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Impact of Hedge Fund Sector Diminishing—Study

Paul Das 22 July 2005

Impact of Hedge Fund Sector Diminishing—Study

As a way of achieving out-performance, the recent unprecedented surge in the demand for hedge funds will ease as the industry commoditises, ...

As a way of achieving out-performance, the recent unprecedented surge in the demand for hedge funds will ease as the industry commoditises, according to a new study published by CREATE, the UK think tank, and KPMG International.

The study, entitled “Hedge Funds: A Catalyst Reshaping Global Investment”, shows that the worldwide growth in hedge funds has been fuelled by the prolonged bear market and the inflow of top talent capable of generating high returns. Their impact has been petering out at the time when the number of start-ups has increased considerably.

The CREATE-KPMG report finds that the quality of the resulting capacity is highly variable. Most of it is, as yet, incapable of generating the high double digit returns that investors are led to expect. At the front end, the biggest risk is poor returns; at the administration end, it is mis-pricing of complex products.

“About 15 per cent of hedge fund managers are stars with a proven track record; but they are unwilling to grow their business substantially for fear of diluting the returns,” said Professor Amin Rajan, the report’s principal author and chief executive of CREATE.

He added: “A further 55 per cent are wannabes with the right pedigree; but they are neither tested nor stretched. The rest are the victims of the brutal burn and churn that characterise their industry.”

The study predicts that the next wave of new money into hedge funds will come from pension funds that have so far adopted a wait and see attitude. Those in the US are likely to have bigger allocations than their peers in Europe and Asia Pacific because of their superior in-house expertise and oversight controls.

Worldwide, allocations will be small: less than 3 per cent of total investments on average. But the sheer weight of new money should commoditise hedge funds and drive down high charges and fees.

Indeed, the study found that hedge fund managers and mainstream fund managers are already diversifying into one another’s product areas, using similar investment strategies and boutique structures that overtly separate high and low return products. Hedge funds are, thus, no longer the only means of achieving high absolute returns in today’s low volatility environment.

“Gaining huge prominence in the bear market, hedge funds will outlast it; as will their top managers. As a catalyst, they have started a chain reaction that extends across the global fund management industry. They have forced mainstream fund managers to go back to their time honoured mission to provide absolute returns.” said Tom Brown, co-author of the report and partner at KPMG in the UK.

The study predicts that the hedge funds industry will consolidate over the next three years because of a wide margin of under-utilised capacity, at the manufacturing, distribution and administration end.

For hedge fund managers, consolidation is likely to occur mainly via high attrition since they run lifestyle businesses which are hard to value. For managers of fund of hedge funds, in contrast, it should occur via mergers and acquisitions; and for administrators via acquisitions by global banks diversifying into prime broking and back office services.

The study concludes that the contours of the fund management industry will change by 2010. If hedge funds are to retain their current uniqueness in it, their managers will constantly have to invent new ways of generating high returns. Those who do not, may either pale into the emerging mosaic or become victims of the creative destruction which they sparked off in the first place.

The study presents the views of 550 top executives in 35 countries involved in hedge funds, their administration, prime broking, mainstream fund management and pension funds; with combined assets worth $23 trillion.

The full report is available at: www.kpmg.co.uk

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