There’s an interesting analysis out of Europe, titled Capacity in the hedge fund industry. The firm Watson Wyatt asks "Can the hedge fund industry maintain quality while continuing its current rapid pace of growth?"

This is a potentially significant issue for investors — even non-hedge fund investors — if for no other reason than Hedgies have become such a dominant factor in day-to-day trading:

"The past two years have seen huge inflows of money into hedge funds, particularly from institutional investors in search of alpha. Successful investment in hedge funds is about accessing highly skilled managers. Average managers do not produce acceptable returns after allowing for fees, and this is particularly true in the hedge fund industry.

But skill is not available on demand. The more money that flows into hedge funds, the more crowded will be the trades and strategies that many hedge funds rely on for their superior returns. It follows that returns in some strategies are likely to suffer."

This raises an issue, we do not too often hear (or read) discussed when the subject of Hedge Funds comes up. Simply put: How many of the 8,000 so-called hedge funds are truly hedge funds? How many are little more than lightly capitalized, over-leveraged day trading outfits, who are frenetically swinging cash around ?

In my experience, the answer is a lot less than that 8,000 number. Indeed, I suspect it is probably less than 10%. That’s an order of magnitude less than what is commonly believed.

We may have a media created myth in the making.

How do I reach this conclusion? The vast majority of the funds I come across are smallish affairs, one or two man shops, with a few million under management. $5, 10, 20 million dollars after a few years of operation. Successful day traders who may have taken on limited partners. In years goneby, they might have been Floor Brokers who went upstairs, or Traders affiliated with other firms. More recently, they were successful SOES bandits or day traders. Today, they swing a few million shekels around, many of them chasing the same IM-relayed rumors as the rest of the street. 

What do I consider a true hedge fund? Outside of the startups (less than 1-2 years old), a serious Hedge fund is any limited partnership managing $100 plus million dollars, putting a well-defined strategy into effect. That’s a considerably smaller percentage of the 8,000 or so funds we hear about all the time.

Consider this point: The Watson Wyatt study looks at how many skilled managers there are relative to all the assets pouring into the hedge fund arena:   

"We estimate that some 5-10% of current hedge fund managers are highly skilled (by which we mean able to add significant value after fees). This means that 300-600 highly skilled managers exist, out of the 6000 or so that are currently operating. Assuming that each of these can manage $1 billion on average, and that three-quarters of this capacity is already spoken for, then $75-150 billion of spare capacity remains with these managers.

However, in 2004, the hedge fund industry grew by around $200-$250 billion. It is possible to conclude that investing with highly skilled managers will become increasingly difficult at the current rate of demand given the limited capacity."

So that 8,000 or 6,000 number is most likely less than 1,000.

Fascinating stuff . . .

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Source:
Capacity in the hedge fund industry 
Watson Wyatt Worldwide
http://www.watsonwyatt.com/europe/topics/htrender.asp?ID=15213

Category: Investing

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9 Responses to “The Myth of the Hedge Fund”

  1. Yet another reason why the time is almost ripe for the various new kinds of futures markets people are talking about.

  2. In their halcyon days, Hedge funds thrived off secrecy.

    The more enshrouded in secrecy they were, the higher the returns for their investors.

    I think the mainstream media has it right, here — the more hedging “strategies” are divulged (to the masses), the less key players will be able to exploit them…

    The days of pure play hedge funds are over.

    One quick illustration: your average mutual fund can short stocks if you want it to.

    I think this could easily play out into a more serious, long term trend.

    Bottom line:There is simply too much money chasing too few good ideas; naturally, investors will pursue whatever can give them an “edge.”

    Right now, the road leads to hedgeville.

  3. wcw says:

    This fits in with the dandy article in the JPM a few years ago entitled, charmingly, “Do Hedge Funds Hedge?”

    By the simple strategem of regressing hedge fund universe returns against lagged index returns, the paper found that in the aggregate the answer is, bluntly, “no.” As the abstract concludes, “When the authors apply standard techniques…they find that hedge funds in the aggregate have significantly more market exposure than simple estimates indicate. Furthermore, after accounting for this increased market exposure, they find that taken as a whole the broad universe of hedge funds does not add value over this period.”

    The way I see it, there are hedge fund guys (as well as private-equity and VC guys) who are so good, they are worth their fees. One in twenty sounds about right. The morass is adequate to mediocre, but they can retain at least some assets because the evidence of their lack of skill is swamped by the effects of luck, timing, the aforementioned stale-pricing problems and other opacities endemic to the industry.

