Comment: Quality pays

Consolidation in the hedge fund industry is inevitable but will ultimately generate new investment opportunities, says Jason Webster of Sagitta Asset Management.


Mr Greenspan's recent comments about hedge fund entrepreneurs embracing a strategy of pinpointing temporary market inefficiencies, and picking 'most of the low-hanging fruit of readily available profits' comes at a time when many commentators are sounding the death knell for hedge funds.


It doesn't require too great a stretch of the imagination to draw parallels between the rapid growth of the hedge fund sector and the technology boom of the late 1990s. Both have attracted large amounts of capital. Both have attracted highly talented individuals from more conservative institutions. And, of course, both offer the potential for exceptional returns through performance fees and equity participation in the underlying business.


That the hedge fund sector will undergo a shakeout is largely a foregone conclusion. Any industry that grows from a few hundred participants to almost 10,000 in the space of a few years will undoubtedly undergo some form of consolidation, and to an extent, this consolidation is already underway.


However, the value of this asset class as an investment tool cannot be discounted as it can provide both capital protection and access to sectors of the investment market that may not otherwise be available. What consolidation ultimately means is that an increased focus on qualitative assessment will be the key to identifying a manager that will weather both the vagaries of the market in which they invest and those of the sector in which they operate.


Look at any article covering hedge funds and it will tell you of the 'huge' and 'astronomical' growth of the sector; and it would be right. Funds under management have grown at a brisk pace as investors of all castes flock to join the ranks of hedge fund elite.


However, the longer-term consequence of these fund inflows is that the underlying markets in which the hedge funds invest will inevitably become more efficient. But isn't that good? In a word: no. The more efficient the market, the less opportunity there is to profit from asset mis-pricing which removes one of the fundamental sources of investment return.


The flipside of this situation is that, as the sector moves through this natural consolidation phase, the number of players in the sector is reduced - lowering competition - and the retreat of capital from the underlying asset classes may mean that the particular sector subsequently offers some excellent prospects. So, rather than sounding the death knell for these strategies, what these recent developments really highlight is the need for increased selectivity of hedge fund managers and a requirement for an intimate knowledge of potential managers from both a strategic and operational point of view. Find a wealth manager who incorporates this kind of analysis as a core component of their investment strategy and you have significantly increased your chances of investment success.


So while the door may be temporarily closing on certain hedge fund strategies, it is opening to others. By identifying managers that deal in niche markets or those that employ a unique investment strategy diligent wealth managers can create a portfolio that offers strong and sustainable return potential.


Critical to success in this area will be firstly selecting the right asset class (which can be addressed through effective asset allocation strategies) and secondly selecting the manager or fund who not only has an outstanding knowledge of their chosen sector, but also an effective strategy for capitalising on available opportunities. This increasingly shifts the bias of due diligence in favour of qualitative analysis as the analyst will need to assess a vast amount of non-quantitative data relating to a particular manager's knowledge, strategy and operations.


No one can doubt that the last few months have been challenging for many hedge funds. Although returns have since improved, when investors look back on this period later in year, it is highly likely that effective qualitative analysis will have played a significant role in separating the period's winners and losers.


Backgtound notes: Sagitta was formed in 1995 as an independent asset management business to provide wealth management services to high net worth investors and their advisers. Sagitta's focus is on asset allocation, fund selection and portfolio construction with a Managed Portfolio Service being at the heart of our business. Sagitta has USD 1.4 billion under management or advice on behalf of more than 100 clients.


 

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