NEW YORK—The hedge fund industry can expect more consolidation, as the shooting star funds launched in the early part of the decade begin to burn out, according to David Smith, chief investment director at London-based fund-of-fund manager GAM.  

Tracing the industry’s history through its formative years in the 1970s, its awkward adolescence in the 80s and “extraordinary” growth spurt in the 90s, by the new millennium, Smith said, “Everyone suddenly wanted total return.”

As a result, scores of funds began to open, with industry assets swelling as novice managers, many of them mediocre; each tries to respond to perceived market demand.

“It seemed that anyone who ever worked in investment banking—indiscriminate of what he did—launched a hedge fund,” Smith quipped.

Add to that academics and scholars, he added, and suddenly investors faced a super-saturated market place. Today, he estimated, the hedge fund industry includes 6,500 funds.  Between 2000 and 2004 alone, 20-25% new managers entered the field.

The result, three years later, is beginning to show itself, said Smith.

The least qualified funds floundered and closed quickly, he said. But many managed to produce positive returns when equity long-only investors saw losses of 30-40%.

As a result, weaker players were able to survive in the industry during that time, but now that has changed.  And the third year is often the make-or-break point in the industry, so now weak players are getting weeded out, either collapsing or by consolidating with other hedge funds.

And while Smith acknowledged that the out-sized average returns of 20% and 30% touted at the turn of the century were an anomaly, these mediocre managers are likewise dragging down industry averages to somewhere close to 8%.

Neither is normal, he said.

“What I do think is realistic is 15% per annum,” he said.

Forward looking for the fourth quarter, U.S. managers will continue to find compelling investment ideas, but will remain cautious with regards to the overall market environment, GAM predicted. In Europe, managers will start to put capital to work again. Sectors such as technology and telecom, which have been out of favor, will start to get mentioned more often.

Smith also tried to debunk myths that there is little to no correlation between hedge fund and equity performance.

“That correlation is evidenced consistently in hedge fund strategy,” he said. And the ratio is strong: close to a coefficient of 0.7, he said. “Are there times when you want to embrace it? Yes. But you need also to be able to break that correlation at certain times,” he noted.

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