The Myth of the Hedge Fund

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 . . .


Capacity in the hedge fund industry 
Watson Wyatt Worldwide

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