Ryan's Blog

Wednesday, October 12, 2005

Rafik Patel, of FSP Search, in conversation with James Cullen about the growth in the hedge fund industry.

Q1: As an introduction, can you give us a broad brush description of the hedge fund universe?

The hedge fund industry consists of around 6,000 funds globally, and manages around $900 billion in assets. Many hedge funds are relatively young (less than five years old) and relatively small (less than $25 million under management), which emphasises the fact that hedge funds have only recently become popular with more mainstream investors.

Q2: We understand that the hedge fund market is no longer the special province of US-based operators, and that other areas – notably Asia and Europe – have seen amazing growth in terms of asset size and startups over the last five years. How has this happened?

This is primarily a matter of supply and demand. With strong investor demand and no signs of fees coming down, it simply makes a lot of sense for experienced portfolio managers, proprietary traders, marketer, etc, to start up a hedge fund operation. With an average fee of 2 per cent flat plus 20 per cent of the profit, these people can do a lot better on their own than working for a large bank or asset manager, even if they manage to raise only $100 million or so.

Q3: Given the sort of exponential growth we’ve been talking about, is there a likelihood that returns will be driven down as hedge funds are flooded with capital? After all, it is the role of managers and arbitrageurs to normalise and provide liquidity to the marketplace?

It is clear that the heydays of hedge funds are a thing of the past – every succeeding year having shown a worse performance than the previous one. Much depends on the specific strategy followed, though. Global macro funds will probably last longest, as many of them operate in liquid markets. More specialised funds, such as convertible arbitrage, are already suffering. There just aren’t enough convertibles in the world to support the assets under management by this type of funds.

Q4: Is it fair to say that the European theatre is best suited to the single-manager fund operation?

No. Most European investors use funds of funds, that is multi-manager funds. For investors who do not have the necessary skills to select funds themselves, who do not have the size to allow them to select their own funds, or who just do not want to take the responsibility for fund selection (as is often the case with institutional investors), funds of funds are basically the only available alternative.

Q5: In relation to single-manager funds, the fund’s manager has total trading authority. It has been inferred that using a single manager can lead to a lack of diversification and higher risk. From an empirical point of view, do these inferences have any validity?

Yes. Individual hedge funds have a high degree of idiosyncratic risk because you are basically building on the ideas of just one or two people. In addition, about 15 per cent of all hedge funds closes every year, because of lack of size or lack of performance. This makes it is almost a necessity to hold a portfolio of funds instead of a single fund.

Q6: With thousands of hedge funds to choose from, each claiming to have an “edge”, where does the novice investor start?

The novice investor should not try to do the fund selection him- or herself. The whole due diligence process and the portfolio building that comes afterwards is just far too complex for DIY.

Q7: Pension funds and hedge funds – will the twain ever meet?

Yes, because pension funds tend to imitate each other. If the big ones go for hedge funds, the smaller ones will follow. With interest rates at a historical low, uncertainty about the future of the stock market, and institutional investors eagerly looking for something to make up for recent losses (or to be seen doing at least something), hedge funds have been welcomed with open arms by the top pension funds. It is only a matter of time before many smaller funds follow suit. The only thing that can prevent this is lack of performance. Hedge funds need to convince pension funds that they are worth the hassle and the relatively high fees. If performance stays out, however, the hedge fund idea will become harder and harder to sell.

Q8: How are investments in hedge funds affected by current market conditions?

Much of the interest in hedge funds is driven by a lack of alternatives. Many investors do not know where to put their money and are struggling to recover from serious losses in the stock market. They are therefore very much open to alternatives at the moment. It is exactly at that point that hedge fund marketers start knocking on your door. What do you expect?


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