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The numbers are staggering. Between 1990 and early last year,
hedge fund assets exploded twentyfold, from $20 billion to
$400 billion, reports Joseph Nicholas in his book Investing
in Hedge Funds (Bloomberg Press, 1999). Not surprisingly,
the number of hedge funds soared as well to more than 3,000
from 200, Nicholas adds. Even more impressive than numbers
is the impact that hedge funds are having (and already have
had) on Wall Street and beyond. For instance, the launch within
the past several years of so-called market neutral funds had
its roots in the hedge fund business.
During the 1990s, hedge funds were among the hottest growth
stories around. As a result, hedge funds went from relative
obscurity to front-page business news. But where does the
hedge fund business go from here, and what, if any, are the
implications for the money management business? It was this
and related topics that were fodder for discussion at Forum
99, sponsored by the Managed Funds Association, a Washington,
D.C., trade group representing hedge funds and managed futures
funds.
Is it only a matter of time before the equivalent of a Fidelity
or a Vanguard arrives on the hedge fund scene? At least one
of the speakers at Forum 99, held recently at the Plaza Hotel
in New York, thinks so. A "natural process of evolution"
is under way in the hedge fund business, said Rama Rao, president
and CEO of RR Capital Management, a Bohemia, New York-based
hedge fund. Rao told attendees that the money management business
is poised for a major restructuring.
Referring to a March 1998 study that he co-authored, Rao
predicted the hedge fund industry will consolidate along the
lines of the mutual fund evolution that has unfolded over
the past two decades. (Rao's study, "The Coming Evolution
of the Hedge Fund Industry: A Case for Growth and Restructuring"
is available at his firm's Web site. Point your browser to
www.rrcm.com/f_ reporthome.htm to read it.) The hedge fund
industry in the years ahead, he went on to say, will shed
its current status as a localized, fragmented industry and
become an institutionalized, globalized business.
GROWTH AND CONSOLIDATION
Drawing on the theories put forth by Harvard's Michael Porter,
Rao noted the hedge fund industry is driven by a life cycle
that's applicable to most businesses and products. He divided
that cycle into four stages: introduction, growth, maturity,
and decline. Having gone through the introduction phase in
the 1980s, hedge funds reached an "inflection point"
around 1990 when assets and the number of funds began growing
at a substantially higher rate (see bar graph above), be explained.
At that point, the business moved from its introduction phase
-characterized by relatively sluggish growth-to its growth
phase. "When an industry undergoes this inflection point,
the balance of forces changes from the old way of doing business
to the new way of doing business," he added.
Hedge fund growth in recent years, Rao observed, is reminiscent
of the mutual fund industry's growth in the 1980s. In the
1980s, Rao continued, mutual funds began to post dramatically
stronger growth rates. The expansion phase subsequently led
to consolidation, globalization, and the development of more
sophisticated analytics. The distribution of the information
arising out of that analysis also began in the 1980s. he said,
with the founding of Chicago-based Morningstar.
In their March 1998 study, Rao and his co-author, Jerry
Szilagyi, who at the time the study was written was in the
financial services division of KPMG Consulting, pointed out
that since the early 1980s "the mutual fund industry
has gone through several phases of evolution-from stand-alone
small funds to large families of funds and now a period of
consolidation and globalization." Rao and Szilagyi believe
the hedge fund industry will follow a similar course over
roughly the next decade.
They explained that, though highly fragmented, the industry
is generally profitable. "Historically, the combination
of fragmentation and high profitability has presented significant
opportunity for evolution or consolidation," they wrote.
"The profitability makes the industry attractive, and
the lack of dominant players creates an opportunity for a
motivated, well-funded consolidator to create an organization
that represents the next evolutionary step," Rao and
Szilagyi concluded. In his presentation at Forum 99, Rao stressed
that the hedge fund business today, like mutual funds in the
early 1980s, is dominated by a relatively small number of
independent organizations. Many of these companies, he observed,
have a lone star manager and offer a handful of products,
if not a sole portfolio. According to Rao, roughly 80 percent
of all hedge funds have under $100 million in assets.
During the question and answer session that followed Rao's
talk, an attendee noted that the popularity of hedge funds
is closely tied to the industry's independence from the Wall
Street establishment. The fact that many of "the best
and the brightest" leave the Goldman Sachses and the
Morgan Stanleys to launch their own hedge funds suggests as
much.
Might hedge funds run by the equivalent of a Fidelity or
a Vanguard be viewed as second-tier products next to those
run by independent hedge fund managers? Rao conceded that
injecting the aura of Wall Street into the hedge fund business
could backfire. However, he underscored his belief that the
opportunities to tame and exploit the business will offset
any potential fallout. Considering that institutions, such
as pension funds, remain a minority of the investors in hedge
funds, the capacity for additional growth by cultivating those
clients is substantial. Institutional investors, he added,
would respond to reliable, one-stop shopping services offered
by the hedge fund equivalent of a Fidelity or a Vanguard.
