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Fund manager diversification will hit returns in the future, says report

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Forty per cent of fund managers worldwide have diversified into long-only funds and 30 per cent into alternatives over the last three years, causing convergence between investment strategi

Forty per cent of fund managers worldwide have diversified into long-only funds and 30 per cent into alternatives over the last three years, causing convergence between investment strategies used in different sectors of the industry, according to a new study by KPMG International and Create-Research.

The report, Convergence and Divergence: New Forces Shaping the Investment Universe, examines the nature, scope, scale and impact of convergence between investment strategies as clients switched from relative returns to absolute returns in the aftermath of the 2000-03 bear market.

Create is an independent think-tank that specialises in strategic change in the global fund management industry and offers advisory, research and forecasting services to top executives in the industry.

The authors argue that as hedge fund managers and private equity firms have fuelled competition by promising absolute returns that are not correlated to conditions in the financial markets, long-only managers have responded by offering products that mimic the returns offered by their new competitors.

‘As a result, hedge funds’ respective returns are converging, as are their back office infrastructure,’ says Amin Rajan, the study’s principal author and chief executive of Create. ‘The ensuing competition is driving out mediocrity, squeezing the margins and institutionalising the alternatives.’

However, such convergence is far from uniform, according to two groups who participated in the study’s three global surveys: 310 investment fund and pension fund managers with USD28trn in funds under management, and 48 administrators with USD38trn of funds under administration.

‘Within each sector, managers have fallen into one of three groups, which can be characterised as purists, who have stuck to their core capability; pragmatists, who have diversified; and procrastinators, who have considered change without action,’ says Anthony Cowell, the report’s co-author and a partner with KPMG in the Cayman Islands.

While pragmatists are doing new things by changing the boundaries of their sector, the purists appear to doing old things better. Thus, convergence and divergence are reshaping today’s investment universe, helping to generate all-round benefits. For investors, this process has delivered better returns and access to all-weather portfolios. For their fund managers, it has improved profitability and enhanced their ability to attract, retain and deploy top talent.

However, the report argues that the pace of convergence will slow down, especially in the long-only sector, as the current credit crunch prompts a flight to quality and simplicity. For alternatives to retain their dizzy growth of the recent past, they will have to deliver absolute uncorrelated returns and create a new generation of customised structured finance products with capital protection and full transparency.

‘Investors want to see a good housekeeping seal of approval via more standardised products, more stress testing, more transparent pricing of illiquid assets, more independent audits and more independent administration,’ says Jon Mills, another co-author and partner with KPMG in the UK.

The report argues that the role of third-party administrators is set to grow in middle office activities such as asset valuation, performance attribution, performance monitoring, risk and compliance. Their industry will continue to consolidate to accommodate large-scale investment in upgrading the old infrastructure of systems and skills. Further institutionalisation of alternatives is likely to enhance the role of large multi-service administrators, leaving the niche players to serve start-ups and independent boutiques.

The study concludes that the combination of convergence and the prospect of a bear market will help to accelerate the pace of industry-wide consolidation in pursuit of investment talent and market position. The pace will be set by large players among long-only managers, investment banks, hedge fund managers and private equity firms, seeking to strengthen their positions inside and outside their core areas of expertise.

The boundaries between asset classes will become increasingly blurred as clients continue to demand a complete separation between returns generated by market movements and those delivered by managers’ skills.

The study draws on global surveys, covering fund managers, pension funds and independent administrators in 28 national jurisdictions, followed up by structured interviews with senior executives in more than 100 organisations selected from the three groups of survey participants.

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