Many traditional asset managers have launched hedge funds to take advantage of the investing talent they already have and to secure higher margins on their assets. Financially, the model has been successful for many. However, running hedge funds in parallel with traditional funds involves many challenges. The main ones are how to manage the different style of investing required, and how to structure the business so that it does not conflict with existing operations.

Possibly the larger issue is that so-called traditional asset management strategies and hedge fund strategies are rapidly converging, especially in institutional management. For example, the same product, called a 130/30 strategy, is being offered to institutional investors by traditional asset managers, such as State Street, and by hedge funds, such as DE Shaw. The product uses a limited amount (30 per cent) of shorting and leveraging to lift returns, making it a hyped-up stockmarket strategy.

This convergence means that for some big institutional managers, such as Barclays Global Investors, Goldman Sachs, Wellington and Bridgewater Associates, managing hedge fund money is not that different from the investing they already do. Already, the term “unconstrained investing” is being used to describe true hedge funds, in part to distinguish them from more general institutional strategies.

The convergence is especially true of quantitative managers, a relatively new wave of sophisticated investors who base their decisions on complex computer models that often use derivatives and synthetics. Their underlying strategy aims to separate beta, or market, returns from alpha, or outperformance. This style of investing lends itself more easily to selling stocks short as well as long and to using a full range of financial instruments – both hallmarks of hedge fund investing.

However, a shift in investing mindset can be difficult for more conventional managers modelled on a single manager selecting stocks based on their view of a company. Many long-only mutual fund managers say they would like to be able to short stocks and theoretically it seems an easy step. After all, the research is already done and the manager might often have views about which stocks are likely to do badly.

In practice, though, the skills are quite different, and there is a lengthy list of mutual fund managers who have quit and then been burnt in their attempts to become successful long/short investors. And quantitative investing, another common hedge fund strategy that is increasingly used in the long-only fund world, requires a big investment in technology and infrastructure for it to work well.

Bill Gross, the bond fund manager at Pimco, was one of the first to describe hedge funds as “a remuneration strategy, not an investment strategy”. He was being scathing, but in some ways, the fee structure rather than the investment approach is what defines a hedge fund.

One of the main issues for traditional managers moving into hedge fund strategies and funds is how to manage remuneration-related conflicts for the firm. First, a company offering hedge funds is offering institutional investors two different fee structures, sometimes for strategies that do not appear that different. Conventional management of an equities portfolio will cost a big investor less than 50 basis points – half a per cent a year. This “conventional” management increasingly is making use of sophisticated strategies similar to those offered by hedge funds, but still demanding low fees.

Hedge funds, however, typically charge 2 per cent a year and a 20 per cent performance fee. So the asset manager must clearly separate the hedge fund offerings, and justify the much higher fee, if they move into hedge funds.

The other conflict for traditional managers is how to compensate hedge fund managers without alienating the rest of the workforce. Since hedge fund managers are usually paid more than traditional long-only managers, this can be difficult. Some top mutual fund managers, such as Legg Mason’s Bill Miller and T Rowe Price’s Brian Rogers, have consistently produced ret­urns in line with average hedge fund returns, but without the risk, and also with the daily liquidity that mutual funds offer. However, they are not paid in the way hedge fund managers are.

Franklin Resources, which trades as Franklin Templeton, is one firm that has grappled with the question of how to manage these conflicts. It plans to increase its alternative assets (it has a hedge fund, private equity and real estate) and set them up as separately run, independent divisions to avoid the appearance of conflicts.

The same conflict is felt by hedge funds offering more constrained institutional products. James Simons’ Renaissance Technologies launched an institutional fund last year and surprised the market by charging much less than his 40 per cent-plus performance fees.

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