A new report from Watson Wyatt asks whether the hedge fund industry can maintain quality while continuing its current pace of rapid growth.
The past two years have seen huge inflows of money into hedge funds, particularly from institutional investors in search of alpha. 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 and a 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 that 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 return do investors actually need to consider hedge fund investing successful?
It is our belief 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 (for instance, hedge funds exploiting constrained long-only managers), or who are not trying to make money at all (as can be observed in the currency markets, for example).
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. Hedge funds usually apply far more leverage to strategies that give lower incremental returns, such as fixed income arbitrage. The 'true' value of assets invested may therefore be understated.
Market opportunity - concentration:
Hedge fund assets by strategy <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />
% No leverage % Inc leverage
Long/Short 34 19
Market neutral 7 4
Short 0 0
EM 5 3
Event 15 17
FI Arb 7 15
Convert 11 12
Macro 7 15
CTA 7 11
Other 8 4
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 per cent of total market capitalisation. Hedge funds' higher turnover means that they may represent 10-30 per cent 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 mean 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, they focus on the same trade (a recent example was short the dollar and long yen).
Conversely, we see fewer opportunities in strategies such as convertible bonds and distressed debt. Hedge funds now dominate the convertibles market (70-90 per cent), so a manager needs to be highly skilled to squeeze returns ahead of fees out of this category.
Another way to spot diminishing opportunities is to see if absolute returns are tailing off, and if there is a narrowing 'spread' between the returns of the best and worst performing managers.
According to our analysis, this is not happening across the board. Only 'relative value' strategies stand out as losing their potential. Fixed income, statistical, convertible and merger arbitrage have all experienced lower returns or a decreasing manager 'spread', or both.
So 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.
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 per cent of current hedge fund managers are highly skilled (by which we mean 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 USD 1 billion on average, and that three-quarters of this capacity is already spoken for, then USD 75-150 billion of spare capacity remains with these managers.
However, in 2004, the hedge fund industry grew by around USD 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 per cent of these managers are highly skilled, and that each can ultimately manage USD 1 billion. That adds up to around an extra USD 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.
These numbers are intended to be only a rough guide to capacity. Looking ahead, a number of intangibles could change the balance. Asset flows or new fund launches might increase, or decrease. Fees might come down on the back of lower returns, changing the dynamics of the industry. New market opportunities might develop for hedge funds (credit default swaps are a recent example), resulting in unexpected new capacity. A clear benefit of hedge funds is their ability to access new opportunities more quickly than traditional managers. All of this 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 USD 15 billion, or 33per cent. 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 per cent of the market. Taking only our estimate of the assets of highly skilled hedge fund managers (USD 225-450 billion), these FoHF managers would account for about 15-30 per cent of the top talent. This does not seem to suggest an unrealistically high level of 'ownership' of the most skilled hedge funds by our top-rated FoHF 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 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 coming available from highly talented new managers every year, this would amount to only USD 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 USD 2 billion pa for each of the best FoHFs will be difficult to sustain.
In addition, we believe that FoHFs will run into portfolio management issues as they grow, similar to those that affected the traditional balanced managers. As portfolios grow, and the number of underlying managers increases, it is easy to lose conviction in decision-making. Also, the large FoHFs may not be able to make meaningful allocations to smaller hedge funds.
Putting these factors together, we believe that growth management will be a major issue for FoHFs going forward, and it may be fair to expect returns to decline. Looking ahead we believe that a return of Libor plus 4-5 per cent pa (net of fees) is a reasonable expectation for a highly skilled FoHF manager that manages growth well. This compares with historic returns from our top rated FoHFs in the region of Libor plus 6 per cent pa.
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 have then 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, which is the expected return per unit of expected risk of the portfolio, assessed relative to liabilities.
According to our analysis, an average pension fund that starts with a 50/50 per cent equity/bond split, and then makes a 5 per cent allocation to hedge funds from equities, would require a return ahead of cash of 2.5-3 per cent pa to improve efficiency in the portfolio.
So 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.
Most of the strategies that hedge funds invest in are not overly capacity constrained. The exceptions are some relative value strategies.
Current growth in the hedge fund market outweighs - 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. Looking ahead, multi-strategy FoHF will have problems growing at current rates without quality declining.
The return required for hedge funds to add value to pension portfolios is around Libor +2.5-3 per cent pa. There is room for returns to fall from historic levels before hedge fund investing becomes unattractive.
Overall, 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 most clients are able to take a little more volatility in their hedge fund allocations. For our part, we are expanding our research into long/short equity funds, and into the growing numbers of niche or specialist FoHF managers and products.
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.