Phillip Coggan, Investment Editor of the Financial times, asks ‘Can the hedge fund industry keep growing at its current pace?’

Phillip Coggan
Originally published in the issue

Can the hedge fund industry keep growing at its present pace? Figures from TASS Research and Van Hedge show that assets under management have reached $800bn while the number of hedge funds has grown from fewer than 1,000 in 1991 to around 7,000 today.

Inflows hit a remarkable $38bn in the first quarter of this year, compared with $16bn in the whole of 2002. Some have estimated that the industry’s assets could reach $3-4 trillion by 2010.

But one must always be cautious about numbers derived from extrapolating current trends. Returns have been disappointing this year. That may or may not be a function of excess capital eliminating profitable trading opportunities. But it certainly could discourage similar flows of capital next year.

Hedge fund inflows comes from two areas; high net worth individuals and institutions. The outlook for both has shifted in recent years.

The appeal to private investors has changed, if only in the popular imagination. In the 1990s, many people dreamed that the great macro managers such as George Soros and Julian Robertson would make them rich. Of course, this was always a fantasy; one already needed to be wealthy to invest with them.

But the appeal these days is much more sober. Hedge funds are designed to keep you rich. Far better a steady single digit return that the 20 per cent plus losses recently seen in equity markets. Man’s great success in marketing protected funds is a case in point.

There is an obvious long-term danger with such funds: a great proportion of the capital is devoted to the guarantee. The higher the return on offer, accordingly, the greater the leverage that needs to be used. That creates the risk that if initial performance is poor, the guarantor may call on the fund to cut its positions. The result, as has already happened with some protected funds, can be the creation of “dead money”; a fund limping to the redemption date, returning the investor’s capital in nominal terms only, a substantial real loss.

Thanks to the structure of such funds, however, it may be some years before widespread problems become apparent, if they ever do. In the short term, the marketing appeal of hedge funds seems likely to remain.

That appeal owes a little to “snob value”. Just as the fashion-conscious want to wear the clothes of the best designers, the wealthy want to feel that their money is being managed by the smartest brains on the planet. The good news is that, short of some absolute disaster in the sector, hedge funds are unlikely to lose that snob value. The stars of Soros, Robertson and Steinhardt may have faded but there are always new kids around on the block. And the ranks of the wealthly seem likely to expand. A report by Merrill Lynch Cap Gemini forecasts that the assets of high net worth individuals would rise from $25trn in 2000 to almost $40trn by 2006. Even if hedge funds grab only a fifteenth of that growth, the industry would double in size.

It seems likely that hedge funds WILL get a decent chunk of that money. For a start, returns from other asset classes look likely to be disappointing. Cash rates are around 2 per cent in the US and euro-zone, and bond yields in the 4-5 per cent range. Equities may rally but US valuations look full by historical standards and many private investors will still be feeling bruised by the bear market of 2000-03.

Secondly, there seems to be greater acceptance of the attractions of pension funds among private bankers and wealth managers. It helps, of course, that sometimes such wealth managers work at investment banks, which have lucrative relationships with the hedge fund industry. Cynicism apart, such managers have recognized that diversification is the best way of protecting investors’ capital and hedge funds may be appropriate in that context.

In short, there is still lots of scope for marketing to well-off retail investors. But risk control and a history of steady returns may these days be a better marketing tool than a record of 20 per cent plus annual growth.

What about the institutional sector? At first sight, it might seem as if hedge funds have a great advantage in marketing to pension funds. After all, the pensions sector has been let down by equity markets in recent years. Asset values haveplunged while liabilities have risen sharply. The absolute return focus of hedge funds ought to be welcome.

One obvious problem is the innate conservatism of pension fund trustees. This conservatism on the part of people who are usually unpaid, but legally liable, is quite understandable.

Let us look at the upside for the trustees. Say they go out on a limb (by current industry standards) and put 10 per cent of their portfolio into a hedge fund of funds. And say that fund delivers outperformance, after fees, of 2 percentage points per annum. Pretty good stuff, you might think. But with a 10 per cent allocation, that would deliver an additional return for the overall portfolio of 0.2 per cent per annum. Not enough to make much of a dent in a big deficit.

But think about the downside. If the hedge fund underperforms, or worse still, suffers a blow-up, pension fund members and the corporate sponsor will want to know what fool authorised putting money into such a risky venture. it is not a good risk-reward trade-off.

As cover, trustees will want a very strong recommendation from a consultant actuary before recommending such a move. So far, actuaries are fairly cautious. It does not help, of course, that hedge fund fees are well above those normally charged in the institutional market.

Furthermore, the intellectual trend in the actuarial industry is towards liability matching. This tends to favour bonds (conventional and index-linked) or a swap-based strategy to match the cashflows needed to pay beneficiaries in future years. While hedge funds have the advantage of offering absolute returns, they do not offer the kind of predictable cashflows that fit into such a framework.

Where hedge funds may gain, however, is from a different trend – towards the greater diversification of pension funds across asset classes, as investors search for “alternative beta”. Here hedge funds may be seen as an option alongside private equity, real estate and commodities. However, that will depend on actuaries deciding that hedge funds are indeed an alternative asset class or simply a different method of generating returns from the traditional asset classes.

The best hope in this area may come from the “niche” strategies of merger arbitrage, distressed debt, convertible arbitrage and so on. Pension funds do not normally have exposure to these areas in their portfolios.

The irony is, of course, that those sectors do not have anything like the capacity needed to absorb even a modest proportion of the assets in the pension fund industry. But the areas where there is more capacity long/short equity, market neutral may be sectors where pension funds feel they already have plenty of exposure.

Hedge funds will of course argue that their superior stock-picking skills and their ability to go short means that they are managing money in a much more efficient way. But they will be competing against traditional fund management houses that are desperate to defend their turf. Many are now offering “unconstrained benchmark” portfolios designed to make the most of their stock-picking skills by focusing on a narrow range of stocks. If pension funds are going to gamble on a new approach, unconstrained benchmarks, rather than hedge funds, may be their first port of call.

The last thought might be a rather controversial one; do hedge funds really want to attract trillions more of assets and a wide range of new investors? A number of the more successful hedge funds have closed to new money. Their managers recognise that there is an optimal size for the fund, one that delivers a good living for those in charge but still gives them the flexibility to deliver excess returns. Some blame the demise of the Tiger fund on its unwieldy size. If this is true at the individual fund level, might it not be true for the industry as a whole? By and large, hedge funds fly under the radar of the mainstream media, save for the two celebrated occasions of George Soros breaking the pound and the collapse of Long-Term Capital Management. Hedge fund managers seem to relish the low profile. But the larger the industry gets, the more the media will be interested. And if Aunt Agatha loses her savings, or a train driver sees a cut in his pension, because of hedge fund failure or fraud, that interest is likely to be intrusive.

Once the media get involved, the regulators are likely to get involved. And that will mean restrictions on the way hedge fund can operate. The current system suits many hedge fund managers. Will change necessarily be for the better?

Phillip Coggan is Investment Editor of the Financial Times