Not long ago, hedge funds were reserved for a few wealthy investors and even fewer pioneering managers.
Now 7,500 funds have assets approaching $2 trillion (Rs78.8 trillion) under management globally, according to Hedge Fund Research Inc. (HFR)—increasingly from endowments and pension funds, as well as wealthy individuals.
Here are eight predictions for the rapidly evolving industry.
Big funds will get bigger. Having investor assets in the tens of billions helps support the back-office and technology demanded by institutional investors. And funds of funds—conduits for more than 40% of hedge fund investment, according to HFR—often want to make big allocations, which leads them towards bigger funds. But smaller funds that lack a unique investment case are already struggling for new money. The biggest hedge fund outfits currently manage $30 billion-plus. Watch for more consolidation and the first $100 billion fund group.
Returns will fall, on average. With so much money chasing similar opportunities, the average fund will find it increasingly tough to beat, say, stock market returns. Institutional investors’ preference to avoid big risks won’t help. Smaller players might appear more likely to reap the benefits of nimbleness, but the more “institutional” fund groups, such as Citadel Investment Group Llc. and Och-Ziff Capital Management Group Llc. have scale that can help them attract the best people and stay on top of multiple markets.
Fees will hold up, for now. You’d expect a crowded field and declining returns to put pressure on the archetypal hedge fund fees: 2% of investors’ assets, plus 20% of any gains. But returns are hugely dispersed around the average, especially after this year’s market volatility. The best do so well that investors will gladly pay up, while the least successful can always just close their doors. As long as investors hope for stellar performance, they’ll pay for it. And with institutional demand for “alternative” investments such as hedge funds rising, funds face only limited competition for investors’ money.
Transparency will improve. As long as funds in big markets of the US and the UK avoid retail investors, regulators probably won’t force much greater disclosure. But two other trends are doing the watchdogs’ work for them. Institutional investors and funds of funds want plenty of information on what funds are up to.
And with several managers—Och-Ziff, for example—now publicly traded, and others likely to follow, the standards for transparency are going up—as underscored by recent “best practices” proposals from industry groups.
Managers will pay more tax. Regulators may resist dictating how hedge funds are run, but lawmakers are unlikely to spare the managers from higher tax rates. In the US, hedge fund managers—and to a greater extent, private equity bosses—can call some of their pay capital gains, which attract a lower tax rate than ordinary income. It’s legal, but it’s such an obvious target that plenty of managers are privately resigned to the rules changing, if not in 2008, then soon after.
Retail investors will want in. Industry groups like the Managed Funds Association say they want to make it harder, not easier, for less wealthy people to get into hedge funds. After all, the funds can involve leverage and other risks some investors can’t tolerate. But as the funds become truly mainstream in coming years, pressure will mount.
Cheap imitations will flourish. Academics and traditional asset managers are developing (somewhat) lower cost approaches that replicate some hedge fund investing techniques. For example, wildly popular “130/30” funds are an outgrowth of traditional stock fund management giving managers limited hedge fund-like flexibility to bet on share price declines and invest more in the stocks they really like.
Blow-ups will still happen. Maybe not in those big funds that are focused as much on gathering assets as on returns. But others still make concentrated bets. Some will hit home runs, bolstering the industry’s mystique. Others—even large ones—will, occasionally, lose out spectacularly. The first $10 billion-plus hedge fund collapse, anybody?