Smaller hedge funds may fade away when markets turn

By Elena Moya

LONDON (Reuters) - Dozens of small hedge funds that have proliferated in London over the past four years are in danger of disappearing because of falling returns, growing competition and a possible change in the economic cycle.

Though more than 450 hedge funds are now based in London, which has become the industry's hot spot surpassing New York, bankers, lawyers and accountants are already seeing the start of another wave of change.

"As expected with a rapidly growing market, the hedge fund industry is likely to face a period of consolidation," said Julian Young, a director at the hedge fund unit of accountancy firm Ernst & Young (E&Y).

Often run by young former bankers working from London's upmarket Mayfair neighborhood, some hedge funds have made fortunes investing on the right side of the surging commodities market or placing the right bets on pending M&A deals.

But it could all end in tears.

"The days of hedge fund managers gambling with someone else's money, losing it and being allowed to do it all over again by investors who invest in his new fund seem to be ending, which is good, as that's not how rational markets should work," said one senior banker.

"There should be some incentive for asset managers to be rewarded for good performance and punished for losing money," the banker said.

The lure of hedge funds is that through their freedom to short-sell they should be in a position to benefit whether markets rise or fall. But industry data suggests hedge fund returns have been unimpressive at best, calling into question their costly fees.

According to Chicago's Hedge Fund Research Inc., the average hedge fund returned 13 percent in 2006, the most since 2003, while the Vanguard Total Stock Market Index fund VTSMX.O, a rough proxy for the U.S. stock market, returned 15.5 percent, with a comparatively smaller annual fee of 0.19 percent.

The Vanguard fund also beat hedge funds in 2003 and 2004, though hedge funds outperformed in 2005.

NOT MUCH VALUE

Billionaire U.S. investor Warren Buffett and Russell Read, chief investment officer of the $225 billion California Public Employees Retirement System (Calpers) -- one of the world's biggest investors -- have said the fee structure of hedge funds, where managers charge a 2 percent commission plus 20 percent of potential profits, isn't worth investors' money.

"I see a lot of people investing for the 2 percent and a chance at a follow-on deal, but it's harder to see investments being made for 20 percent of the upside," said Lachlan Edwards, head of European restructuring at Goldman Sachs in London.

"If a hedge fund manager is buying distressed debt at 98 pence, there's not much value to the manager in that 20 percent," Edwards said.

Almost half of the world's $1.4 trillion managed by 9,800 hedge funds comes from wealthy investors and the rest is supplied by institutions, according to a recent report by New York consultants Hennessee Group. Hedge fund assets have nearly doubled in three years.