Notwithstanding significant investments in hedge funds by California Public Employees Retirement System and General Motors Investment Management Co, pension plan remain reluctant to invest in hedge funds, despite interest in other alternative investments like private equity.
A full three quarters of those plans that don’t currently have exposure to hedge funds are not even considering future investment, perhaps deterred by the risk of a repeat of Long Term Capital Management, the report concludes.
Fund of funds currently invest $100 billion in hedge funds, or about 20% of the industry’s $450 billion in assets, but only a quarter of that comes from institutional investors. The remainder still comes from high-net worth investors.
However, the study projects that the market will grow by 20% over the next two to three years, barring a market shock or the collapse of a major hedge fund.
Declining Market Inefficiencies
Following this period of growth, the inflows of new money into these vehicles will reduce the potential for profit and dampen the appeal of funds of hedge funds, the report continues. In addition, more and more financial services firms will be entering this arena, driving up the supply of these vehicles.
Barra expects the fees that fund of hedge funds levy to remain steady, since as long as they outperform stocks and bonds, demand for fund of hedge funds will continue to outpace supply, placing upward pressure on the fees.
The report also predicts a consolidation among fund of hedge fund managers, reasoning that as hedge-fund investors become more sophisticated, their expectations will increase in terms of:
- screening the underlying managers,
- constructing a portfolio, and
- monitoring the portfolio risk
The increasing cost of running the business will make it necessary for providers to scale up to be profitable.