efficient markets leave fund managers fewer opportunities to add value
The hedge fund universe has expanded substantially since the start of the millennium. During the three-year equity bear market period between March 2000 and March 2003 leading funds of hedge funds (FoHFs) consistently produced positive returns while many equity long-only investors were experiencing losses of 30%-40%.
Demand for hedge funds began to pour in from wealthy private clients and intermediaries. This increase in demand was matched by the launch of many new hedge funds.
Between 2000 and 2004, the number of new managers grew at a rate of 20%-25% each year. That resulted in the universe of hedge funds doubling over the period.
Martin Harrison, client director at GAM, said: "It is now widely recognised that including hedge funds within a portfolio of traditional assets, such as equities and bonds, can significantly improve risk-adjusted returns.
"But achieving the best results depends on careful fund selection and sizing of these funds within an investment portfolio. For instance, a well constructed portfolio should not just include equity hedge funds but also trading and arbitrage funds, which perform quite differently."
"The hedge fund universe has changed significantly over the past 15 or so years, with numerous new strategies and sub-strategies having been developed. In 1990, macro hedge funds accounted for more than 70% of the hedge fund universe, but this type of fund now accounts for only about 10% of hedge funds. At the same time, equity hedge now accounts for more than 30% and arbitrage strategies 12%."
He added that with the rapid growth in the number of hedge funds, it is becoming increasingly difficult to find the winners. GAM's FoHF team believes there are some 6,500 hedge funds in existence, although other groups report even more.
"Assets under management in the hedge fund industry have grown from $39bn in 1990 to $1.2 trillion in 2006 and funds now number more than 14 times what they were," he said.
"Despite this significant growth, the proportion of managers adding significant value probably hasn't changed. So, while there are many more needles, the haystack is much bigger requiring much larger research teams."
Furthermore, the industry is facing its own issues. It is harder now to add value given the higher correlation across asset classes and geographies.
For instance, increasingly efficient markets mean it is becoming more difficult for hedge fund managers to find good arbitrage opportunities.
Data from 2000 to 2006 shows there has been compression of hedge fund returns, making construction of a truly diversified portfolio more problematic.
Harrison said: "Finding the right hedge funds is the challenge, which is why a well resourced and experienced fund of hedge fund team is important in identifying funds." key points
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