Hedge funds might be red hot today, but, according to a new study from the U.K.-based think-tank Create and financial services consulting giant KPMG International, their popularity will cool in the coming years.

The study, which taps 550 global fund executives from across 35 countries, admits that since the onset of the latest bear market, the growth of hedge funds has been nothing short of spectacular. Driven by mutually reinforcing factor - such as the prolonged bear market, wealthy investors seeking to quickly recoup losses from that bear market and the movement of talented investment managers to the field who are capable of delivering big returns - an amazing 8,000 hedge funds now control assets in excess of $1 trillion. That's 2% of global investment assets.

The explosive growth that hedge funds have enjoyed in recent years, both in bull and bear markets, however, isn't likely to continue.

"What has driven the growth is a recognition by investors of the diversification opportunities and also the gross returns that hedge funds have earned," said Mikael Johnson, co-author of the 93-page paper, Hedge Funds: A Catalyst for Reshaping Global Investment, and a partner with KPMG who chairs the firm's global leadership team for alternative investments.

"The reason respondents in the study think growth might be stunted in the next few years is because of capacity constraints," Johnson said in a telephone interview from a fund forum in Monaco.

But that doesn't necessarily mean that in its current incarnation the hedge fund industry can't take on additional assets, added Johnson, who was joined on the study by KPMG colleague Tom Brown, along with Create's Amin Rajan and Barbara Martin.

Skill Set Bottleneck

The bottleneck, Johnson said, is a lack of talent and relevant skill sets in the back office, legal, accounting and finance departments to accommodate all the new products and funds that are being launched.

"That has slowed the industry's ability to absorb all that growth, and that is something the industry must solve in the near future to accommodate investor demand to get into hedge funds," Johnson said.

The question of talent, however, also extends to managers, according to the study, released earlier this month. Johnson and his colleagues found that around 15% of the current managers are genuine stars capable of delivering returns that are in line with client expectations. Most are former proprietary traders from investment banks and most are based in the U.S. But there also exists another 55% who are "wannabes," the study offers.

These managers tend to be "long-only" managers and are generally based in Europe or, to a lesser extent, Asia Pacific. Another 30% are "has-beens," or "victims of the churn and burn that characterize their universe," the study says. As a result, the surplus capacity is sub-prime.

"So that's another reason why many of the respondents to the study feel that growth will level off until new investment managers come in with new, creative strategies to drive better returns," Johnson remarked.

Hedge funds, by nature, are also highly focused, so investment opportunities are limited. That means future returns will likely be lower, risk will be higher and only the most creative managers will thrive. That sort of "innovate or liquidate" environment provides even the best investment managers with a just a three-year window.

"It will be survival of the fittest," Johnson added. "These being investment products, that's only natural. One's longevity in the business is equal to their ability to generate great returns. Nothing is a given, nothing is permanent."

Pensions to Supplant


Talent constraints aside, the study shows that pension funds and institutional investors will soon supplant ultra-high-net-worth individuals as the primary drivers in the next hedge fund growth spurt. Over the next three years, the study finds, one in every three pension funds will invest in a single strategy hedge fund, which is up from one in five over the last three years. Two in five pension funds will invest in multi-strategy hedge funds, while one in every two will choose a fund of hedge funds in which to invest.

Regionally, the greatest interest among pension funds and institutional investors in hedge funds will be in North America, followed by Asia Pacific and Europe. Investment amounts will vary widely by region, with North America being most bullish, but, given the investor, even less than 3% on average would be a significant influx of activity. In North America, pension fund and institutional investors cut their teeth on hedge funds during the last bull market and that served to raise their trustees' knowledge and comfort level, the study says. Governance structures have also been put in place that enables trustees to monitor their hedge fund investments on a weekly or monthly basis.

By contrast, their peers in the U.K. are approaching hedge funds with extreme caution and their hedge fund activity is further slowed by a lack of resources for research, due diligence, or frequent monitoring, the study says.

According to Johnson, the new willingness among pension funds and institutional investors to choose hedge funds reflects overall market place acceptance for them as a viable diversification opportunity. As a result, it's forcing traditional, or mainstream, investment managers to rethink their product offerings.

"A few years ago, people were saying hedge funds were a fad and they are going to go away," Johnson offered. "Today, they are saying, We better get into this game and make sure that we are competitive.'"

Back-Office Restructuring

Consolidation within the widely dispersed industry is also underfoot and will continue to leak into the back office side, the study shows. For instance, JPMorgan Chase recently acquired a major stake in leading hedge fund player Highbridge Capital Management, while HSBC recently grabbed up top-five hedge fund administrator Bank of Bermuda, and earlier this year BISYS bought hedge fund administration specialists Hemisphere and RK Consulting

Therefore, the authors suggest, the significance of hedge funds does, indeed, extend well beyond their status as an asset class or alternative investment strategy.

A small spark, they said, has created a chain reaction.

(c) 2005 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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