2003 and 2004 saw huge inflows of money into hedge funds, particularly from institutional investors in search of alpha. We believe successful investment in hedge funds is about accessing highly skilled managers. Average managers do not produce acceptable returns after allowing for fees, and this is particularly true in the hedge fund industry.

But skill is not available on demand. The more money that flows into hedge funds, the more crowded will be the trades and strategies that many hedge funds rely on for their superior returns. It follows that returns in some strategies are likely to suffer.

Last year's disappointing hedge fund performance might be an indication that this trend is already in evidence, although low volatility anda dearth of the major market dislocations that hedge funds thrive on also contributed to the lower returns in 2004.

Over the last six months, we have been assessing how the growth of the hedge fund market is likely to affect future returns. We have looked at the issues from four perspectives:

• Market opportunity. Do attractive opportunities still exist for hedge funds, and can trades be implemented in sufficient size?
• Manager opportunity. Are there still hedge funds which we believe offer attractive risk/return characteristics and is there enough spare capacity with these managers?
• Fund of hedge fund (FoHF) manager opportunity. This is the route through which most institutions have invested in hedge funds, and the assets of FoHF managers have also grown considerably. Given this, can FoHF managers still access high quality investment managers?
• Return/risk requirements. Given their risk parameters, what returns do investors actually need to consider hedge fund investing successful?

Market opportunity

We believe that more participants trying to make money in the same market in a similar style will eventually limit return potential. The ideal environment for hedge funds is one that has lots of market participants creating trading opportunities, but who are not trying to make money 'their' way ( e.g. hedge funds exploiting constrained long-only managers), or who are not trying to make money at all (e.g. in currency markets).

In trying to assess how crowded certain strategies are becoming, we looked at the level of involvement by hedge funds in the different equity and bond markets, and also the level of trading in these markets by hedge funds. We also made allowance for the leverage employed by hedge funds.

We concluded that in our view opportunities do still exist in most areas – in particular equity strategies and macro trading.

In equities, our estimate is that hedge fund activity represents approximately 1.5% of total market capitalisation. Hedge funds' higher turnover means that they may represent 10-30% of all equity trading, but this by no means makes them dominant in the market as a whole, although at the margin they may dominate trading in particular securities on occasions. Hedge funds also follow many different strategies in the equity markets, which means that a particular niche is less likely to be crowded.

Hedge funds have a smaller presence in the fixed income markets than in the equity markets. Our concern here though is that managers tend to focus on similar trades, arbitraging away opportunities very quickly.

Macro traders exploit many different markets, including derivatives, so their territory is vast. Sometimes, though less so than fixed income hedge funds, macro traders focus on the same trade (e.g. short the dollar and long the yen). Conversely, we see fewer opportunities in strategies such as convertible bonds and distressed debt. Hedge funds now dominate the convertibles market (70-90%), so a manager needs to be highly skilled to squeeze returns ahead of fees out of this category.

Although certain strategies do appear to be suffering from overcrowding, in general hedge funds are not so dominant in the market that they have become victims of their own success.

Skilled hedge fund managers should still be able to find plenty of opportunities to exploit.

Manager opportunity

The next question is whether it is possible to access skilled managers. In other words will there be enough supply to satisfy the growing demand?

We estimate that some 5-10% of current hedge fund managers are highly skilled (able to add significant value after fees). This means that 300-600 highly skilled managers exist, out of the 6000 or so that are currently operating. Assuming that each of these can manage $1billion on average, and that three-quarters of this capacity is alreadyspoken for, then $75-150 billion of spare capacity remains with these managers.

However, in 2004, the hedge fund industry grew by around $200-$250 billion. It is possible to conclude that investing with highly skilled managers will become increasingly difficult at the current rate of demand given the limited capacity.

Investors are already responding by seeking out the best new managers. New fund launches are running at the rate of 500 to 1000 a year. Assume, again, that around 5% of these managers are highly skilled, and that each can ultimately manage $billion. That adds up to around an extra $50 billion of capacity, which is a relatively small amount.

