Rising hedge fund demand could hurt results-study
By Svea Herbst-Bayliss
NEW YORK, Oct 17 (Reuters) - Strong demand for hedge funds, one of the year's hottest investments, may be a double-edged sword, researchers say, arguing that returns could drop as more investors get a taste for these loosely regulated funds.
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Hedge funds attracted new attention this year because many have consistently outperformed the ailing stock market, largely because managers use strategies that are generally off limits to most mutual funds.
But the flood of demand from individuals as well as institutions may ultimately force managers to take on more risk, something that could hurt returns and may curb interest in these vehicles, according to a new study from money management consultants Barra Strategic Consulting Group.
``First (rising demand) may suppress returns as market inefficiencies become more fully exploited,'' study authors Christopher Acito and Peter Fisher wrote.
Hedge funds generally cater to wealthy individuals who have at least $1 million in investable assets. Since January, the average fund has returned 2.2 percent, according to data from hedge fund tracker CSFB/Tremont.
That compares with a more than 18 percent decline in the Standard & Poor's 500 index (^SPX - news) as slower growth has hurt corporate profits and sent stocks broadly lower.
In part, hedge funds have been so successful because many have quietly sold stocks short, without attracting much attention. This strategy has been especially successful at a time of deep market losses.
But with more money managers clamoring to get into the business, the field will become more crowded -- and that could make it harder for funds to operate quietly and quickly.
This year alone, 1,000 new managers are expected to set up shop, joining the 5,000 hedge funds that already exist.
To make the out-sized returns that investors have grown to expect from hedge funds, managers may take on riskier trading positions in the coming years, Barra researchers said.
Excessively risky positions badly tarnished the industry's reputation three years ago when hedge fund Long Term Capital Management used so much leverage, or borrowed money, that losses wiped out nearly all of the firm's capital. The U.S. Federal Reserve then engineered a private-sector rescue plan to keep LTCM's collapse from unhinging global markets.
``Reduced returns and increased risk will potentially dampen future demand,'' Barra researchers concluded.
In the meantime though, there are no signs that demand is letting up.
Some industry analysts expect assets under management will jump to $1.5 trillion in the next five to 10 years from $500 billion in 2001. Despite the expected rise, the hedge fund industry is still dwarfed by the roughly $7 trillion mutual fund industry.
While the Barra study said the $1.5 trillion estimate is too high, researchers expect steady demand with so-called funds of funds acting as the industry's engine of growth.
Over the next two to three years, Acito and Fisher said funds of funds, which seek to spread risk by investing with a number of individual hedge fund managers, will contribute significantly to the expected rise in assets.
``It is reasonable to believe that the fund of hedge fund market can generate annual growth rates of 20 percent for the next two to three years, barring any market or hedge fund catastrophe,'' the authors said.
Growth in Europe and Asia may be even higher because the base of assets under management there is lower than it is in the United States.
To meet the demand, a wave of newcomers, including most recently online broker Charles Schwab Corp. (NYSE:SCH - news), are planning to roll out funds of funds.
Even though funds of funds are very expensive, adding another layer of fees on top of the individual managers' fees, investors feel the costs are justified because fund of fund managers add an additional layer of security. |
