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Hedge fund growth not all good news, analysts warn

A staff reporter

30 January 2005

Hedge funds continue to bask in the glow of popularity but some commentators are warning that returns have been less than glamorous so far this year and starry predictions of the industry's growth could be vastly overrated. Private banks continue to roll out hedge funds and funds of hedge funds for their clients who are only too keen to lap up the alternative investment products. But some analysts are warning that the rapid growth of the industry could be a mixed blessing and signs of capacity constraints are already emerging in some areas. Andrew Popper, head of alternative investments at SG Hambros, said hedge funds comprised the bulk of sales the bank was making to its private clients as investors were attracted by their benefits. "The market is still growing further, there's a lot of interest there, a lot of new funds being launched, a lot of inflow from private clients going into hedge funds," Popper told Private Client Management. "People are regarding the alternative investments or the hedge funds as building blocks that are necessary in developing a well-diversified portfolio." There is around $450bn in assets invested in hedge funds globally, more than 20 per cent of that in funds of funds. Private investors by far outstrip institutions when it comes to investing in the products, accounting for around 75 per cent of all assets. Investment remains strongest in the US, with Europe and Japan still catching on to the investment form. Double edged growth sword A recent report by the Barra Strategic Consulting Group estimates that the market for funds of hedge funds, already estimated at $100bn in assets, could see an annual growth rate of 20 per cent over the next two to three years and even higher in Europe alone. The report said that as alternative investments became more mainstream, investors were adopting more core and satellite allocation techniques and hedge funds were well suited that that type of investing. It added that as the market became more sophisticated, investors would appreciate the specialised skills offered by fund of funds, including due diligence, portfolio construction and risk management. "Considering each of these factors, it is reasonable to believe that the FOHF market can generate annual growth rates of 20 per cent for the next two to three years, barring any market or hedge fund catastrophe. Clearly, this rate may be higher in Europe or Japan where the current base of assets under management is low," the report said. However, it also warns against over-optimistic growth expectations for the industry. It questioned some of the figures which have been bandied about recently, such as forecasts of a $1.5tn industry within five years. Such a flood of money would suppress returns as inefficiencies became more fully exploited, the report said. Popper agreed that rapid industry growth was not all positive news for investors. "That needless to say raises challenges for the industry because in some areas at least of hedge fund strategies we are beginning to reach capacity constraints and that's probably one of the reasons that we are seeing some decline in the quality of the result," he said. Popper said there was a risk that some strategies would reach capacity. "If there are too many people trying to arbitrage there are inefficiencies. We may continue to see pressures in the results. There is definitely a risk in that respect at least for some of the strategies." Lower returns in 2001 Another report, this time by Allenbridge Performance Analysts, cautions that more funds performed better in 1999 and 2000 than so far in 2001. Jacob Schmidt, director of hedge fund research at Allenbridge, said median performance in 2001 so far was at a five-year low for both single manager and multi manager funds. The report also fund that the two categories of funds were more alike in terms of returns than previously thought. "A critical analysis of the last five years' returns shows that hedge funds do not always deliver what they promise," said Schmidt. "While the industry experiences an exponential growth in new funds and assets under management, returns have declined over the last years." Analysts say there are a number of reasons for the correlation of returns with the recent slide pointing to tighter risk management and less or no leverage. Regarding multi manager funds, limits on asset allocation mean that when the industry has a difficult year and returns are highly concentrated among single managers, fund of funds will also struggle. The report is, however, positive overall about the industry's future. "For the investor, the question remains whether the party is over and returns will slowly disappear as the marketplace gets too crowded and arbitrage opportunities disappear," it said. "We do not believe that this is the case." Inconsistent reporting Another industry problem was the rapid entry and sometimes even quicker exit of market players. Dr Narayan Naik, head of the newly established European Centre for Hedge Fund Research and Education, said gauging industry success was difficult because of movement in and out. A lack of rules about performance reporting means that fund managers can start reporting while performance is good then simply stop when it begins to decline. "There are limited controls on hedge funds. When they go belly up they just stop reporting," said Naik. Naik also said investors were duped into believing some hedge funds were risk free when they were in fact not. "Some of our work shows that the so-called market neutral and non-directional funds contain a lot of risks. They often have systematic risks in the same way traditional mutual funds have. If that is the case, then the risk-free rate of interest they use as a benchmark to claim their incentive fee is not the correct benchmark so they may be getting overcompensated. If the investor doesn't know, he may end up paying too much," he said.