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Saturday October 20 2018
 
Funds of the Future

Financial Times August 9, 1999

by Daniel Bogler

 

      Could hedge funds become the mutual funds of tomorrow, a routine part of every investor's portfolio? Given their secrecy, perceived volatility and the bad press they have received over the past two years, that might seem unlikely. In fact, it is already starting to happen.

 

      The huge rise in Western stock markets this decade has left investors with a problem, albeit a nice one: where to put their money. In the US alone there are more than 2m high net worth individuals - the principal investors in hedge funds, who have the required $1m in investable assets. Together, they have more than $5 trillion of financial assets, Institutions, including pension funds and insurance companies, are in charge of another $10 trillion.

 

      These investors are becoming more sophisticated and thus increasingly willing to put money into "alternative investments" such as hedge funds in their search for market-beating returns.

 

      Because hedge funds can sell short, use leverage and take concentrated positions, they can produce those superior returns. Admittedly, they bear higher risks. But demographics is on their side as wealth passes from the conservative post-war generation to more risk-friendly Baby Boomers.

 

      These factors have fuelled growth in hedge fund assets from $20bn in 1990 to more than $170bn by 1996, according to a study by KPMG and RR Capital Management, a New York hedge fund. It predicts a further ten fold rise to $1,700bn by 2006. Meanwhile, the number of funds has risen from fewer than 500 to more than 2,500 in five years.

 

      But this has done little to modernise the industry. As private investment vehicles, hedge funds are exempt from many basic regulatory requirements, giving their managers broad discretion and little incentive to inform investors, whose money can be locked up for several years.

 

      While the top 15 per cent of funds, including George Soros' Quantum group and Julian Robertson's Tiger Management, control 80 per cent of managed assets, many are closed to new investment. Most funds are local, niche players with assets of less than $100m. Yet all carry their own marketing and support structures.

 

      This will change, according to Rama Rao, chief executive of RR Capital Management and co-author of the report. He predicts that sophisticated investors will put pressure on hedge funds to transform themselves into a global, institutionalised industry.

 

      "Hedge funds are now where mutual funds were in 1980, just before growth and consolidation took off," Dr Rao says.

 

      Promisingly, the US Securities and Exchange Commission now allows hedge funds to update investors on their performance over their web sites, more or less in real time, replacing outdated quarterly reports, It has also relaxed its rules to allow 499 investors in a limited partnership, the most common hedge fund structure, up from 99 two years ago. As transparency and accountability increase, however, so will competition, making it harder for small funds to justify their administrative overheads.

 

      Dr Rao predicts this will lead to the evolution of "families of hedge funds", where a group of funds with complementary strategies is run by one central operation. These families will look very similar to the big mutual fund houses.

 

      A number of caveats spring to mind. The near-collapse of Long-Term Capital Management will have put many people off hedge funds for good and has sparked talk of stricter regulation. It is also questionable how well these funds, many with short track records, would perform in a bear market.

 

      Having said that, research by Matthias Becker at St Gallen University in Switzerland suggests long-term performance of hedge funds averages between 17 and 20 per cent comparable with recent gains by the US stock market but above long-range nominal equity returns of about 10 per cent.

 

      The quid pro quo is higher risk of course, though they can actually help diversify an investor's portfolio, thus reducing overall volatility. You may not be comfortable investing in hedge funds, but your children probably will.


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