The Future of the Fund Management Industry

- Hedge funds provide diversification and an alternative source of alpha

- Hedge funds will continue to play an increasingly important role in asset management as a growing number    of investors turn to them to provide an alternate source of alpha and diversification in a traditional portfolio.

Growing recognition that stocks, bonds and property investments are not without risk, and the increasing correlation between these traditional assets, have made both private and institutional investors aware of the need for diversification. Investors seeking medium to long-term returns in excess of the market, or alpha, will increasingly do so through non-traditional investment products such as hedge funds.

Source of alpha

The attraction of hedge funds as a growth asset is due to the wide array of investment tools at their disposal.

A common analogy is that mutual funds are like golf players who turn out with a nine iron, while hedge fund

managers take to the links equipped with a complete set of the most technologically advanced clubs.

The key is that these specialised strategies provide investment alpha and a low correlation with traditional

investments. They are thus a fourth asset class to diversify a traditional portfolio of stocks, property and bonds.

The solid historic performance is shown by the CSFB Hedge Fund Index which returned an annualised 10.9% with a volatility of 7.9% from inception in 1993 to 28 February 2006. By comparison, the MSCI World Stocks Index returned 8.7% with a volatility of 13.8% and the Citigroup Global Government Bond Index returned 5.9% with a volatility of 6.5% during the same period.

In the longterm this performance differential and the low correlation with equities and bonds is why investors

turn to hedge funds and other alternative investments in their search for alpha and to provide diversification in long-only portfolios. This implies that mutual funds will increasingly become passively managed sources of market beta, while hedge funds provide the spice and diversity within portfolios by continuing to target alpha.

Future of hedge funds

While this shift seems inevitable, it is likely that it will coincide with broad changes in the hedge fund industry
as a whole. Figures from Hedge Fund Research and other sources show that there are over 8,600 hedge funds and funds of hedge funds managing in excess of USD 1.1 trillion. Of that number, about 8% of funds have been operating for less than a year and only 35% have a track record of more than five years. About two thirds of funds are registered offshore and despite recent regulatory changes there is little to suggest that this is changing. Industry assets have grown at about 25% a year from about USD 38 billion in 1990, though that growth rate has slowed to about 18% since 2000. Hedge funds provide diversification and an alternative source of alpha Hedge funds will continue to play an increasingly important role in asset management as a growing number of investors turn to them to provide an alternate source of alpha and diversification in a traditional portfolio.

Strong performance of equities led to slower hedge fund growth in 2005. This growth was clearly segregated

between hedge funds that could deliver consistent alpha and true diversification and those that could not.

Fragmented industry

One consequence of hedge funds’ rapid growth is that the industry remains relatively fragmented though there are signs of consolidation. The top 50 managers currently account for about 40% of industry assets, up from 35% in 2003, while the next 50 managers have seen their share of assets grow from 14% to 17%. The other 8,500 managers have fallen from 51% of assets to about 43%. North America remains the biggest market for hedge funds, managing approximately 72% of assets. As a result, further consolidation seems likely and, if the US is anything to go by, there is still plenty of room for future industry growth. The industry’s strong growth has also attracted attention from regulators who are insisting on greater transparency to protect smaller investors. That demand is being echoed by institutional investors who now account for approximately half of all new hedge fund assets.Institutional investors are also creating demand for lower volatility products, which are also more suitable for risk-averse smaller investors, while high net worth private clients continue to target high performance.

Split

This shift in the industry’s demand dynamics is creating pressure for a broad bifurcation of hedge fund distribution. On the one hand, smaller offshore operations will offer high returns in tax efficient structures that are distributed to wealthy private investors through family offices and private banks. On the other, large distribution groups will offer lower risk hedge fund investments such as highly diversified fund-of-hedge fund portfolios directly to private clients and structure similar products for institutions.

Those larger firms will ultimately differentiate themselves on their service offering, their ability to structure reliable products attuned to clients’ needs and their ability to source uncorrelated capacity in alpha producing strategies. These requirements imply significant economies of scale which will drive consolidation among the larger, on-shore facing managers, and specialisation among smaller off-shore funds.