    However, since large pools of money are only just getting around to the realization that alpha should be expensive, but beta nearly free, I have no great confidence that the hedge fund industry is likely to shed its dead weight any time soon.

    If I were greedier, ambitious and amoral, I’d start a whole string of hedge funds. It’s free money for managers who can gather a few assets until folks finally figure this out.

  4. HBT says:

    to underscore BR’s comment that most of the 8000 or “hedge funds” are micro-capitalized &/or day-trading outfits, it is important to note that of the $1Trillion under management in the hedge-fund industry, three-fourths of that is managed by only the 238 biggest funds ! ( I think I may have read that on this blog?)

  5. HBT says:

    I haven’t posted here in months & now I am contributing to this non-issue… twice … but here goes:
    below is a press release from EDHEC which contradicts describing one of the studies BR quotes from above…

    Much Ado about Nothing: There is absolutely no proof of a ‘capacity effect’ in the hedge fund industry

    EDHEC Business School Lille, Nice, France
    Press Release

    Nice, June 16, 2005:

    In a study entitled “The Right Place for Alternative Betas in Hedge Fund Performance: an Answer to the Capacity Effect Fantasy”, the Edhec Risk and Asset Management Research Centre contradicts the conclusions of two recent reports on the capacity effects in the hedge fund industry:

    •“The Critique of Pure Alpha”, Alexander M. Ineichen, UBS Investment Research, March 2005
    •“Capacity in the Hedge Fund Industry”, Watson Wyatt LLP Investment Consulting, March 2005

    These reports postulate that the essential part of hedge fund performance comes from the intervening parties’ capacity to take advantage of market anomalies (pure alpha strategies). The increase in volumes, so the argument goes, would render arbitrage more difficult on the one hand, and on the other, the influx of managers would be lowering the level of expertise and talent in the industry.

    For Edhec, this approach to hedge fund performance in terms of pure alphas has not been proven, and it would be more appropriate instead to consider that it is the betas and the managers’ capacity to take properly rewarded risks that contribute to the essential part of their performance. In our analysis, only 25% of the variability in the returns of hedge fund strategies is due to pure alpha (i.e. security selection) and pure alpha accounts for less than 4% of the returns of hedge fund strategies!

    Alternative investment alpha is linked more to a capacity to time risk factors correctly than taking advantage of market anomalies. No microeconomic study has proven that the positions taken by hedge funds are so significant in certain market segments that they would durably prevent them from making profits.

    Most contributions on the capacity effect evoke short-lived and intermittent “cornering” phenomena and are based essentially on an observation of poor overall performances that do not distinguish between the beta effects (degradation of factor premiums or returns) and the alpha. Moreover, one should note that the low number of observations on which hedge fund performance statistics are based mean that they are neither representative nor statistically significant.

    Finally, it is appropriate to recall that the statistics published by the Centre for Economics and Business Research in its briefing of May 18 are not confirmed by an exhaustive approach to the incidents of debt repayment in the alternative industry either. The 20% of hedge funds for which closure is predicted in the next two years are not bankrupt funds, but funds that have ceased their activities, notably because the investors were not satisfied with their performance. This selection of managers by the market is a natural and virtuous phenomenon. Interpreting it as a major difficulty and equating “natural” closure with bankruptcies that are liable to provoke a crisis in financial markets neither complies with the elementary rules of scientific prudence nor is it relevant in relation to industry practices.

    Contact: For more information, or to receive the study cited above, please contact: Carolyn Essid – Tel.: +33 (0)4 93 18 78 24 – E-mail: carolyn.essid@edhec-risk.com or visit our web site: http://www.edhec-risk.com

    About Edhec

    http://www.hedgefundcenter.com/wrapper.cfm?article_type=academic&content_id=640&content_type=articles&aff_id=0

  6. cm says:

    I know an anecdotal story from somebody writing automated real-time trading software for an investment house. They are limiting their exposure in specific markets supposedly not because of risk control, but because they want to operate at the margin of the market, not become the market itself, as their strategies won’t work when they are too big.

  7. nate says:

    did you see the article on Buffett on the cover of the most recent wknd WSJ? I know Buffett is not exactly a “hedge fund” person. Buffett is not exactly a trader either. He is more of a long-term investor.

    Anyways, you should read the article on Buffett. He has one very lean organization. He does not have a super-rigid “plan” or formula.

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