Hedge funds are not the money magnets they once were. While they continue to take in funds, they’re not doing it as fast as they once did.
Last year, the $1.1 trillion hedge fund industry increased their inflow by just 4 percent, or $40 billion. That’s well down from the 19 percent increase in 2004 and further still from the record 34 percent three years earlier.
Some investment advisors, once committed to hedge funds, have begun to lose interest in the soon-to-be regulated investment vehicles. “We had been heavily involved in hedge funds,” says Sandi Bragar, a principal with San Francisco, Calif.-based registered investment advisor Kochis Fitz. “But we’ve moved away from that. There are a lot more players and a lot of competition, which has eaten into [hedge fund] profits. So we’re looking more towards the private equity end of things.” The expenses involved also cut too deep into the after-fee rates of return that the firm seeks for its clients, she adds.
Hedge funds still outperformed the broader equity market in 2005. The Hennessee Hedge Fund Index rose 8.03 percent in 2005 versus a 4.9 percent gain on the S&P 500. But that’s well below the double-digit returns investors got accustomed to in the 1990s. And for many, single-digit returns can’t justify the kinds of fees that many hedge funds charge: 2 percent on assets and 20 percent of profits. There are two reasons for the sagging performance numbers, says Geoffrey Bobroff, president of Bobroff Consulting in East Greenwich, R.I. One is the influx of new managers into the business, while the other is flat financial markets. “We’ve gotten a lot of managers entering the hedge fund business, and when that happens, the overall performance tends to sag, the reason being that they’re not all competent hedge fund managers.” The overall returns may actually be worse than what’s reported. When hedge funds blow up or fail, they close shop, which means their returns aren’t reflected in overall industry numbers. In the first nine months of 2005, some 484 hedge funds closed their doors, which, according to Chicago-based Hedge Fund Research, is an attrition rate of 6.5 percent. That’s well above the prior year’s 267 closures.
Still, it would be a bit premature to write off all hedge funds. They “have a legitimate place in the market place,” says Bobroff. “If we are in 15- to 17-year cycle of low returns, hedge funds may still be the best alternative, but people may need to ratchet down their expectations.” If a manager can still produce a 20 percent return in a 5 percent return environment, the fees may be worth it, he says. For those doing less, there may be pressure on fees, he says.
One promising note for the future: younger baby boomers seem to favor hedge funds, private equity and other alternatives investments more than older boomers. According to a 2005 Spectrem Group survey of 1,000 investors with at least $500,000 to invest, those in the 40- to 45-year old age group hold a greater percentage of alternatives than those over 45. As these younger boomers move into the prime earning years, they may put more of their money into hedge funds, and it is the wealthy that are the biggest market for hedge funds.
Data from Hennessee Group show that wealthy individuals and family offices account for some 44 percent of the $1.1 trillion invested. Fund of funds are the next biggest investors in the business, accounting for 28 percent.
Arbitrage and event-driven funds saw net assets grow 12.2 percent in 2005, while average returns were around 5.3 percent, as measured by the Hennessee Arbitrage/Event Driven Index. Long/short equity funds notched net asset growth of 11.5 percent for the year, and the Hennessee Long/Short Equity Index advanced around 7.0 percent.
Though the hedge fund industry continues to grow, it is still just a small part of the U.S. equity and bond markets, which combined comprise over $28 trillion.