Report Suggests Diversification Will Drive Down Hedge Fund Returns

by Phillip Morton, Investors Offshore.com

06 November 2007

Worldwide, 40% of fund managers have diversified into long only funds and 30% into alternatives in the last three years, causing convergence in investment strategies used in different sectors in their industry. However, in cash terms alternatives have attracted larger sums, according to a new study published by KPMG International and CREATE-Research.

The report shows that as hedge fund managers and private equity firms have fuelled competition by promising absolute returns that are not correlated to conditions in the financial markets, long only managers have responded by offering products that mimic the returns offered by their new competitors.

“As a result, their respective returns are converging, as are their back office infrastructures. The ensuing competition is driving out mediocrity, squeezing the margins and institutionalising the alternatives” explained Amin Rajan, the study’s principal author and chief executive of CREATE-Research.

However, such convergence is far from uniform, according to two groups who participated in the study’s three global surveys: 310 fund managers and pension funds with US$28 trillion of funds under management; and 48 administrators with US$38 trillion of funds under administration.

“Within each sector, managers have fallen into one of three groups which can be characterised as: purists, who have stuck to their core capability; pragmatists, who have diversified; and procrastinators, who have considered change without actions,” observed Anthony Cowell, the report’s co-author and partner at KPMG in the Cayman Islands.

According to the report, while pragmatists are doing new things by changing the boundaries of their sector, the purists appear to be doing old things better. Thus, convergence and divergence are reshaping today’s investment universe, helping to generate all-round benefits. For investors, this process has delivered better returns and access to all-weather portfolios. For their fund managers, it has delivered improved profitability and enhanced ability to attract, retain and deploy top talent.

However, the report argues that the pace of convergence will slow down, especially in the long only sector, as the current credit crunch creates a flight to quality and simplicity. For alternatives to retain the dizzy growth of the recent past, they will have to do two things: deliver absolute uncorrelated returns, and deliver a new generation of customised structured finance products with capital protection and full transparency.

“Such investors want to see a good housekeeping seal of approval via more standardised products, more stress testing, more transparent pricing of illiquid assets, more independent audits and more independent administration” added Gordon Rajamohan, the report’s co-editor and Senior Manager at KPMG in the Cayman Islands.

The report shows that the role of third party administrators is set to grow in middle office activities like asset valuation, performance attribution, performance monitoring, risk, and compliance. Their industry will continue to consolidate in order to accommodate large scale investment in upgrading the old infrastructure of systems and skills alike. Further institutionalisation of alternatives is likely to enhance the role of large multi-service administrators, leaving the niche players to serve the start-ups and independent boutiques.

The study concludes that the combination of convergence and the prospect of a bear market will help to accelerate the pace of industry-wide M&As in pursuit of investment talent and market position. The pace will be set by large players among long only managers, investment banks, hedge fund managers and private equity firms, seeking to strengthen their positions inside and outside their core areas of expertise. The boundaries between asset classes will become increasingly blurred as clients continue to demand a complete separation between returns generated by market movements and those delivered by managers’ skills.

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