Wow. Things have really changed. Remember when mutual funds were the �safe investment� to which savvy investors flocked? And how we all learned that there was no magic in mutual funds, but that it depended on who the fund manager was, what his or her track record was, and what sectors he chose to invest in?

Well�mutual funds have apparently been replaced by hedge funds. Large institutional investors have decided that they should make large allocations to this class of alternative investment. Widows and orphans� money, your alma mater�s endowment, and large foundations all invest in hedge funds. And what are those funds? They are a variant of private equity.

More money actually flowed into hedge funds between 2001 and 2004 than into mutual funds. That money is earmarked for the capital markets. Hedge funds are now a source of capital that have to be reckoned with. That�s good if you are trying to be the investee. But since hedge funds are largely unregulated, and many have been started by people without much track record or experience who have raised large sums of money, there�s a bit of risk in being the investor.

So this morning I sat in a room full of pension fund managers, general partners, service providers and other potential investors to hear a managing director of Merrill Lynch talk about the outlook for this year�s capital markets. The people in the room were asking the question �where should I put my money,� while I was asking what�s the difference between a hedge fund and a mutual fund?

The answer is, less and less, except the hedge funds can invest in private equity. In fact, they can invest in almost anything. So naturally these folks have a big curiosity about what�s going to happen to the capital markets in 2005.

After the great year of 2003, there were questions about whether 2004 would produce a correction. It did not, because GDP grew consistently in 2004, and although the large caps didn�t do well, we had acceptable returns on the S & P.

2004 was a tale of three markets: the first quarter was quite robust, but by the middle of the year rising oil prices and uncertainty about the election and the Fed�s actions caused the market to level off. Once Bush won and oil didn�t run up to $80 a barrel, the market zoomed ahead and we had the January effect of 2005 in December 2004.

IPOs tripled between 03-04, as did secondaries. So the IPO market really re-opened in 2004 and will continue to be open for a while in 2005. The backlog from 2003 was mainly in technology, health care and finance. At the end of 2004, the backlog was in telecom, chemicals, real estate and finance.

The world is fickle for being able to take on IPOs. At the end of 2000, and until 2002, more deals were withdrawn from the marketplace than actually got done. In 2004, the majority of deals got done, but got done outside the acceptable price ranged. So there was liquidity, but not up to expectations. On the other hand, IPOS did well in the secondary market in 2004.

But 2004 is over. What does Dunleavy think about 2005? He says there are some questions:

How far will the Fed go?
Is the world, particularly emerging market economies, prepared for a period of increasing interest rates-- or are new crises around the corner? Greenspan says that rising interest rates have been advertised for so long and in so many places, that everyone should be hedged against them or ready to lose money. However, at the end of every tightening, a financial calamity seems to occur for which somebody is unprepared, like the bankruptcy of Orange County or the tech wreck.

What happens when the Fed tightens? Well, EPS subsides within the next six months, so the expected growth of earnings per share in 2005 will be muted. When the yield curve flattens, EPS and GDP both slow down. The offset to that should be taking a look at balance sheets. Corporations are as liquid as they have been in 42 years. But household debt is the highest it�s been in 30 years; apparently, the consumer is almost entirely responsible for the trade deficit. It�s a wash.

So where will the action be in 2005? M&A is the most active sector of private equity. The way to grow becomes through acquisition rather than through capital spending. If you are awash in cash, but you�re still afraid to hire because you don�t know what the future will bring, you always decide to buy rather than build.

Will there still be a window for IPOs? Sort of. There will be access to the capital markets, but the question is what the valuations are. Are you looking for liquidity, or the top tick? If you are a spinoff from a sponsoring parent, you will do okay.

And where will the �smart money� go? Hedge funds are getting multimillion dollar commitments with multi-years lockups, even when they are new and their management has no real track record. This makes me wonder what the real definition is of smart money.