Over the hedge

There are about 8,000 hedge funds worldwide managing in excess of $1 trillion (£555bn) worth of assets. This is before adding in the leveraging raised on the back of core holdings.

The soaring growth in the sector is set to continue, according to LJH Hedge View, an industry newsletter published by Florida-based LJH Global Investments LLC, which projects that hedge fund assets could reach $4 trillion (£2.22 trillion) by 2010.

These would be large numbers in most people’s book, but analysts at JP Morgan Securities calculate that, in the context of the world’s equity and bond markets together with total bank lending, hedge funds appear to account for less than 1% of the world’s financial assets and so are still a niche area. But among other things, JP Morgan’s research concludes that, “As they grow larger, (hedge funds) will eventually erode the same market opportunities and mispricings they have relied on to create their superior returns. Opportunities are disappearing fastest where hedge funds are active, where there are deep derivative markets, and where the same trading rules have been used for some time.”

Pension fund trustees might find this emerging situation alarming. After all, the whole attraction of a hedge fund is that it can achieve superior returns because it is smarter and fleeter of foot than the average mainstream fund manager. Most people put up with their lack of regulation as part of the price paid for the upside. But not only is the upside disappointing and the fees high, they seem about to ramp the very markets from which they reap their benefits.

Added to this, more hedge funds are now trying to give themselves greater time and increased stability by requiring their investors to accept longer lock-ins. Morgan Stanley’s Huw van Steenis and Bruce Hamilton have identified a significant number of hedge funds that have set up “long only absolute return funds”. These require investors to maintain their investment in the funds for, say, 12 months or more, rather than being able to liquidate their positions on a quarterly or six-monthly basis.

Again, pension fund trustees may start to feel uncomfortable. Being locked into underperforming, unregulated hedge funds for longer periods removes flexibility and may feel like being tied to a rapidly sinking, heavy object, while prudence would suggest cutting loose and swimming to more attractive, safer waters.

Part of the problem hedge funds face is lack of volatility in markets. Interest rates and foreign exchange rates are fairly stable in the major currencies, and stock markets are not fluctuating wildly. A key element in the hedge fund skillset has been being able to exploit short-term market movements that give scope for arbitrage. No one seems to be predicting high levels of volatility in markets this year though natural disaster, war, oil price rises, terrorism and political risk in several countries could easily throw things off course.

Industry analysts are saying there are still opportunities to be found in the hedge fund universe. Laurent Fransolet at JP Morgan Securities believes opportunities are abundant in less used areas of the financial markets. These include, for example, specialist fixed-income managers moving into areas such as credit-based strategies, where mainstream markets may be mispricing short-dated bonds which are close to the investment grade break point. He also highlights emerging market funds, where large price movements and thin markets provide the sort of arbitrage opportunities upon which hedge fund managers traditionally thrive.

The area which is least attractive at the moment could well be funds of hedge funds, which is where mainstream pension funds and other asset managers are now increasingly apportioning funds under their control because they can gain exposure to a variety of investment strategies and managers under one overall manager. The danger is that unless the manager selects a series of high performers for his fund of funds, a reversion to the mean is likely, which neutralises the principal attraction of unregulated hedge funds for pension fund trustees.

When latecomers charge into a market with pockets full of other people’s money, it is time to be concerned – especially so if whizz kids are promising great things they can deliver and then tell you they need to hang on to your money for longer.