Hedge Funds' 2004 Windfall Could Be Problematic

January 22, 2004 (PLANSPONSOR.com) - Hedge funds may become a victim of their own success in 2004, a new research report asserts.

According to a Greenwich Associates study, hedge funds could be hit with at least $250 billion in new assets as institutional investors up their allocation from the current less than 1% to between 5% and 7%. The problem, according to Greenwich, the added cashholds the potential to disrupt the industry by increasing competition for arbitrage opportunities and by renewing demands for transparency and fee-structure reform.

“Greenwich research suggests that hedge funds will experience rapid and continued growth as pension funds increase their allocations to the asset class,” Greenwich Associates consultant Woody Canaday said in a news release. “But the fact is that trees do not grow to the sky, and the industry could soon be facing some major questions.”

Greenwichsaid part of the industry’s dynamic comes from the fact that pension funds have started to play a much greater role in hedge funds – formerly largely the domain of wealthy individual investors and foundations/endowments. “Pension funds, with their enormous resources, have started to allocate significant amounts of money into hedge funds, and they are planning to put in huge amounts.” Greenwich Associates consultant Frank Feenstra said in the statement.

The $11 billion currently allocated to hedge funds by US pension funds represents only one-fifth of 1% of their $5 trillion asset base. Greenwich research indicates that target allocations for these pension funds are 7% of assets for corporate funds and 5% for public funds.

Greenwichresearchers pinpointed several areas of concern for 2004. The most immediate threat to future hedge fund performance comes ironically from past success, and the resulting explosion in the number of hedge funds in the market.

This propagation could make arbitrage opportunities more difficult to find, and eye-popping returns more difficult to achieve, Greenwich warned. Since the basis of most hedge fund management is arbitrage, the growing number of managers in the market is making it progressively harder to find or create arbitrage opportunities.

If the plethora of newcomers produces subpart returns, Greenwich said investors should look towards the fees paid to the fund managers. “Our pension fund research shows that plan sponsors are expecting hedge funds to outperform equities,” said Canaday. “But that expectation is built on the brilliant past performance of some famous hedge funds, and on the hope that others will continue to discover arbitrage opportunities.”

While pension funds are universally sensitive about management fees, many of them are hypersensitive about transparency. “Most hedge funds feel their approach is proprietary,” said Canaday. “But many plan sponsors feel that they themselves have a fiduciary responsibility to dig deeply into the ways in which their beneficiaries’ funds are being invested.”

Meanwhile, Greenwich researchers said total compensation for fixed-income investors at hedge funds increased 1% year-over-year, to $473,000. On average, bonuses decreased 2% from $299,000 to $294,000, and salaries increased 6% to $179,000 in 2002. By comparison, fixed-income investors overall reported a 3% increase in average compensation, totaling $321,000 in 2002 – 32% below their counterparts at hedge funds.

Greenwich Associates interviewed 126 fixed-income investors at hedge funds and professionals at 1,032 pension funds and endowments for its latest research.