The recent struggle by a number of hedge fund strategies to generate sufficient returns has prompted plenty of media attention — and disappo...

The recent struggle by a number of hedge fund strategies to generate sufficient returns has prompted plenty of media attention — and disappointment among private investors. In 2004, hedge fund returns averaged around 9.6 per cent, a good margin above risk-free asset returns, but less than the 15.4 per cent they notched up in 2003, according to CSFB/Tremont, a provider of fund data and products. Moreover, hedge funds, on average, have made little if any money so far in 2005, extending the period of low returns. Perhaps it’s not surprising that Tremont also reported that hedge fund inflows slowed considerably in the first quarter. And there’s some anecdotal evidence that it was institutional investors, not private clients, who provided the new money that did come in. The key to understanding the recent disenchantment lies in the widespread belief, promoted by the industry, that all hedge fund managers can make money in all market environments. After all, that’s the appeal of hedge funds to many investors — so called absolute return. But forces at work in the industry are now making that objective more difficult to attain. Chief among them is the industry’s low barriers to entry, or the ease with which a new hedge fund operator can raise money and set up shop. Too many players are gunning for the same opportunities — there are now around 8,000 hedge funds, up from 5,300 two years ago, according to Hennessee Group — and bringing down average returns. And just like with any other industry that has been overwhelmed with competitors, the rate of attrition is, and will likely remain, high. Given that backdrop, it’s imperative for investors to choose managers with a proven record of strong performance regardless of market environments. Too many of the new entrants are generating returns that are closely correlated with market performance — they are beta players, if you will, rather than alpha managers who generate returns through their own skill. Hedge funds have evolved as they’ve grown over the past 15 years or so. In 1990, hedge funds managed less than $40 billion in assets and catered almost exclusively to the ultra-wealthy. Today, Hennessee Group estimates that assets under management are approaching $1 trillion and investors include pensions and endowments, as well as many more individual investors. Hedge funds are no longer the exotica they once were, and while not yet commonplace, they’re much more accessible than ever before. Regulation is going to increase the profile of the industry even more. In October 2004, the Securities and Exchange Commission demanded that hedge funds register as investment advisers by February 2006. While adherence to this regulation may bring additional costs to the industry, the improved compliance procedures and bolstered back-office capabilities should help to expand investor confidence in the funds. Indeed, institutional investors clearly still find the risk-reward profile and diversification attributes of alternative investments attractive. In wide-ranging interviews with chief investment officers at pension funds and endowments earlier this year, industry publication Pension & Investments found broad satisfaction with the performance of real estate, private equity and hedge funds, as well as with the diversification they add to portfolios. That’s why top managers can persistently impose stringent terms such as long lock-ups and scaling performance fees. Consider this: In the second half of 2004, there were at least three funds that raised a combined $9 billion and closed for new investment immediately after opening, according to Absolute Return magazine. In short, the hedge fund industry is undergoing the natural growing pains of any rapidly expanding field. Any industry with low barriers-to-entry and potential for outsized profits — be it software makers or hedge funds — eventually attracts so many players that some sort of shakeout or consolidation occurs. When that takes place, expect the newcomers with low asset bases to fade first. Such a shakedown may strengthen the hedge fund industry in the long run. After years of robust performance and increasing interest by institutional investors, hedge fund managers are now developing deeper technological and operational infrastructure as well as greater transparency. The likely outcome will be more viable, long-term businesses that continually align themselves with their investors’ best interests. So, despite the recent turbulence, we think hedge funds — and the diversification and potential to enhance returns that they add — deserve a place in the portfolios of many high net worth clients.