Thursday, March 24, 2005
Emphasis on Strategy Selection as We Build Portfolio
Case remains for investing in hedge funds -report
Wed Mar 23, 2005 03:23 PM ET
By Pratima Desai
LONDON, March 23 (Reuters) - A shortage of talent and too much money in some hedge-fund strategies means future returns could disappoint investors, but the case for investing in them is still intact, consultants Watson Wyatt said in a report.
That was because hedge funds were still likely to return enough to improve the efficiency of an institutional portfolio.
"We believe that there is still room for them (returns) to come down from historic levels before the case for investing in hedge funds is no longer supportable," the report said.
Institutional investors have piled into hedge funds since the 2000 equity market crash, looking to diversify from traditional assets, preserve capital and seeking absolute returns instead of relative returns based on benchmark indexes.
Watson Wyatt estimates that out of around 6,000 hedge fund managers, only 5-10 percent are highly skilled and able to add significant value after deductions of fees, however.
Hedge funds normally charge annual management fees of 1-2 percent and performance fees of up 20 percent.
Analysts estimate hedge-fund assets have doubled to around $1 trillion since 2000 and that average returns slipped to around 9 percent last year from more than 15 percent in 2003.
Large inflows mean returns in strategies in convertible bonds and fixed income which buy and sell mispriced assets have dwindled as managers chase the same opportunities.
One way to spot falling returns is to see whether the gap between the returns of the best and worst is narrowing.
"Only relative value strategies stand out as losing their potential," Watson Wyatt said. "Fixed income, statistical, convertible and merger arbitrage have all experienced lower returns or a decreasing manager spread or both."
However, Watson Wyatt thinks that global macro funds -- those which make directional bets in stock, bond, currency and commodity markets on the basis of economic trends -- have a much larger territory to play in and fewer capacity constraints.
They estimate hedge-fund activity represents about 1.5 percent of total stock-market capitalisation and about 10-30 percent of all equity trading.
"But this by no means make them dominant ... Hedge funds follow many strategies in the equity markets, which means that a particular niche is less likely to be crowded," the report said.
BEST AND WORST
The job of finding the best hedge funds for institutional investors such as pension funds has mainly fallen to funds of hedge funds, who undertake the due diligence and monitor the business and investment risks.
A survey of 18 funds of hedge funds carried out by Watson Wyatt found the return spread between the best and worst managers had narrowed and that absolute returns had fallen.
"We estimate that our top-rated fund of hedge fund managers account for roughly 8 percent of the market," the report said.
"Taking only our estimate of the assets of highly skilled hedge fund managers -- $225-$450 billion, these funds of hedge funds would account for about 15-30 percent of the top talent."
Watson Wyatt questions how much growth can be sustained without manager quality falling and said there is not much spare capacity available from existing managers. "Most of the capacity for fund of hedge funds will come from new managers," it said.
But given strong demand and assuming $50 billion of extra capacity a year with highly skilled managers, Watson said there was a limit to the growth of fund of hedge funds.
"We believe funds of hedge funds will run into portfolio management issues as they grow, similar to those that affected the traditional balanced managers," the report said.
"Looking ahead, we believe that a return of Libor plus 4-5 percent per annum -- net of fees -- is a reasonable expectation for a highly skilled fund of hedge fund manager that manages growth well."
That is probably enough to make a case for investing in funds of hedge funds.
Watson Wyatt used the example of an average portfolio with a 50 percent allocation to bonds and 50 percent to stocks. "A five percent allocation to hedge funds from equities would require a return ahead of cash of 2.5-3.0 percent per annum to improve the efficiency in the portfolio."
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Wed Mar 23, 2005 03:23 PM ET
By Pratima Desai
LONDON, March 23 (Reuters) - A shortage of talent and too much money in some hedge-fund strategies means future returns could disappoint investors, but the case for investing in them is still intact, consultants Watson Wyatt said in a report.
That was because hedge funds were still likely to return enough to improve the efficiency of an institutional portfolio.
"We believe that there is still room for them (returns) to come down from historic levels before the case for investing in hedge funds is no longer supportable," the report said.
Institutional investors have piled into hedge funds since the 2000 equity market crash, looking to diversify from traditional assets, preserve capital and seeking absolute returns instead of relative returns based on benchmark indexes.
Watson Wyatt estimates that out of around 6,000 hedge fund managers, only 5-10 percent are highly skilled and able to add significant value after deductions of fees, however.
Hedge funds normally charge annual management fees of 1-2 percent and performance fees of up 20 percent.
Analysts estimate hedge-fund assets have doubled to around $1 trillion since 2000 and that average returns slipped to around 9 percent last year from more than 15 percent in 2003.
Large inflows mean returns in strategies in convertible bonds and fixed income which buy and sell mispriced assets have dwindled as managers chase the same opportunities.
One way to spot falling returns is to see whether the gap between the returns of the best and worst is narrowing.
"Only relative value strategies stand out as losing their potential," Watson Wyatt said. "Fixed income, statistical, convertible and merger arbitrage have all experienced lower returns or a decreasing manager spread or both."
However, Watson Wyatt thinks that global macro funds -- those which make directional bets in stock, bond, currency and commodity markets on the basis of economic trends -- have a much larger territory to play in and fewer capacity constraints.
They estimate hedge-fund activity represents about 1.5 percent of total stock-market capitalisation and about 10-30 percent of all equity trading.
"But this by no means make them dominant ... Hedge funds follow many strategies in the equity markets, which means that a particular niche is less likely to be crowded," the report said.
BEST AND WORST
The job of finding the best hedge funds for institutional investors such as pension funds has mainly fallen to funds of hedge funds, who undertake the due diligence and monitor the business and investment risks.
A survey of 18 funds of hedge funds carried out by Watson Wyatt found the return spread between the best and worst managers had narrowed and that absolute returns had fallen.
"We estimate that our top-rated fund of hedge fund managers account for roughly 8 percent of the market," the report said.
"Taking only our estimate of the assets of highly skilled hedge fund managers -- $225-$450 billion, these funds of hedge funds would account for about 15-30 percent of the top talent."
Watson Wyatt questions how much growth can be sustained without manager quality falling and said there is not much spare capacity available from existing managers. "Most of the capacity for fund of hedge funds will come from new managers," it said.
But given strong demand and assuming $50 billion of extra capacity a year with highly skilled managers, Watson said there was a limit to the growth of fund of hedge funds.
"We believe funds of hedge funds will run into portfolio management issues as they grow, similar to those that affected the traditional balanced managers," the report said.
"Looking ahead, we believe that a return of Libor plus 4-5 percent per annum -- net of fees -- is a reasonable expectation for a highly skilled fund of hedge fund manager that manages growth well."
That is probably enough to make a case for investing in funds of hedge funds.
Watson Wyatt used the example of an average portfolio with a 50 percent allocation to bonds and 50 percent to stocks. "A five percent allocation to hedge funds from equities would require a return ahead of cash of 2.5-3.0 percent per annum to improve the efficiency in the portfolio."
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# posted by Tom @ 2:30 PM 