If Rao and Szilagyi are correct that the hedge fund business
is destined for a fundamental realignment, it will be a high-stakes
proposition. According to Rao, hedge fund assets should grow
to $1.4 trillion by 2006. What will drive that growth? So-called
high-net-worth investors, a critical source of hedge fund
capital, are expected to expand their ranks at an above-average
rate relative to general population growth. Whereas "all
households" (that is, those with investable assets) are
expected to increase by one percent over the coming decade,
those households with investable assets of over $1 million
are expected to increase by 14 percent. That trend, Rao added,
will drive demand for hedge funds, as high-net-worth individuals
pour $400 billion into the funds over the next 10 years.
Wealthy investors, particularly younger ones. Rao emphasized,
are more aggressive in investing than previous generations,
which explains the growing lure of hedge funds. Rao said that
from 1992 through 1996, for example, hedge funds overall produced
higher and superior returns both in terms of absolute and
risk-adjusted returns, relative to the stock market. That,
in turn, attracted high-net-worth investors to the niche.
Institutional investors also have been increasing their
allocations to hedge funds, and Rao expects that trend to
continue. Again looking at the period from 1992 through 1996,
hedge funds produced returns that were generally non-correlated
to conventional stock/bond investment portfolios. That characteristic
understandably appeals to institutional investors.
TOMORROW'S LEADERS
D. Dixon Boardman, managing general partner of Optima Fund
Management, L.P, a New York hedge fund, underscored Rao's
point that the hedge fund business is evolving. Reflecting
on the changes that have taken place over the past decade
or so, Boardman also noted that the number of hedge fund choices
has gone from several hundred to several thousand. "The
hedge fund universe not only was a lot smaller a decade ago,
but it also was less diverse and less visible." He added
that 10 years ago there wasn't a plethora of mortgage arbitrage
funds, emerging market debt funds, or market neutral funds.
Finding a "suitable" hedge fund was also a good
deal more difficult, Boardman emphasized. "Today, you
can use not one but several Internet-based systems to run
multicriteria screens to identify manager candidates. You
can use those same Internet-based systems to perform in-depth
statistical analysis on a universe of managers," he added.
That said, Boardman cautioned his audience not to confuse
ease of quantitative analysis with thinking. "While the
information technology available to hedge fund investors has
changed, one very important fundamental aspect of the process
has remained the same: judgment." Data, quantitative
analysis, and even general due diligence are mere tools, he
emphasized. "They will not in and of themselves tell
you who really are the best and the brightest in the business,"
Boardman stressed. The search for high-quality managers who
exercise intelligent risk controls still requires judgment,
Boardman observed.
Judgment, as Boardman sees it, comes only by way of experience.
"Judgment tells me markets go in cycles. Of course, the
only cycle we have seen for quite some time is an up cycle,"
he observed. "I'll not presume to be some great market
guru. Nonetheless, Boardman said he felt compelled to predict
that one day, the markets will go down. "Even more likely,
[the market] might just become a bit more volatile, or perhaps
it will continue to go up at a much more modest pace. If these
shifts do occur, judgment tells me it will probably be more
difficult to be a long-only equity manager." As a result,
"investors' expectations, which I believe are highly
inflated will certainly change. Investors will seek alternative
investment strategies." At that point, hedge funds, or
at least some hedge funds, will reap big rewards, Boardman
suggested.
If a bear market isn't on the horizon, alternative investment
strategies might get a helping hand from an investor's other
nemesis: volatility. Boardman warned that when a bear market
arrives (as it most surely will), hedge fund managers had
"better get it right or their credibility will come into
question, especially after periods like 1994 and 1998."
The hedge funds that are destined to capture investors'
attention in a bear market or a period of increased volatility,
according to Boardman, will be those run by managers who "buy
stocks they like and short stocks they don't like, based on
fundamental analysis." In particular, "the most
effective and successful hedge funds will be those that focus
on a specific industry or theme." What matters is that
they "possess superior breadth and depth of knowledge"
in their niche.
The move from the general to the specific, Boardman noted,
marks the history of his firm. Starting with a diversified
fund of funds, Optima now offers a "broad" menu
of hedge fund products, including portfolios targeting small
caps, technology companies, and Japanese equities. Boardman
announced to his audience that later this year Optima will
launch an energy hedge fund. "The point I'm trying to
make is that our business has evolved in the direction of
much more focused, strategic types of hedge funds."
Boardman added that his comments weren't meant to condemn
other hedge fund strategies, such as arbitrage, futures trading,
and equity generalists. "Some of my best friends are
arbitrageurs, futures traders, and equity generalists,"
he joked. Still, Boardman stressed that he expects the more
focused funds to become the leaders in terms of consistent
forward performance. Like Rao, Boardman also expects greater
institutional participation in hedge funds. Ten years ago,
perhaps 90 percent of the money going into hedge funds was
from private investors and 10 percent was institutional. Ten
years from now, those numbers will probably be reversed,"
be predicted.
Some things won't change, Boardman said. Despite predictions
that investors will demand lower fees, Boardman forecasted
that the standard 20 percent performance-based fee will remain
intact. Nevertheless, he did hold out the possibility for
a greater use of hurdle rates (predetermined returns that
must be "hurdled" before managers earn a performance-based
fee). How will hedge fund managers get away with charging
fees that appear exorbitant, even by Wall Street standards?
"They can only justify these fees if they deliver what
their investors expect, which is either superior absolute
returns, risk-adjusted returns, or diversification and down-side
protection," Boardman concluded.
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