LONDON -- Hedge funds could become victims of their own success.
Advisers are warning the potential surge in institutional investment in this asset class could test the ability of many hedge funds to generate returns. The larger a hedge fund becomes, the less nimble it is and the more likely returns could be sacrificed.
The problem could be particularly acute for investors in Europe, where the range of hedge fund strategies is limited compared with the United States, said Patrick Harrigan, managing director of fund-of-funds group Oxford Advisers Ltd., Grand Cayman, Cayman Islands.
Consultants and managers recommended institutions consider using fund-of-funds structures diversify and reduce capacity risks.
In the past 18 months European pension plans with exposure to hedge funds have been increasing their allocations. And cautious investors with no hedge fund holdings have begun making inquiries in the hope of improving returns in the face of dismal performances from both bonds and equities.
A recent survey by Watson Wyatt Worldwide, Reigate, England, and Indocam Asset Management, Paris, predicted investments by European pension funds in alternative assets such as hedge funds could reach $11 billion by 2003. The total amount invested in alternatives by the second quarter of this year was $1 billion.
Mr. Harrigan believes European pension funds could invest as much as 5% to 10% of total assets in hedge funds over the next few years. Initial allocations are likely to be small, at 1% to 3% of assets, but would increase as plan sponsors became used to the asset class, he said.
But Giovanni Beliossi, senior quantitative analyst at First Quadrant Ltd., London, warned that even an average allocation to hedge funds of 2% to 3% would be double current levels and could cause capacity problems for some hedge funds.
Unlike traditional asset managers whose fees are based on assets under management, a large chunk of the hedge fund management fee is related to performance. And for hedge funds, there often is a direct link between the size of assets, market liquidity and performance.
"Past a certain level of assets, hedge funds can lose their nimbleness," said Mr. Beliossi. Their inability to execute trades swiftly can seriously affect investment returns.
As inflows to hedge funds increase, opportunities for pension plans to invest in them may shrink as the funds close to new money when they become too large to be managed effectively.
Mr. Harrigan said the capacity problem had been acute this year as investors, dissatisfied with poor returns from traditional markets, moved into hedge funds to gain exposure to strategies uncorrelated to the equity and bond markets.
"We feel capacity is a major issue at the moment," said Mr. Harrigan. And he has seen it first hand.
Lack of capacity
He warned that the lack of capacity at established hedge fund managers might see institutions invest prematurely with newly established hedge funds. Many of these new managers have performance track records of no more than 18 months and have not been tested under crisis conditions, such as those experienced during the third and fourth quarters of 1998.
"Investors have been forced to use managers a lot earlier than they had wanted," said Mr. Harrigan.
But capacity depended very much on the asset class.
"There is no level of size that is good for all hedge funds," said Mr. Beliossi. Equity futures on markets such as the FTSE or the Dow Jones tend to be very liquid and relatively large positions can be traded. Currency markets also were relatively liquid and hedge funds with strategies in these markets may have greater capacity to manage larger amounts of assets.
But getting a diversified exposure to a range of hedge fund strategies could be hard. Among most European hedge fund managers, only a few styles are offered compared with the United States. Styles offered in Europe typically have been long-short equity and merger arbitrage strategies.
Short-only, statistical arbitrage, volatility arbitrage and more complicated futures-oriented strategies common in the U.S. are rarely seen in Europe, said Mr. Harrigan.
"If you are using just European money managers you are limited by their styles and strategies," he said.