When Fortress Investment Group filed to become a publicly traded company earlier this month, it was the Wall Street equivalent of the CIA signing up for Facebook. Being open to the scrutiny of the public is antithetical to pretty much everything that a hedge-fund operator does. But the world of hedge funds isn't what it used to be. Once they were known for being secretive and small--for taking money from millionaires, making winning trades in exotic investments like swaps and warrants and collecting massive fees in near anonymity. The setup was disrupted only by an occasional, spectacular blowup. Over the past four years, though, assets in these funds have more than doubled, to $1.3 trillion, while returns have flagged--and that changes a lot of things.
Confronted with this evolving landscape, hedge funds have had to grow up. You can see it in the way managers trek to Washington for Capitol Hill meet-and-greets. You can see it in the way big-name banks like Morgan Stanley and Citigroup poach existing shops and expand their hedge-fund practices. You can see it in the run-up of bloated, billion-dollar-plus firms. You can see it in how hedgies talk about their industry as if it is an industry, and not an unrelated mishmash of investment strategies.
And you can see it at Fortress, not just because of the IPO but also because the company joins, under one roof, hedge funds and private equity, the practice of buying and running companies. It's yet another sign that lines are blurring and hedgies are no longer the loners of the investment world. Eddie Lampert used his hedge fund to take over Kmart and Sears, then funneled the stores' cash flow into derivatives trades--which last quarter made $101 million, half the company's net income. Nelson Peltz used his to storm onto the board of H.J. Heinz. "By many different definitions," says William Goetzmann, professor of finance at Yale School of Management, "we're seeing the institutionalization of hedge funds."
You're part of it too, albeit indirectly. Pension funds, foundations and endowments--cautious money--flooded into hedge funds after stocks tanked following the late-'90s boom. The institutions were seeking an edge. They didn't get much of one for long: the industry's last year of 20%-plus returns was 2003, according to Hedge Fund Research, and since then funds have on average returned an unflashy 9% a year, partly because the torrent of new money makes markets more efficient.
But for institutional investors like pension funds, with obligations 15, 20 and 40 years out, 9% isn't that bad. They also like the idea that hedge funds provide a cushion in down markets since they don't closely mirror returns from stocks or bonds. David Hsieh of Duke University's Fuqua School of Business studied hedge funds before and after 2000 and found a general decrease in risk.
In other words, now that Big Money is onboard, hedge funds are playing it safer. "Historically, the people who were giants of the industry were unusual, dynamic and hard to classify," says Yasho Lahiri, a partner at law firm Baker Botts in New York City, who represents hedge funds and investors. "Today people want repeatable process."