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Hedge Fund Sector Reaching Early Maturity

7 October 2005

Hedge Fund Sector Reaching Early Maturity

- Hedge funds transforming the investment landscape
- Shortages of prime capacity developing

As a way of achieving out-performance, the recent unprecedented surge in the demand for hedge funds will ease as the industry commoditises, according to a study published by KPMG International.

The study presents the views of 550 top executives in 35 countries, including New Zealand, involved in hedge funds, their administration, prime broking, mainstream fund management and pension funds; with combined assets worth US$ 23 trillion.

It shows that the worldwide growth in hedge funds has been fuelled by the prolonged bear market and the inflow of top talent capable of generating high returns. Their impact has been petering out at the time when the number of start-ups has increased considerably.

The KPMG report finds that the quality of the resulting capacity is highly variable. Most of it is, as yet, incapable of generating the high double digit returns that investors are led to expect. At the front end, the biggest risk is poor returns; at the administration end, it is mis-pricing of complex products.

In presenting the results to various New Zealand mainstream fund managers, Bill Wilkinson, partner financial services said “the results for New Zealand were very similar to those in the global survey”.

The study predicts that the next wave of new money into hedge funds will come from pension funds that have so far adopted a wait and see attitude. Those in the USA are likely to have bigger allocations than their peers in Europe and Asia Pacific because of their superior in-house expertise and oversight controls. Worldwide, allocations will be small: less than 3 percent of total investments on average. But the sheer weight of new money should commoditise hedge funds and drive down high charges and fees.

Indeed, the study found that hedge fund managers and mainstream fund managers are already diversifying into one another’s product areas, using similar investment strategies and boutique structures that overtly separate high and low return products. Hedge funds are, thus, no longer the only means of achieving high absolute returns in today’s low volatility environment.

“Gaining huge prominence in the bear market, hedge funds will outlast it; as will their top managers. As a catalyst, they have started a chain reaction that extends across the global fund management industry. They have forced mainstream fund managers to go back to their time honoured mission to provide absolute returns.” said Mr Wilkinson.

The study predicts that the hedge funds industry will consolidate over the next three years because of a wide margin of under-utilised capacity, at the manufacturing, distribution and administration end.

For hedge fund managers, consolidation is likely to occur mainly via high attrition since they run lifestyle businesses which are hard to value. For fund managers, in contrast, it should occur via mergers and acquisitions; and for administrators via acquisitions by global banks diversifying into prime broking and back office services.

The study concludes that the contours of the fund management industry will change by 2010. If hedge funds are to retain their current uniqueness in it, their managers will constantly have to invent new ways of generating high returns. Those who do not, may either pale into the emerging mosaic or become victims of the creative destruction which they sparked off in the first place.

ENDS

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