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Comment: An apocalyptic turn for hedge funds?

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Shoham Cohen, co-founder of Singapore-based hedge fund service provider ESC Financial Services, argues that recent criticism of the industry fails to recognise the limitless potential of n

Shoham Cohen, co-founder of Singapore-based hedge fund service provider ESC Financial Services, argues that recent criticism of the industry fails to recognise the limitless potential of new managers and emerging strategies.

The times are challenging for the hedge fund industry. Aside from being consistently attacked in the media by critics, the industry now suffers from industry leaders prophesying an end to the industry. But I would argue, conversely, that the potential for the hedge fund industry is infinite.

In January, George Soros said that hedge funds have become too popular. Steve Cohen, founder of SAC Capital Management, maintains that the days of big returns on hedge funds are already over. Warren Buffett, in his annual letter to shareholders released at the end of February, criticised hedge funds for their high fees.

But while it cannot be denied that the industry has not delivered the expected performance over the past few years, it remains far from taking an apocalyptic turn toward extinction. Hedge funds are a very imperative diversification component in any investment portfolio, and that will remain true for years to come.

As with any other investment field, there are good and bad hedge fund managers. But within this industry there are also emerging managers, emerging strategies and new regulations, all of which point to a sustainable future for the industry.

Current facts support this positive outlook. The hedge fund industry attracted USD60bn from global investors in the first quarter of 2007 alone, according to Hedge Fund Research, taking its total assets to around USD1.6trn, compared with some USD22bn for the global mutual fund industry.

Fifteen years ago, the industry consisted of about 500 managers and some USD40bn in assets; today there are more than 10,000 hedge funds. Not all managers are capable of managing a hedge fund vehicle, and these have resulted in fund failures. But from a historical, technical, and practical perspective, the industry still has a plenty of room to grow and to perform.

Nevertheless, these are indeed challenging times for many hedge funds managers and strategies.

Compared with 10 years ago, many strategies are currently struggling to perform as too many managers chase the same exotic and limited markets. Many hedge fund strategies that had only a few managers that controlled assets flowing in them a few years ago are now supersized and chased after by too many players. Bigger managers are challenged in their diversification, risk, and execution management as capacity becomes an issue.

However, some of the declarations by industry gurus fail to take into account the bigger picture. As a fairly young industry with a moderate global market share, the hedge fund sector has a bright future ahead. While some core strategies may become outdated, new ones are emerging, allowing more room for new players.

Since hedge funds are designed to take advantage of any possible market and opportunity, managers have to show creativity and capability to structure interesting and exotic vehicles. Thankfully, they have historically proven themselves to be both creative and capable. Wherever money and wealth can be created, investors are likely to find hedge fund managers becoming involved. A new and innovative generation is already creating new hedge fund vehicles and strategies.

Earlier this year, Paramount Vantage and Morgan Stanley announced the creation of Marathon Funding, a USD150m film fund that will invest in film production. At the end of 2006, two UK managers created a fund that buys stakes in the contracts of sportsmen, taking a slice of the transfer fees that clubs pay to trade players.

Further strategies will emerge in the future such as music recording funds, talented student hunting funds, space travel financing funds, book writers financing funds, warehouse financing funds, lawsuit financing funds, and art and antique funds.

I predict that in the future the industry will offer personal hedge fund pools, enabling private investors to manage their own hedge fund instruments, and there will be room for tailored managed funds. I challenge more managers to hurdle the psychological barrier of setting up a fund and developing new strategies.

It is not at all the end of the hedge fund industry. Messrs. Soros, Cohen and Buffett may be somewhat downbeat, and their comments may result in a tougher regulatory environment for hedge fund managers, perhaps leading to a decrease in the number of managers.

However, the industry will continue to grow, evolve and attract new managers, strategies, and investors. It is inevitable that some hedge fund strategies will become overexposed along the way, but this will simply lead to the maturing of those strategies and the emergence of new ones. The industry’s future is one of limitless potential.

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