It follows that a lot of investors in hedge funds are going to be disappointed. But equally, we would argue that the ratio of new money to talent is not so extreme that a skilled investor cannot still be successful. It will just become a lot harder going forward, and means that the hedge fund landscape needs to be monitored on an ongoing basis by both existing and potential investors.

Funds of hedge funds opportunity

Funds of hedge funds (FoHF) are the preferred route into hedge funds for most institutional investors. Because of the growing constraints on capacity, the question is whether FoHF managers can access hedge fund talent in a meaningful way. In other words, will FoHF managers find enough capacity with highly skilled managers to meet demand, and will they be able to maintain expected returns?

To help in our analysis, we complemented our ongoing manager research by polling 18 FoHF managers to find out how they view asset growth and capacity management.

Recent flows into FoHF managers have been phenomenal. In the first six months of 2004, our top-rated FoHFs grew by $15 billion, or 33%. At the same time, the 'spread' between the best and worst managers in our FoHF universe narrowed, and absolute returns fell. Short-term market conditions may be the cause, but this does raise concerns.

We estimate that our top-rated FoHF managers account for roughly 8% of the market. Taking only our estimate of the assets of highly skilled hedge fund managers ($225-$450 billion), these FoHF managers would account for about 15-30% of the top talent. This does not seem to suggest an unrealistically high level of 'ownership' of the most skilled hedge funds by these managers.

However, if this percentage were much higher, it would stretch our belief that our favoured FoHF managers really do invest only with the best managers.

There are no strong signs at present that suggest that standards have dropped. However, we do have questions about how much growth can be sustained going forward without manager quality declining.

It is clear that if growth continues there will not be a lot of spare capacity available for FoHF managers from existing hedge fund managers. Most of the capacity for FoHFs will therefore come from new managers. Assuming that they secure one third of the new capacity becoming available from highly talented new managers every year, this would amount to only $17 billion (based on our earlier estimate of $50 billion of new capacity a year). There is a limit, therefore, on the amount at which FoHFs can grow if they are to maintain quality levels. Given that there will need to be turnover of existing managers, we estimate that growth beyond $2 billion pa for each of the best FoHFs will be difficult to sustain.

Required returns

On the assumption that our analysis is correct, the question then becomes "When do hedge funds stop being attractive from a portfolio perspective?" In other words, how much return do pension funds actually need from hedge funds to improve their risk/return profile?

In order to answer this question, we have made some prudent assumptions for the volatility of FoHF returns, and their correlation with mainstream equity markets. For a given allocation to hedge funds, funded from equities, we havethen calculated the required return over Libor needed from hedge funds to improve the pension fund's portfolio efficiency. We have measured efficiency by calculating the information ratio assessed relative to liabilities.

According to our analysis, an average pension fund that starts with a 50%/50% equity/bond split, and then makes a 5% allocation to hedge funds from equities, would require a return ahead of cash of 2.5-3% per annum to improve efficiency in the portfolio. Although we expect that returns from hedge funds may decline, we believe that there is still room for them to come down from historic levels before the case for investing in hedge funds is no longer supportable.

In conclusion

In conclusion we would make the following points:
 

• Most of the strategies that hedge funds invest in are not overly capacity constrained, with the exception of some relative value strategies. However, growth in the hedge fund market has outweighed – by about 4:1- our estimate of the amount of highly skilled capacity that will become available in the average year. This means that a lot of investors will be disappointed, but skilled allocators to hedge funds should still be able to access talented managers.
• There is room for returns to fall from historic levels before hedge fund investing becomes unattractive from a portfolio perspective.
• We believe that there is still a case for investing in high quality, core multi-strategy FoHFs although the case is not as strong as it was. FoHF managers will have to be extremely disciplined at managing their future growth to maintain their quality standards.
• We believe pension funds that are looking to invest directly in hedge funds should focus on less capacity-constrained strategies such as long/short equity. These may be more volatile, but we believe that pension funds are able to take a little more volatility in their hedge fund allocations.

A final word about hedge funds – we believe that highly skilled hedge fund managers are here to stay. The concern for pension funds is how to successfully access this pool of talent.