The sea change in attitudes over recent years towards hedge funds has been remarkable. Only a couple of years ago, general opinion was that hedge funds were the preserve of the super wealthy, but today hedge funds are enjoying unprecedented growth and are one of the fastest growing sectors in asset management. Funds of hedge funds, in particular, are really moving into the mainstream as can be seen by the percentage of hedge fund assets managed by fund of funds managers - currently approximately 40% according to Hedge Funds Review.
More recently industry commentators have been asking whether the returns seen by hedge funds are sustainable? They are, after all, simply another asset class and are only as good as their managers. Those groups with the best resources and greatest experience will be the minority, but they will be best placed to offer their investors long-term outperformance from this asset class.
There are two key issues concerning the hedge fund industry: capacity and quality. The demand for hedge funds has meant the number of funds and fund managers new to the industry has grown exponentially. Looking at the theory, the hedge fund industry does not appear to have a capacity problem.
According to Hedge Funds Review there are approximately 6,500 hedge funds globally with a notional capacity of $1 trillion. (Approximately 550 new funds were launched in 2002 and an estimated 720 in 2003). However, the real question is what proportion of this theoretical capacity is with really talented managers?
It is probably realistic to assume that 5% to 25% of these managers will be truly talented. Assuming that inflows into hedge funds for 2004 will be around $15 billion, the estimate for "talented capacity" comes to between $7.5 billion and $37.5 billion.
There is clearly a constraint on quality if not on total capacity. Increasing numbers of funds with only average performance are surviving and it is the identification of high quality investment talent that has become the real challenge.
This quality constraint has led to the relatively small percentage of outperforming funds experiencing exceptional inflows. The response to this has often been the temporary closing or capping of funds of hedge funds to maintain performance. This makes the search for quality funds in which to invest even more difficult.
To understand these issues more clearly, potential investors need to examine why hedge funds have become so popular. They have historically achieved equity-like returns with bond-like volatility. More importantly, from the perspective of Modern Portfolio Theory, these returns tend to be uncorrelated with bond or equity markets.
This lack of correlation in the 2000-2003 bear market boosted the general popularity of hedge funds. During this period many hedge funds outperformed long only equity portfolios, by a substantial margin in some cases.
The primary objective of a hedge fund manager is to generate consistent performance on behalf of investors. It is not to gather assets. Successful hedge fund management depends far more on the manager's skills in identifying opportunities than traditional long only management. As those who've been involved with hedge funds since their infancy nearly 40 years ago will tell you, the industry has, until recently, been self-regulating.
If a manager did not deliver the expected performance, no one invested and the fund simply disappeared. This has changed as the huge demand for hedge funds now means that managers can attract investors, even if they subsequently fail to meet investors' expectations.
The growth in the number of funds of hedge funds or multi-manager funds has in turn created a demand for underlying funds. Many multi-manager funds have become satisfied with investing in adequate hedge funds delivering adequate returns, rather than striving for top decile performance.
It is the job of a good multi-manager to weed out the mediocre but, for all but the best resourced, this is becoming ever more difficult. It is a myth that increased accessibility to hedge funds has led to increased transparency.
If a fund of funds manager is not in the know, it is unlikely that the best underlying managers will be willing to divulge the level of detail of information that a manager needs to be able to make really informed decisions.
A successful fund of hedge funds operation must have vast and expert resources. This not only requires a small army of investment and sector specialists, but also people who can ensure that careful and full due diligence on funds, managers and back office operations is carried out.
Some investors new to the asset class are expecting hedge funds to provide an investment panacea and expectations of annual returns are quite simply unrealistic. However, some fund of funds managers appear to be all too ready to foster such expectations which can only lead to disappointed investors.
Hedge funds and funds of hedge funds can be an important constituent of a diversified portfolio but are not designed to outperform equity markets in all conditions.
Fund of hedge fund managers also need to run concentrated portfolios to maximise returns. Unlike investing in long only funds, experience suggests that there is no benefit from investing in additional funds beyond an optimum number.
Indeed, adding to the number of funds in a portfolio can have a detrimental effect on risk-adjusted performance. This optimum number depends on the strategy and investment objectives of the overall fund. By definition the optimum fund size is also restricted, which is why many funds of hedge funds cap at a relatively modest size to protect investors' interests. $300 million is the typical maximum hedge fund size.
Traditionally the best single-manager hedge funds have been reluctant to manage very large funds in order to protect their performance. Some of the most talented trading managers attract such high levels of investor interest that they can open and close a fund on the same day.
The "cloning" of successful funds of funds has enabled managers to cap existing successful funds when they reach an optimum size and launch similar new funds. These new "cloned" funds can invest in the next generation of talented managers for that particular strategy.
The aim is to maintain the performance, portfolio balance and size of the first fund while opening up opportunities for new investors. The challenge is to ensure that the quality of investments is replicated to match the performance of the original fund. This depends on the overall manager's quality and the group's resources in identifying new investment talent.
In the current environment with money flowing into the best funds of hedge funds so quickly, the only way a manager can carry on identifying the very best managers is to grow its research resource. This is a very labour and intellect-intensive business. By insisting on the best specialists, growing teams steadily ahead of demand and only investing in the most talented underlying managers the experienced multi-managers should be able to maintain consistent performance for investors.
The challenges of capacity and quality mean that new and existing asset classes are being traded in different ways. Different geographies are growing in popularity as demonstrated by the dramatic increase in funds investing in Asia and, in particular, China. New financial instruments are also leading to the emergence of new strategies.
Undoubtedly the hedge fund industry will continue to present its managers with intellectual challenges and the need to keep pace with constant change. It has shown its ability to evolve to meet ever-changing market needs in a truly Darwinian fashion. It has adapted, evolved and implemented new techniques and technologies as soon as the interest or demand for them has arisen. This pace of change has proved astonishing. It looks set to continue and this ability to adapt is undoubtedly one of the industry's key strengths.
By David Lam, Managing Director - Clients, Asia Pacific, GAM
Extracted from Summer 2004 issue of Asian Private Capital Magazine
