WSJ: JP Hedgie

Staid old JP Morgan is buying its way into the wild hedge-fund circus, taking control of Highbridge Capital. Is it crazy? Perhaps. But banks were on the losing end of the 20-year transition to mutual funds. There was $40 billion in mutual funds in 1980 compared with more than $4 trillion today. Now banks want the money back.

The growth in mutual funds was perhaps inevitable. During the August 1983 to April 2000 running of the bull, stocks pretty much just went up. Fidelity and others figured out how to slice and dice the market, move money around by phone or Web. Over the same period, trust departments at banks, that should have managed every 401K plan, became sclerotic. Capital, not being stupid, flowed to managers that could perform.

But in the last five years, investors have rediscovered a stock-market maxim, stocks can actually go down. A couple of years in a row of 20% or more losses is like getting hit in the head by a two-by-four — once you come to your senses, you quickly figure out how to avoid getting hit again. The answer may be hedge funds. In 1949, a guy named Alfred Winslow Jones figured out he could improve his investment returns by borrowing money to buy stocks with one hand and simultaneously selling stocks he didn’t actually own with the other. If he constructed the right transaction, he could make money in a raising or falling market. That’s how he discovered a “hedge.” A.W. Jones is still on a door over at One Rockefeller Center.

Banks were on the losing end of the 20-year transition to mutual funds. There was $40 billion in mutual funds in 1980 compared with more than $4 trillion today. Now banks want the money back.

By the late 1960s, it was a real business, and you start to recognize the names. Soros and Steinhardt and even Buffet ran some of the 200 hedge funds that popped up. You must be a millionaire to invest in a hedge fund — an “accredited investor,” in regulator-speak. The Feds, focused on the downside, figure its OK to let rich people be stupid — after all, they can afford to lose it all. But all that really does is keep ordinary folks from getting great returns.

By the ’90s, a couple hundred funds had become thousands, many of them fast-money operations eking out tiny returns on each trade but buying and selling so much stuff a day that it eventually added up. That’s what Julian Robertson at Tiger and the Nobel laureates at Long Term Capital Management did. They ran vats of capital through monster trading floors filled with computer monitors covered in dancing green and red prices, hedging anything that moved. While these blowups got a lot of press, behind the scenes, hedge funds got respect.

It comes down to incentives. Mutual funds charge, say, 1.5% to actively manage your money. The only way they can make more dough is to manage more funds (or allow late trading, but that’s another story). So they run ads every time their funds do well to attract more and more capital, until they’re so bloated — $30 billion, $40 billion and $50 billion mutual funds are not uncommon — they become mediocre just trying to carry their own weight. There just aren’t that many great investments. Mutuals end up looking like index funds that charge 0.1% fees. In a flat market, both are dead vehicles.

Hedge funds can be small and fast and sleek. They often charge the same 1% to 2% fees, but also an incentive fee of 20% of the gains. That may sound greedy, but it allows hedge funds to stay smaller and not just grow for the sake of growing. Hedge-fund managers are in the same boat as their investors, goals aligned. (OK, I used to run a hedge fund and that was the line I used to raise money, but I think it’s quite true.) Plus, unlike most mutual funds, hedgies can both buy and short stocks. The bad ones use too much leverage, borrowing money to amplify meager returns, or are chock-full of derivatives, but since the spectacular collapse of Long Term Capital, those types of funds are on the wane.

So why does JP Morgan want in? Because despite the bad rap of some hedge funds, it really is becoming an institutional product. Pension funds are putting money into them; state treasurers are kicking the tires, eager to invest. Fund of funds are vehicles through which individuals, even those without $1 million to invest, can put money into hedge funds. My guess is that hedge funds, with just $800 billion in total today, will surpass capital in mutual funds by 2010.

But just saying you’re in the business doesn’t mean much, especially for a bank. Customers don’t like paying incentive fees if they don’t have to, even if it’s better for them in the long run. This will be a wrenching transition.

JP Morgan probably figured it could buy into the business, keep it separate for a while, and serve two types of customers. It’ll be tough for others to follow. Goldman Sachs and Morgan Stanley are giant hedge funds themselves, with huge profits from proprietary trading. Fidelity and Janus and the other mutual fund giants can’t lead this charge without collapsing their own bread-and-butter business. JP Morgan, with its steady commercial lending and fledgling investment-banking business, may be the perfect company to conduct this experiment, even though it’s hard to buy into hedge funds as it’s near impossible to lock up talent for long. All eyes are on this deal — although I suspect most on Wall Street are hedging their bets.

Mr. Kessler is the author, most recently, of “Running Money: Hedge Fund Honchos, Monster Markets and My Hunt for the Big Score,” just published by HarperBusiness.