it has to be admitted that there is a bias to the “it is our intention to launch” camp, as opposed to those with a firm timetable. There are several factors explaining this trend:

• Investors increasingly want absolute return, non-correlated products.
  


• Hedge fund investment has historically been the preserve of the wealthy, a market in which long only management companies have been slow to enter.
  


• The best long only fund managers are increasingly starting their own hedge funds.
  


• The standard 2% management and 20% performance hedge fund fee structure translates into a 5-6% net fee, assuming 15-20% annualized returns, whereas long only mandates are priced as low as a tenth of that.
  


• The trend towards indexation on long only money is driving down fees and making personnel resources increasingly redundant.
  

The path that the long only houses have taken to set up their hedge funds is similar.
Rather than take over an existing hedge fund and re-launch it, they have on the whole taken one of their better known long only managers, created an independent cell within the larger organization, seeded it, added a risk management system and launched it. Interestingly, in all cases, they have used the brand of the long only firm for the hedge fund.

The major problem facing these companies is how to incentivise the manager. Self-employed hedge fund managers are motivated by personal remuneration and the desire to escape the bureaucracy of big organizations. Most long only houses get around this by offering a guaranteed salary and then some kind of profit share. Simplistically, the split tends to be the entire management fee to the house, and a 50:50 split on the performance fee. There are often bells and whistles attached with the percentage changing depending on who raised the money, the manager or the house. There is sometimes a charge to the manager for pooled research and other corporate overheads employed. This sort of structure does, however, create 2 further problems:

1. Friction between the hedge fund team and the remaining long only managers who are not on similar incentive packages.
   


2. The temptation for the manager to use his time at the long only house to build up a performance track record and shorting experience with a view to jumping ship to a genuine hedge fund when the opportunity arises.

There is also the broader issue of how to grow a hedge fund within a long only business without cannibalizing the core business. If the managers want to run hedge funds, the marketing people want to sell them and customers want to buy them, who is going to look after the core long only side.

It is probably too early to reach a conclusion on the likely success of this strategy, although the odds are probably in the long-only houses favour. The major reason is that the long only houses have marketing expertise and muscle. They are getting into hedge funds because they already know which of their current customers are looking to build their exposure to the asset class. The record of the early entrants, furthermore, supports this conclusion, as the following table shows: