A new report from JPMorgan indicates that as hedge funds grow larger they could erode the market opportunities and mispricings they have relied on.
The new report, prepared by Jan Loeys and Laurent Fransolet, is entitled "Have hedge funds eroded market opportunities?". It confirms that hedge funds, with almost USD 1 trillion under management before leverage, have become a dominant force in market trading.
But it warns that opportunities to create superior returns are disappearing fastest where hedge funds are very active, where there are deep derivative markets, and where the same trading rules have been used for some time.
Opportunities remain ample where there are fewer hedge funds, where derivative markets are not deep yet, and where funds use new trading rules, proprietary information, or advanced analytics.
In interest-rate markets, a lot of basic relative value opportunities have been eroded. Funds have moved to newer products, and to the interaction between volatility and rates to reach the next level in relative value.
In credit, the basic mispricings in short-maturity, BB-rated credits and momentum trading remain largely in place. But a deepening of the CDS market and the growth of credit funds will eventually erode many of these opportunities.
In equities, well-published anomalies and relative value have been eroded significantly, although this is partly owing to low volatility.
Currencies continue to offer good opportunities for active investing. Hedge funds are very active here, but their impact is offset by the size and diversity of other players in the FX market. As a result, the age-old opportunities - the carry trade and momentum - are alive and well. Standard models are suffering, although novel trading rules are still offering high returns to risk.
The report stated: "This year has been a difficult one for all active investors. Both structural and cyclical factors are at play. In some markets, structural trends have reduced opportunities. On the cyclical side, this is largely because of the lack of momentum in views on the global business cycle."
The authors note: "We believe this will prove temporary, with new active trading opportunities emerging later this year or next."