GLOBAL - Hedge fund returns are likely to suffer from the growing influx of money into the market, warns Watson Wyatt.
In its new report – Capacity in the hedge fund industry – the consultant said the more money that flows into hedge funds, the more crowded the trades and strategies that many hedge funds rely on for superior returns will be.
Watson Wyatt said last year’s “disappointing” hedge fund performance could indicate this trend is already in place, although the consultant noted low volatility and a dearth of the major market dislocations that hedge funds thrive on also contributed to the lower returns.
“It is our belief that more participants trying to make money in the same market in a similar style will eventually limit return potential,” Watson Wyatt said. “In our view, opportunities do still exist in most areas – in particular equity strategies and macro trading.”
According to the report, hedge funds follow various strategies in the equity markets, meaning a particular niche is less likely to be crowded. Macro traders exploit a range of markets, including derivatives, providing vast territory.
“Conversely, we see fewer opportunities in strategies such as convertible bonds and distressed debt,” Watson Wyatt noted. “Hedge funds now dominate the convertibles market (70 – 90%), so a manager needs to be highly skilled to squeeze returns ahead of fees out of this category.”
Despite the expected drop in returns, Watson Wyatt maintains there is still a case, although less compelling than before, for pension funds investing in high quality, core multi-strategy FoHFs.
“We believe pension funds that are looking to invest directly in hedge funds should focus on less capacity constrained strategies such as long/shore equity,” the report said. “These may be more volatile, but we believe that most clients are able to take a little more volatility in their hedge fund allocations.”
On manager skill, Watson Wyatt concludes that investing with highly skilled managers will become increasingly difficult at the current rate of demand given the limited capacity. As for fund of hedge funds (FoHF), the preferred route into hedge funds for most institutional investors, the firm questioned how much growth could be sustained going forward without manager quality declining.
“Looking ahead we believe that a return of Libor plus 4-5% pa (net of fees) is a reasonable expectation for a highly skilled FoHF manager that manages growth well,” the report stated. “This compares with historic returns from our top rated FoHFs in the region of Libor plus 6% pa.”
Watson Wyatt said it believes highly skilled hedge fund managers are here to stay – the concern for pension funds is how to successfully access this pool of talent.
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