Research shows rumors of capacity problems are greatly exaggerated

NEW YORK — Despite hype to the contrary, new research finds that hedge fund managers should have at least 30 years of comfortable growth and plenty of spare capacity now.

Citigroup Alternative Investments, New York, recently completed a study, "How Large Could the Hedge Fund Industry Grow? An Analysis of Equity Short Constraints and Industry Capacity." The study's authors are Ryan Meredith, vice president/senior research analyst, and Vineet Budraja, vice president research, at Citigroup Alternatives; Tanya S. Beder, chief executive officer of Tribeca Global Management LLC, a Citigroup subsidiary; and Rui de Figueiredo, associate professor at the Haas School of Business, University of California at Berkeley.

The study notes "the rapid growth of hedge funds as an asset class has inevitably created concerns about just how large the total market can become and whether capacity constraints in either the overall market or in an individual strategy can affect performance."

The Citigroup analysis focused on possible constraints in the market for short equity sales. "Because short sales are an important tool that many hedge fund managers use to capture value, understanding how constrained this instrument is, provides guidance regarding how large the total market can become," said the authors.

While the size of the short-selling market is finite and subject to supply and demand interplay, the Citigroup team also noted that hedge fund managers are not the only ones who short stocks. Other users include institutional investors, individuals and both flow and proprietary traders, who use shorting to speculate or to hedge trading exposures.

The researchers estimated the amount of current and future shorting by hedge fund managers in six equity strategies: convertible arbitrage, long-short, market-neutral, global macro and merger arbitrage. Using data from Hedge Fund Research Inc., Chicago, as of year-end 2004, the researchers calculated that assets under management in these strategies was $476 billion, that the average leverage of the invested capital is about 154%, and that the average level of short equity exposure in these six strategies is about $176 billion.

Based on year-end 2004 data, the Citigroup team estimated the total U.S. equity market to be about $13.8 trillion, of which $3.5 trillion was covered by Nasdaq. Using Nasdaq data on shares sold short, the researchers estimated the total amount of direct shorting in the U.S. market was $440 billion, or 3.2% of the U.S. market. Therefore, hedge fund shorting of $176 billion accounted for about 40% of the overall market for short shares in the U.S.

Assuming asset growth of 24% per year for the hedge fund industry, the Citigroup analysts estimated that at the current level of shorting, hedge fund managers would completely dry up the market for direct short selling in five years.

Since many hedge fund managers use synthetics to get short-selling exposure, by adding in over-the-counter equity forwards and swaps and equity options, Citigroup researchers estimated that hedge fund managers in the U.S. would not exhaust the market for 14 more years, even if the shorting market doesn't grow.

And since hedge fund managers short not only individual securities, but also broader indexes through equity index options and futures, the study found that by adding in this additional capacity, hedge fund managers now account for only 0.2% of the overall short market ($78.4 trillion total) and would not exhaust the market's shorting capacity for nearly 30 years.

Using a less theoretical approach, researchers at the Risk and Asset Management Research Centre of the EDHEC Business School in Lille, France, surveyed 183 hedge fund professionals from May to July to gauge whether they are worried about capacity affecting performance of individual hedge funds.

A majority — 65% — said they are confident about the future of the hedge fund industry and said they expect assets to grow at a minimum annual rate of 10% in the next five years.